Blackadder 5 – Baldrick’s Cunning Plans for Greece

The European Sovereign Debt crisis increasingly resembles an episode of Blackadder. German Chancellor Angela Merkel is a rather matronly version of Queenie, while French President Sarkozy is clearly Lord Percy. The part of Edmund Blackadder appears custom made for Jean Claude Trichet while the part of well meaning but bumbling Baldrick represents an amalgamation of Luxembourg Prime Minister Jean Claude Junker and European Council President Herman Von Rumpuy. The next episode takes place on Thursday.  Greece is no longer sufficient to improve overall European sentiment. It is still a necessary condition and attention will be focused on the meeting this Thursday for at least another temporary solution for Greece. Greek Prime Minister Papandreou has made it clear that the country has reached the limits of fiscal austerity and that Europe needed to make concessions to prevent a disorderly Greek default. His solutions are unconstitutional and require at the very least parliamentary approval and at the most exacting a change in treaty with all the attendant risks that this will fall foul of the German Constitutional Court and/or referendums in individual economies.

There is now general acceptance that Greece needs debt relief.  The problem is that both the Lisbon Treaty for the €uro and the ECB’s own rules have a no bailout clause (article 124). Article 125 allows market intervention in exceptional market circumstances and the ECB’s own rules allow it to purchase government bonds from member countries for the normal operation of monetary policy. This latter provision was used as justification for the ECB’s Securities Market Program last year for buying peripheral government debt. However, these purchases were highly controversial within the central bank and hawks viewed this as temporary. This program was used heavily last summer but purchases slowed to a trickle in the first quarter and the central bank failed to intervene as Portugal progressed rapidly towards inclusion in the European Financial Stability Fund. The ESP is currently €77bn and the ECB believe that future secondary market purchases should be conducted by the European Financial Stability Fund.

There are two possible ways in which the ESFS can be used to purchase peripheral government bonds. The most efficient method and the one that least stigmatizes the individual economies is for the ESFS to purchase these bonds. However, current rules specifically prevent these secondary market purchases and any change will require parliamentary approval, which would be difficult in Germany, Holland and Finland.  In Germany, the junior coalition partners Free Democrats and the Bavarian Christian Social Union, have campaigned against these secondary purchases, while the Finnish government has demanded that Greece puts up collateral in return for any restructuring. The alternative maybe more palatable, lending additional funds to Greece to allow it to make secondary purchases and retire debt at less than par, since the default risk of owning this secondary debt lies with Greece. 

This would also represent a voluntary exchange of debt, which would avoid selective default from the rating agencies, which in turn would allow the ECB to continue accepting Greek debt as collateral.  The problem is that voluntary exchange would only be possible with those financial organizations that have already marked-to-market their positions, as the bank stress tests showed this will not include official holders of Greek debt (ie the ECB) or bank hold-to-maturity investments. It would undoubtedly have some impact at the margin and provide temporary relief for Greek and other peripheral debt, but the net impact on Greece’s debt to GDP ratio relatively modest.  We estimate that this facility could save €20-30bn at most, which in turn would allow a 10% reduction in the debt to GDP ratio. This is not sufficient. More importantly, it would add to the total size of the latest Greek package.

The official estimate from the Troika (IMF, EU and ECB) is that Greece will have a deficit of €5bn in the third quarter based on the assumptions that the full year contraction of activity will be 3.8% and the deficit will be 7.5% of GDP. This estimate also includes additional privatization receipts of €1.7bn in the third quarter. None of these conditions seem likely. Before the current chaos, the growth estimate appeared too optimistic and a more realistic estimate of the annual GDP correction is 4.5%. We doubt that conditions will be in place to receive any privatization receipts and the deficit in the first five months of the year show that expenditure restraint and revenues missing their target. Indeed, we believe that the deficit is likely to be more than 10% of GDP.

The Troika believes that the Greek economy will grow by 0.6% during 2012 and further 2.1% in 2013 necessitating additional funding of €70bn assuming that the government can achieve €18bn of privatization receipts over this period. We believe that the government will struggle to achieve less than a third of this privatization total, whilst the growth estimates are scarcely believable given the fiscal austerity, silent run on the domestic banking system, which in turn is compressing financial conditions. Indeed, it is reasonable to assume that growth will continue to contract over the next two years given these monetary and fiscal constraints. This suggests that the actual funding requirement will be more than €100bn over this period. If this program is extended until the middle of 2014, then we believe than an additional €50bn worth of funding will be required. If the voluntary debt exchange is included, then the total required should rise to €170-180bn. There is €45bn still available from the original package, which mitigates somewhat this total, but it remains to be seen whether politicians in the core economies are willing to agree to a fund of this size.

