What's Next for Greece and Why it is Important

There has been a dramatic shift of opinion regarding a Greek exit from the EMU.   As this chart from www.intrade.com shows that market perceives the chances of a country (presumably Greece) exiting EMU down to 15% from as high as 40% as recently as early August.   

It is at the lowest since the contract began trading in late Q1 2010.  While there are different issues that may compromise the preciseness of the odds (inferred from the pricing) of this market, it does jive with reports suggesting a shift in the position of some key officials, including Merkel.  Even the tone of some officials, like Hollande and Juncker, have moderated and both have come around to the view we have consistently maintained; namely that a Greece exit would not solve any of Europe's problems, and, indeed, would likely exacerbate them.

The IMF has said that in order for it to regard Greece's debt as sustainable, a precondition for it to agree with the payout of funds negotiated under the second aid package, it would need to reasonably project Greece's debt/GDP ratio to fall form about 160% last year to 120% by 2020.  How it arrived at 120% is neither clear nor demonstrable.  Why not 115% or 125% ?  And given how frequently the IMF changes its GDP forecasts and its own track record of said forecasts, how much value should policy makers or investors put in the IMF's 7-8 year forecast?  

In any event, Greece currently has a little more than 300 bln euros of debt.  Of this, roughly 2/3 is in the hands of the official sector.  This includes the EFSF, the IMF, the EU, the ECB and bilateral aid.  As we have argued, the only way to get a meaningful reduction in Greece's debt burden then is for the official sector to compromise.  

There is some indication that some officials appear to be coming around to this view.  However, the IMF reportedly insists, it will not accept a haircut.  The ECB too wants to recluse itself.  This stance by the ECB, if maintained, will undermine its claim that it will not seek seniority status for the new bonds purchased under the OMT scheme.  

The legal basis of such claim is suspect (enforceable?) in the first place, but if it is not willing to lengthen the maturity, accept a lower interest rate, or sell it to the ESM or Greece at cost rather face value, can investors will trust that, if push comes to shove, the ECB will not take a haircut on SMP purchases, but take it on OMT purchases?  

Moreover, if true the IMF and ECB's stance will push a greater burden on the remaining official sector, the EFSF, EU and bilateral loans.  This can only increase the angst of the creditor countries, who already think their pockets are being picked, and increase the tension between the creditors and debtors.