Darkest before the Dawn

Currency in Crisis

It looks bleak. The European debt crisis has pushed peripheral yields, premiums and credit default swap prices to new highs. The situation looks intractable. And now on top of the dire situation, the political backlash in Greece is forcing a change of government.

The brinkmanship game ends when some one blinks and one of the reasons why so many are so pessimistic is they can't see who is going to blink first. The irresistible force meets the immovable object. A Greek default is understood to increase the risk of Portuguese and Irish default. The firewall that has thus far protected Spain will come under attack. Italy may not be that far behind. Martin Feldstein once warned of the risks of war should EMU fail.

The scenario of existential risk needs to be avoided. The reason why many market observers do not see the likely grounds for a compromise is that they have unnecessarily linked two issues and they forgot a key player. The two issues that do not need to be linked are the tranche for Greece under last year's plan and a new package for Greece, on the recognition that it cannot return to the capital markets next year as envisioned.

To examine this issue, though first requires bringing another player to the table that has been forgotten. Many seem the line drawn between the ECB, EU, France and some other countries on one side, and Germany, Finland, Austria and a few other countries on the other side. The former wants only voluntary agreement to roll-over current short-term Greek government bonds. They believe that designed properly, it can avoid the appearance of a distressed exchange which the rating agencies have already warned against. The latter are more forceful about extending maturities by a number of years. In its present form it is hard to see how that avoids a default rating.

The forgotten player in that line up is the IMF. It says it cannot agree to the next Greek payment unless the country's finances are secure for the next 12 months. This is not possible without the Europe. What to do? The IMF is the most likely and capable of blinking first. It would entail accepting the intention of Europe to provide a new funding package for Greece rather than a hard commitment. This will allow the first Greek package to proceed and allow officials several months to find a workable agreement on Greece 2.0.

The wild card actually becomes the Greek political situation. The Greek government has stood out from the other troubled peripheral countries by surviving. Between the mass demonstration/general strike and some fissures within the ruling Socialist party, is threatening to topple the government. A new cabinet will seek to push through the new austerity measures as a vote of confidence. This will take place in the coming days and before the IMF/EU have to write a check to Greece.

If the austerity is approved, leaving aside the issue of implementation risk, the IMF/EU can provide the next tranche of aid. This alone will allow a pullback from the edge of the abyss and help stabilize the global capital markets, even though thorny issues implicit in Greece 2.0 would not be addressed.

At the same time, there is some risk that it is too late, the toothpaste is out of the tube. Moody's decision to put three top French banks' long-term credit ratings on review for a possible downgrade in light of their exposure to Greece has aggravated the already increasing difficulty (read more costly) for European banks to secure dollar funding. The pressure is evident and investors should monitor it as a thermometer of the pressure. Month and quarter end pressures will not help, but if the news stream turns more positive, like the scenario outlined here, and the cost of dollar funding for European banks does not stabilize, it would be a sign that officials are too little too late.