The Importance of Greece

There has been much skepticism about Greece's fiscal progress and interim reports suggesting that it was recording a budget surplus when debt servicing, and one-off factors were excluded, were greeted with scorn. And even some of those accepting that it had recorded a primary budget surplus warned that this will increase the likelihood of a default.

We disagreed. After the private sector debt restructuring, the lion's share of the debt is in the hands of the official sector. The examples of debt restructuring when a primary surplus was achieved are based on private sector holdings.

Rather than default, we thought forbearance was the most likely result of Greece achieving a primary budget surplus. Today the EC confirmed that Greece recorded a 1.5 bln euro primary budget surplus last year. Over a year ago, EC officials held out the possibility of reducing the debt servicing costs by extending maturities and lowering interest rates. The euro area finance ministers meet again in early May and Greece will feature prominently.

Many investors and observers marveled at the incredible Greek 5-year auction earlier this month that was well over-subscribed and produced a yield of just below 5%. It is now yielding about 4.8%. The yield on Greece's 10-year bond has fallen 215 bp this year and is now below 6%. As impressive as this is, Portugal has done even better. Its 10-year yield is off 225 bp this year to 3.64%.

Our own models suggest Greece is a B credit, but S&P and Fitch has it at B- and Moody's puts the sovereign rating at Caa3. This warns of the risk of modest upgrade, though of course still far from investment grade. Greece's debt has not peaked, but perhaps a year or so away. Last year, its debt was 175% of GDP.

The budget deficit of 23 bln euros included about 7.2 bln euros for debt servicing costs (~4% of GDP). That would have produced a primary deficit of 16 bln euros or about 8.7% of GDP. However, the EC also granted Greece extra leeway. It allowed Greece to exclude one-off factors that largely was support for the banking system to the tune of 10.8% of GDP. Also, transfers from euro member central banks of their profits from Greek bonds they hold. It is through these machinations that EC concludes that Greece indeed had a primary surplus in 2013 of 0.8% of GDP.

EU officials may want to continue to ensure that Greece sticks to its commitment and may offer small adjustments with the promise of more if key fiscal targets are achieved. Some have suggested that easing the terms of debt servicing is a bribe to ensure that Greece does not default. Yet, we do not see Greek officials threatening default. In fact, in word and deed, Greek people have indicated they do not want to default. Some have argued that forbearance by the creditors has the same effect as a default, but this is patently untrue. Taking longer to service the debt and to pay a lower interest rate is not a default in substance or appearance.

The risk of deflation in the euro area has increased the risks that the ECB adopts more unconventional policies. However, when looking at country-level inflation, most economists, including the IMF, expect only Greece to experience outright deflation this year. On an EU-harmonized basis, Greece CPI stood at -1.5% in March. The April report is due May 9. This is largely seen as good deflation in that it is a necessary adjustment, within the confines of monetary union that will boost Greece's competitiveness.

In addition to the decline in inflation, two other risks have been reduced which encourage spread compression. First, the denomination risk, this is the risk that Greece drops out of monetary union, has been significantly reduced. Second, the risk of default has been reduced by a combination of austerity and forbearance. Still, even though Greece continues to share the common currency, its creditworthiness is not the same as Germany, for example and it is the extent of this gradation that is explored, not just in Greece, but in Portugal, Spain and Italy as well.

The same factors that led to the success of the sovereign offering are also helping Greek banks raise funds. On March 18, Piraeus bank sold 500 mln euros of a 3-year bond with a 5% coupon. The indicative yield is now near 3.6%. National Bank is preparing to sell senior bonds in May and may seek, according to reports, to issue 2.5 bln euros in equity.