Greece Tensions Growing More Acute

Currency in Crisis

The pressures on Greece continue to increase and this is reflected in the credit default swaps and the interest rate spread over Germany. Indeed, that is a key development in the euro zone over the past month, Greece yields have risen above Ireland, which had been the highest yield in EMU this year. Ten year Greek yields are just below 5%, while Ireland is near 4.75%.

Greece fundamentals are poor. It was lagged going into recession and may lag on the exit. That lag may mean that the ECB may unwind some liquidity facilities before Greece is ready.

As we have noted previously, the new Greek government revealed a much larger deficit that the outgoing government 'fessed up to. The budget deficit this year is near 12% of GDP. The current account deficit was around 14.5% of last year and is fallen this year. The monthly deficit is around 2 bln euros this year which is about a third smaller than the same period in 2008.

The EU estimates that Greece's public debt to GDP stood at almost 100% last year and will rise to 135% by the end of 2011 without dramatic action.

Some of the efforts the new government, which had campaigned on a platform to increase spending, to rein in spending, like freezing state worker pay at 2000 euros a month is meeting stiff resistance.

Greece has moved to shorter maturities to reduce its debt servicing costs, but this will "kick the can" down the street but only until Q2 next year, when Greece will have 18 bln euros coming due.

The new talk today suggests that senior Greek officials are meeting with several large Chinese lenders and a possibly a couple of large US banks to either buy Greek bonds in the secondary market or in a future placement. Why should investors with no Greek exposure be interested in this story ? First, as tensions on the periphery remain high, with Greece just the most acute example, it could influence the timing and magnitude of the ECB's withdrawal of liquidity.

When the ECB first offered 1 year funding at a fixed rate of 1%, we suggested that in that act of monetary policy lay a fiscal support program on ideas that some of the receivers of the funds would buy high yielding European bonds and interest rate differentials over Germany did narrow, lending credence to our argument. One of the implications of the pressure in the region is that it may favor the ECB replacing 12-month refi operations with a six month operation (s).

Second, the pressure on Greece may spill over to other periphery members. This is not suggest that Greece or another country will drop out of the euro zone, like "bets" www.intrade.com suggested the odd of a country dropping out of the euro zone by the end of 2010 was nearly 1 in 3. Those odds have fallen considerably.

The point is that the euro zone remains a great experiment of monetary union without political union. This coupled with the fact that member countries do not control the euro printing press, like the US controls the dollar press and UK the sterling press, makes it harder to conceive of the euro eclipsing the dollar.

Thirdly, the pressures on Greece may illustrate that the opportunity for strains that were felt sharply during the crisis will not necessarily diminish during the recovery. Inside the euro zone, few countries can compete with German and its ability to resist upward pressure on unit labor costs. Outside of the euro zone, many key trading partners, like the UK, have experienced currency depreciations that adversely impact some euro zone members.