The scale of this funding requirement and the opposition of important groups of Finnish, German and Dutch politicians as well as the fact that these secondary debt purchases will not have a material impact on Greece’s debt to GDP ratio means that the European Commission is currently working on more than two dozen possible debt restructuring plans in order to comply with German suggesting that debt relief should amount to €70bn. Here the plans largely consist of lowering interest costs for Greece as well as encouraging banks to roll over Greek debt into longer term maturities, possibly guaranteed by other Eurozone governments. The French plan in which banks rolled over 50% of maturing debt into 30yr Greek government debt, whose coupon is set at 5.5% plus an additional premium based on Greek growth as well placed an additional 20% into a special purpose vehicle appears to be dead. It was a cunning plan for French banks but an expensive deal for Greece.  The problem is that any of these plans are likely to fall foul of the ECB determination not to accept bonds in default.  Bond in default cannot be accepted by the ECB under its constitution. There have been two suggestions to circumvent this restriction. The first is the hardline proposal to force the default and challenge the ECB to refuse these bonds as collateral, since it would contravene the requirement to ensure the smooth operation of the monetary system and monetary policy, but we don’t believe that politicians are willing to play chicken with the central bank. An alternative is to allow selective default in the hope that this will be short-lived. In this scenario, the success of the debt exchange leads to sharply lower spreads allowing the rating agencies to upgrade the rating within three months. This is wishful thinking since the ECB rules would not allow it to wait for any improvement in the ratings.

The credibility of this latter suggestion highlights the desperation of politicians caught between the ECB and single currency constitutions and market chaos. Any suggestion in between is a second best solution that will not lead to a sustainable solution. Moreover, the longer politicians’ prevaricate the greater the widening of peripheral spreads in the near-term. In desperation, it is possible for politicians to act now and seek forgiveness, rather than ask permission, from politicians and the German Constitutional Court. Indeed, the Constitutional Court has a history of allowing past misdemeanors and imposing conditions on future behavior. This policy would require common issuance of Eurobonds. This policy has obvious attractions of reducing interest rate volatility and would be the natural progression from eliminating intra-regional exchange rate volatility to eliminating intra-regional interest rate volatility. However, in the absence of a political union and optimal currency, volatility will eventually be transferred to politics and the economy.

The determination of politicians to buy their way out of trouble cannot be over-estimated. The simplest action on Thursday would be to avoid all of the difficult default and constitutional issues and provide more debt for Greece. The opposition Social Democrats in Germany have expressed willingness to pursue a Marshall Plan for Greece, provided increased loans at lower interest rates for longer maturities. In this latest version, the private sector involvement in debt restructuring is derived from a tax imposed upon European banks. This would provide a fig leaf for German demands of private sector involvement without causing selective default and annoying the ECB. The European Commission and parliament have been seeking a number of pan-European opportunities to raise revenues and escape the confines of national funding of its deficit. The problems here are that non-€urozone economies are likely to object to higher taxes to pay for these €urozone transfers (most notably the UK. Moreover, this solution may be less painful in terms of the cost to core economy voters, but its economic costs in terms of tighter financial conditions and slower capital growth within the European economy, which would exacerbate the slowdown we expect in the second half of 2011 and into 2012. Nevertheless, a Marshall Plan would impose fewer performance targets on Greece and therefore fewer flash points when these targets are not met, but they would also increase the moral hazard for the single currency and reduce further incentives for fiscal austerity or compliance with these targets. 

We believe that even in the event of any resolution to the Greek crisis on Thursday, and beyond the immediate short squeeze, the focus would then shift to additional packages and debt relief for the next two candidates Ireland and Portugal. They would expect the same favorable loan conditions as Greece and would undoubtedly require additional funding. We believe that spreads would have to widen further to force this provision on European politicians. More importantly, adding debt on top of debt is not a lasting solution. We continue to believe that in the absence of currency devaluations, debt devaluations are the next best alternative. Debt devaluations are necessary to provide fiscal relief, but they do not materially improve competitiveness. Supply side reforms are essential and there has been important reforms amongst the peripheral economies over the past couple of years, but they are not sufficient and more importantly, the payback for these reforms in terms of their impact on productivity and productive potential growth takes several years. This means that the focus will remain on competitiveness and the lack of growth amongst the peripheral economies.

However, the most important shift over the next few months will be the deterioration of economic conditions within the core economies. The combination of global economic slowdown in the second quarter, coupled with the ECB’s misguided interest rate hikes as well as the heightened interest rate and financial market volatility is expected to lead to further slowdown for this week’s key economic data. There has been considerable complacency over European growth. According to Goldman Sachs, consensus expectations for European growth have barely budged since the start of the year, with the rolling 12 month consensus economic forecast moving from 1.36% in January to 1.30% during July. The strength of global demand during the first quarter and the bifurcation of financial conditions during the periods of stress have helped to ease financial conditions in the core, particularly Germany, through lower interest rates and weaker Euro and tighten them in the periphery. Moreover, until the past few weeks this tightening of peripheral financial conditions was confined to the minor economies. This is changing with contagion spreading to Italy and Spain. The purchasing managers’ indices in Spain, Italy, Ireland, Portugal and Greece are all below the psychologically important 50 level denoting slowing activity.

The flash purchasing managers’ indices for France and Germany will be released on Thursday and the German IFO index on Friday. The composite PMI index is expected to fall to 52.3 from 53.3, while the IFO index is expected to decline to 113.0 from 114.5. More importantly, the wide gap between IFO current conditions and expectations indicates that sentiment and crucially economic activity will continue to deteriorate over the summer. Our central view on Europe remains that the sovereign debt crisis with strong growth in core Europe is difficult but manageable as long as politicians continue to extend and pretend, but that all pretence is lost when activity amongst the core economies slows to zero. The lack of volume and high volatility means that aggressive positions are dangerous, but we remain underweight Greece, Ireland and Portugal as well as holding underweight positions in Italy, Spain, France, Belgium and the €uro.