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Capital Markets

Sovereign debt: Greece gets junked and calls in the EU and IMF

Risks of European sovereign contagion are elevated; Restructuring Greece’s debt could make matters worse

It was a move that caught the European Union by surprise. On April 23 the Greek government bowed to the pressures of the financial markets, and the prospect of financial collapse, by asking for the activation of a €30 billion lifeline that could grow to €45 billion after a contribution from the IMF.

Interest rates on Greek debt soared in the days leading up to the announcement after the EU revised Greece’s budget deficit upwards by almost one percentage point to 13.6% of GDP. This effectively meant that Greece would be locked out of the debt markets as it seeks to refinance €8.5 billion in bonds maturing on May 19. By activating the loan facility almost a month before then, it now has enough time to wait for the market to calm, while leaving time for necessary details to be ironed out before the funds are disbursed.

Perhaps Greek officials had seen what was coming – a downgrade to junk status from Standard & Poor’s on April 27.

Sovereign CDS

Five-year, bp 

Source: Citi Investment Research and Analysis

Bringing in the IMF should be seen as a positive step for bondholders, says Marco Annunziata, chief economist at UniCredit Group in London. It’s expected to impose detailed measures to underpin the planned fiscal adjustment over the following two years, as well as implementing structural measures to make the fiscal adjustment sustainable, and also laying out a projected growth profile, says Annunziata. In the meantime the first obstacle will be the official approval of aid by individual EU members, which in some cases might need parliamentary approval. That’s likely to weigh on market sentiment, while investors will want to see several months of an improving track record before becoming more confident that debt sustainability is within reach and a restructuring can be avoided.

As things stand, a debt restructuring would make matters worse, rather than better, says Citigroup’s head of credit strategy, Matt King. A sizable debt restructuring might cause turmoil for the European banking sector, particularly for Greek banks, because it would severely deplete their capital, and given that they’re already dependent on European Central Bank liquidity for funding, regardless of the severity of the haircut, it would require them to post more collateral to the ECB – collateral that they are unlikely to have. Given the huge exposures to Greek debt, European banks would take heavy mark-to-market losses on their holdings of Greek and other olive-belt sovereign bonds, which would require significant capital injections.

"Once again, the risk of a snowball is obvious: as larger and larger countries are affected, the problem is compounded," says King.

Politically, a restructuring might be unpalatable, and King attaches a higher probability to an "interim solution", where Greece, probably at the insistence of the IMF, reschedules payments and/or tries to reduce the debt outstanding through a debt exchange. As long as this is done in a voluntary fashion, that is, one that is not legally binding on bondholders, it wouldn’t trigger CDS contracts. Nonetheless, it merely delays what some see as inevitable, and uncertainty still remains over whether the EU/IMF aid will provide support beyond 2010. In an April 11 statement, the support is described as a three-year package, with euro area member states covering "up to €30 billion in the first year", with the IMF contribution assumed to be between €10 billion and €15 billion. But there has been no other official information about the subsequent years, which the EU says will be decided upon the agreement of the joint programme with the IMF.

Government debt/GDP, 2009

Source: Citi Investment Research and Analysis, EU Commission, OECD

Analysts say there is an assumption in the markets that because of country-level politics, and resistance from voters, it might well be that Greece can only count on access to funds to avoid default over the next few weeks and months, and not years. Dominoes

Greek funding requirements through to the end of 2012 run to €110 billion – and almost three-quarters of that is to cover redemptions. It seems almost certain European governments and the IMF won’t be willing to foot that bill. But the EU will need to hold its nerve and avoid a restructuring event that could set in motion a series of restructurings in other southern European sovereigns, accelerating a sell-off in the debt of Spain, Portugal and Ireland. Therefore an interim measure could give other endangered sovereigns time to put their fiscal deficits in a less vulnerable position, King says.

Greek gross funding requirements until the end of 2012

Portugal is seen as most vulnerable. The 10-year Portuguese/German yield spread reached 260bp by the end of April as Greek debt costs soared. They’re now almost eight times the spread when Portugal joined the EMU in January 1999. Moreover, its five-year CDS traded as high as 270bp, having doubled in the past month, and is trading at very similar levels to where Greece was in early March. "It seems clear which domino currently looks in danger of falling over on the European table. Maybe now we have a slightly better idea which other domino might be hit if it does so," says BNY Mellon’s Simon Derrick.

Still, politicians and central bankers will be fully cognizant of the market’s brutal response to slow deliberations during the banking crisis, realizing that the quicker and the broader the solution, the cheaper the bailout will be.

In 2008 the contagion was contained when policymakers implemented liquidity schemes, such as Talf and SLS, in addition to bank deposit and bank bond government guarantees. To that end, Citigroup suggests the most benign solution would be a socialization of the debt problem in the eurozone. They argue that it’s feasible in theory, given that the debt to GDP ratio of the eurozone as a whole in 2009 was only nine percentage points higher than for the core countries in isolation, and only moderately worse than the UK and US.

That could be a tall order, however, because the lack of social cohesion across Europe and the fact that the Maastricht Treaty explicitly prevents one country from assuming the obligations of another, Citigroup says.

Extra support

Another option might be for the ECB to step in to add extra support, by purchasing government debt outright in the secondary market, though it might be reluctant to do so for fear of it undermining the bank’s independence, say analysts. Another possibility would be to use an institution such as the European Investment Bank to provide lending to sovereigns with funding difficulties.

The EIB is big – with subscribed capital of €164 billion in 2007 – and it has an triple-A rating, allowing it to raise debt on favourable terms. There would of course be complications. For one, the EIB was set up under the Treaty of Rome, so its capital comes from all EU members, not just the eurozone. Moreover, the EIB provides project funding, and it cannot lend more than 50% of the cost of a project.

The EIB already made clear in February that its statutes did not permit it to provide bailouts in the form of balance of payments support to individual member states. However, King believes that the EIB or another entity could in principle form part of a solution if Greece were designated a "project". Whatever the form the rescue takes, time will be of the essence, as there is now a real risk that the sovereign debt crisis will run out of control.

"Rather than running behind the snowball, the EU needs to get ahead of it in order to prevent it from rolling further," says King.

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