Goldman Gets Even More Skeptical On Greece And European Domino Theory

From Erik Nielsen

First of all, apologies for having been silent on a day like today with the dramatic sell-off across asset classes, but I have been in back-to-back meetings in Washington all day.

  1. To the extent today’s sell-offs were driven by Greece (and Portugal), I think it was surprising – and possibly overdone.  I am aware of two events today relating to Southern Europe:  First, S&P’s downgraded Greece and Portugal by several notches, sending Greece into junk, and there was more noise out of Germany that could be interpreted as possible trouble getting the promised money approved and disbursed.  Meanwhile in Washington, I learned nothing today that gave me second thoughts on my expectation of a bigger than previously announced program, as discussed yesterday.
  2. Neither set of today’s news can be said to be surprising.  First, while its difficult to anticipate the exact timing and extent of downgrades, it is not particularly difficult to anticipate the direction of the ratings agencies.  Like so many others, I have argued for years that the rating agencies tend to be lagging indicators of what we discuss on a daily basis, and today’s actions were no different.  And importantly, if I am right that the official sector will move to a fully funded program (as argued in my note yesterday) then the downgrades really doesn’t matter.  Greece will not have to access the market for the next year or so (assuming that the official package comes through), and the downgrades have NO impact on the eligibility of Greek securities at the ECB.  And, as I have argued in recent months, and as demonstrated  a few weeks ago, if needed, the ECB will change its rules – its of course embarrassing for them to do so in reaction to actions by the agencies, but there is no way that the ECB will be the trigger that sends Greece or its banks out over the cliff.
  3. Second, the noise out of Germany today demonstrated yet again the complexities of getting parliamentary approval for the disbursements, but we knew about this (including of the German political dilemma) – and we also know that the process is moving ahead in the other countries as well as at the IMF, and all they need by May 19 is some EUR10bn before we head into several months of smaller and smoother payments.  While it appears that the inner workings of the trio of the IMF, the Commission and the ECB missions could be better, the IMF has faced plenty of these crises in the past, and they know how to wrap up a program and get the money out in time.  I remain of the opinion that it is overwhelmingly likely that official money will indeed be released to get Greece through May.  I also continue to expect that the agreement will be announced sometime between Friday and early next week, and disbursements will follow within a week or two.
  4. What could go wrong?  In the short term, I can think of two serious risks: First, a collapse of the Greek financial system, e.g. via a run on banks.  If that were to happen, I would expect an immediate guarantee by the government and recapitalisation of the banks, as necessary, implicitly underwritten by the ECB.  Second, a sudden dramatic political shift in Greece away from the present policy towards one of confrontation with its creditors.  In that case, the international support becomes obsolete, of course, and we’ll be heading straight towards debt restructuring.  In the longer term, all the same risks that I have discussed for months remain, including the government’s ability and willingness to carry through the necessary reforms.  The required cocktail of tough fiscal measures and structural reforms aimed at restoring competitiveness has long made me think that the odds are against them making it longer term.
  5. And the domino theory?  In the short term, anybody with financing requirements can be hit by lack of liquidity, so its not inconceivable at all that the IMF will need to get ready for another Euro-zone case in coming months.  But on fundamentals, we have long argued (and continue to believe) that Greece is clearly the more exposed; Portugal is a border line case, and Spain and Italy are fine on fundamentals.  And remember that Greece is just 2.5% of (booming) Euro-zone GDP –Portugal is even less.  Also, while Greece has EUR300bn in debt, some EUR40bn is held by Greek banks, a fair amount is held by other Greek entities, and the rest by mostly European financial institutions, mostly in France and Germany; many of which are either fully or partly government owned or controlled.  I have my doubt that this is sufficient to trigger a lasting crisis much beyond the Greek (and Portuguese) shores.

Stay tuned

Erik F. Nielsen
Chief European Economist
Goldman Sachs