EMU May Not Be Cooked in Greece

Currency in Crisis

The ebb and flow of reacting to headlines over the Greek crisis appears to be largely dictating the ebb and flow of the capital markets. It may come to a head on Tuesday as the government, fresh from a modest reshuffling to appease the coalition that makes up the socialist party, tries to jam through its new austerity program.

The approval of the austerity measures appear to be the key to the IMF and EU releasing the next tranche of funds, or some part thereof. One of the key facts in is that the government has a five seat majority in parliament. A failure of the vote of confidence or the austerity program (vote for which is likely next week) against the government would lead to a collapse of the socialist government. The other key fact is through maturing debt and coupon payments due next month (July 15 and July 22) amount to about 7 bln euros and there are maturities in August (Aug 19th and 20th) of about 8 bln euros.

Greece will raise some funds through its bill auctions (including June 21). However, if Greece does not get the IMF/EU funds by middle of July it will be likely default. This would trigger of chain reaction that it is impossible to grasp in its entirety. It is very uncertain. In politics as is gambling and trading, one ought to avoid the risk of ruin. And this has essentially been at the core of my belief that European officials will ultimately find a way not to allow this to happen. That said, the ability of our species to shoot itself in the foot know no bounds.

The Greece government survives the vote of confidence and gets its austerity plan through parliament. The EU and IMF free up the next tranche of funds. The fifth under last year's program, then what? Then officials turn their attention to a package for Greece that provides funding for the next few years. This is where the private sector gets bailed in. What happen to the IMF that insisted on private sector taking a hit before providing funds?

Apparently, what many of Greece's neighbors want is for Greek institutions to roll-over their maturing debt into government bonds. That is sort of Greek version of the Vienna Accord. Greek banks essentially promise to re-commit funds that are freed up in maturing issues to back into Greece. According to BIS data, Greek banks hold about 47 bln euros of sovereign bonds. Given the average maturity of Greek bonds, roughly 2/3 are likely to mature in the 2012-2014 period.

The goal of raising 30 bln of government financing through this roll-over, requires nearly 100% compliance (volunteering) by Greek banks. It would become a little easier if the public sector pension funds that hold about 30 bln euros of government paper also participated. This seems to be a stretch. Other holders would need to participate.

Still even if this goes smoothly, which of course is unlikely, there are three increasingly pressing challenges. Those challenges are Ireland, Spain, and Italy.

The same macabre dance being played out over Greece may be the dress rehearsal for Ireland. Ten-year yields have risen around 250 bp over the past two months to approach 11.5% European officials will likely have to conclude that it is not longer realistic to expect Ireland any more than Greece can return to the capital markets next year.

Spanish yields are also rising and it cannot be simply written off as Greek contagion. As Spanish officials have begun penalizing banks for paying more 100-150 bp more than Euribor to attract depositors, Spanish bank borrowing from the ECB rose last month by more than 20% to 53 bln.

Spain is also among the most sensitive to the coming bank stress tests (early July). This will help highlight how much capital the cajas need and thus the size of the FROB facility. This may not be known until late September. It will then have a large fourth quarter funding need. In fact, this more than events like last week's failed auction, may be behind the government apparently front loading this year's financing needs (Jan-April running about 16 bln euros above funding needs).

On top of this are the regional governments, where deficit and debts are likely to be shown greater than the previous governments allowed. Ahead of next year's national elections, it may be difficult to rein in spending.

Moody's decision late last week to put Italy's sovereign rating on watch for possible downgrade also has little to do with developments in Greece. Berlusconi has faced two significant blows--the local and regional elections--and the referendum, which repudiated his program. The credit warning may boost some austerity measures, but the poor growth outlook and the political climate is note very conducive to significant reforms. Italian bonds have come under pressure, but still holding up better than Spain (Italy-Spanish 10-year spread widening gradually), even if not as good as Germany and France.

The point is not being particularly alarmist about Italy or necessarily Spain. Instead, the point is the debt crisis is bigger than Greece, even if it has been dominating the focus. The assumption that Ireland can return to the capital markets in H2 2012 needs to be re-examined. Just like Greece needs 2.0 so will Ireland and that all assumes the Greek government will survive the vote of confidence and parliament will approve the austerity measures. Implementation risks are for a different post.