PSI: So What? So Yesterday

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The market has been focused on the negotiations over the private sector involvement in reducing Greece’s debt burden. The optimism that a deal would be reached shortly was one of the factors that helped the euro gain around 4 cents against the dollar in recent days. Although progress was reported over the weekend, contrary to some expectations, no agreement was reached.

Currency in Crisis



The euro zone finance ministers, recall, had rejected what the IIF said was their last best offer, a 4% coupon on the new bonds. Reports suggest it has come back and is now willing to accept a 3.75% coupon. This still is unlikely to be acceptable as the Eurogroup head Juncker had indicated a desire for a coupon below 3.5%. Moreover, the role of the dissenting private investors (hedge funds) is still unaddressed.

Yet, the PSI is so yesterday. (Which my young hip webmaster informs me is a song by Hilary Duff, you can check out the music video here). There are many moving parts and the PSI, which has dominated the market’s attention, is being superseded by other developments, even if an agreement is still not in hand.

Three Further Developments

First, it appears increasingly evident that even with the PSI, the adjustment is insufficient to bring Greece’s debt to a sustainable trajectory for the international creditors (IMF and EU), which is a 120% debt to GDP in 2020. This has helped spur pressure on the ECB. It is not that the ECB should take a loss necessarily, though there have been calls for that, but rather that it forgoes a profit.

The conservative estimate is that the ECB holds 40 bln euros of Greek bonds, though the true amount has not been made public. The conservative estimate is that it acquired the bonds at a 25% discount. Forgoing profit would lower Greece’s debt obligation by 10 bln euro.

In addition, some national central banks of euro zone members may also have Greek bonds. In certain respects their holdings may be more vulnerable to an outright loss than the ECB’s holdings. The ECB says it bought the bonds for monetary purposes, not for investment, which makes forgoing a profit appropriate. The national central banks did not buy Greek bonds for monetary purposes but for investment. The revaluation of other assets, like bunds and gold, will likely more than offset the loss from Greek bond holdings.

Second, the EU-IMF has reportedly presented Greece with a ten page “must do” list as a pre-condition to a second aid package. The measures include reducing public payrolls by another 150k over the next three years, cuts in health care defense spending (which we have previously noted that Greece spends ore more than twice the share of GDP on defense as most other countries in the euro zone, including Germany).

The EU-IMF also reportedly is demanding that Greece cut the 750 euro monthly minimum wage and eliminate the two month salary bonus granted to private sector workers. Greek resistance is growing. Last week on the eve of talks with the EU-IMF, the parliament voted against extending pharmacy hours, which were part of the effort to increase the flexibility of the economy.

Greece’s technocrat Prime Minister Papademos has not been feted as has Italy’s technocrat prime minister Monti. The Berlusconi-led faction has not directly opposed Monti’s reforms. It is biding its time, it appears, allowing Monti to do the heavy lifting and positioning itself to benefit in the next election from the political backlash against the reforms, some potentially dramatic.

Papademos is more a lame duck, with elections likely in the March-April period and Samaras, the head of the New Democracy is likely to be the next Prime Minister, according to the polls. Samaras is opposed to further austerity measures.

Third and most dramatic, a German proposal was leaked after the markets closed on January 27th. It called for two monumental concessions from Greece.

First, Greece would cede fiscal sovereignty to the EU. The euro zone finance minister would appoint a budget commissioner that would have control over important spending and tax decisions.

Second, and just as inflammatory, the German proposal called upon Greece to accept that its debt servicing obligation is paramount. It is the first and foremost demand on state revenues.

Surrender to Creditor Interests

Perhaps in the 19th and earlier 20th century, creditor nations would send their troops to insure the repayment of debt. Now they send in people, mostly men, not wearing soldiers’ uniform, but the uniform of bankers and accountants.

The power of the pen is as mighty as the power of the sword and more humane, but what is involved is largely the same. The German proposal, which the IMF seems to support, demonstrates the loss of confidence is Greece, including Papademos, to implement the public sector reforms and other structural changes that are necessary ensure that the creditors have a reasonable chance of being paid back.

The immediate response from Greece was two-fold. First, Finance Minister and Deputy Prime Minister Venizelos rejected the German proposal and cautioned Germany (and others) from giving Greece an ultimatum between assistance and dignity. Second, Papademos held a meeting with heads of the major political parties, including Samaras and reported a commitment to back painful reforms in principle.

The Greek response can hardly be surprising, but Germany’s proposal is not simply a tactic to get eke more concessions from Greece. Germany’s CDU has drawn up a similar proposal last November, (after the October accord that agreed on a new process to monitor the implementation of the reforms).

More than a Gambit, a Blueprint

Some will speculate that the German proposal is designed ultimately to get Greece to leave the union, as there is no formal mechanism to eject a member. Yet this does not smell right. Neither Germany nor France has advocated that Greece leave and has said so in word and deed.

What they seem to recognize that many noted economists don’t: that Greece leaving the union, which implies are hard default as well, could very well open a can of worms that would make the Lehman debacle seem like child’s play.

The 3-year liquidity the ECB has made available (and the second tranche will be offered in February) may not provide a sufficient firewall and tempts risk of contagion that exacerbates the pressure on other periphery countries, some of which may very well be on the knife’s edge themselves, and possibly the core as well.

Germany seems to sincerely expect that Greece will capitulate because it is the least bad alternative. It is astounding but Germany may be under-estimating the power of nationalism. Although Germany (and France) has said Greece is unique, the proposal is also clearly a blueprint.

Reuters reported earlier today (January 29th) that a government source in Berlin indicated that “Germany’s proposal was aimed not just at Greece but also other struggling euro zone members that receive aid and are unable to make good on their obligations.”

This is an unambiguous signal for Portugal, which has come under increasing pressure in the capital markets, despite the Troika recognizing it is on track, especially in the aftermath of S&P downgrade, where it joined the other two in recognizing Portugal is below investment grade credit. It should also be a signal to private investors that they may be asked to participate in an eventual second package for Portugal.

It is of course difficult, if not impossible, to know how the politics will shake out. The greater the price tag of EU/IMF assistance, the greater the incentive to look elsewhere.

Samaras, the head of the New Democracy Party, and most likely to succeed Papademos as prime minister, met last week with Russia’s Putin. In addition to a discussion of bilateral cooperation on energy issues, commercial interests were also discussed. Russian firms see potentially attractive investments in Greece’s ports, airports and railway infrastructure.

Russia has almost $500 bln in reserves. A modest deal for Russia could be a big deal for Greece, a NATO member incidentally. These developments, especially the German proposal, are new and unanticipated. After rallying almost 5% off the mid-January multi-month lows, the euro is vulnerable to these developments that individually and collectively increase uncertainty.

Moreover, we suspect investors will find these developments in Europe to outweigh the pushing out to late 2014 the first Fed hike by a consensus of Fed officials. Whether the $1.3200 area is a sufficient cap for the euro, or given market positioning, $1.34-$1.36 is tested, medium term investors should look at the euro’s modest recovery as new opportunity to lighten European exposure and increase US exposure.