Friday, April 30, 2010

Greece: Setting Up for the Final Act?

According to our esteemed financial press it is almost a done deal. Greece has agreed to austerity measures designed to cut their deficit by 10% of GDP in three years and with this they will get an infinite amount of money from the IMF (20% courtesy of American taxpayers). With this financing, they will not have to come to market anymore (why are 2 year bonds still trading over 12%?).

"There was not much room for us to negotiate," the Greek official said. "This is the way the IMF works—if you want the money, you go by their terms. "
Makes sense. In the old days, before too big to fail, lenders used to dictate covenants for emergency financing. The IMF, as we know, thinks all the Greeks have to do is cut spending and raise taxes. Apparently, the Greeks needed the IMF to show them they didn't need to run deficits all those years because their economy would have worked the same with much less spending.

Interestingly enough, this flies in the face of the Trillions in stimuli that have been showered in the US, China, Brazil, the UK, and others, based on the theory that the worst thing you can do to a slumping economy is cut spending. I suppose Keynesianism only works in countries of certain size? I guess I missed that lecture in my macro 101.

In any case, it is clear that the overpaid geniuses at the IMF are back to their old methods. The debt must be paid at all costs because it was issued. Whether there is any chance of the Greek economy ever generating enough surpluses to pay the IMF, now first in line ahead of the bondholders, it is apparently of no interest to the politicians who just want this unforeseen crisis to away fast.

Meanwhile, in Athens, the unions are certainly going to think about what it is best for them. Can you blame them? At some point, they may realize that the problem is as much Germany's (or France's) as much as it is theirs. Why? because if Greece cannot deliver the austerity measures and the IMF does not provide the money to cover the deficit the German banks will lose (again) several billion euros. In this context, it is perfectly reasonable for the Greeks to claim shared responsibility and reject the austerity terms while accepting the money. At that point, the Greek politicians will prefer the voters to their friends in high places.

Therefore, if you think this crisis is over I suggest you consider you consider what would you do if they cut your salary because the government has issued too much debt. If you think this is a ridiculous proposition because Greek public employees are, in your view, overpaid, consider how much success you think you could have convincing them (hint: Greek unions do not like to be pushed around).

The bottom line is that, no matter what the Greek government says, a 10% deficit cut will be difficult to implement. The guys at the IMF have plenty of experience in the matter. If I have to bet, I'd guess the first audit will result in a disagreement of some kind over lack of progress. At that time, the IMF, after consultation with the G7, will issue a waiver. By then, the markets may be ready to reconsider the viability of the Greek debt (by then) junior to the IMF loans

Of course, it is possible that this time will be different and Greece will be the first country ever to emerge from a situation like this without a devaluation.

Meanwhile, the Greek bond curve is still inverted.

Thursday, April 29, 2010

Greece: What to Believe?

As I wake up this morning I hear my favorite news broadcaster (NPR, if you must know) proclaim something to like "markets are rallying overseas on news that the IMF has announced a $150B package for Greece." (NY Times version here

After a quick breakfast I rush to my computer to check prices. The rally still has the euro below US$1.33. My brokers, however, are all tripping over each other to bombard me with messages showing Greek CDS' at 520-620 (that is -150 from last night, dude!!). I even have one that says "...eveything back to normal !" (sic)

Wait a minute! Didn't they announce this package before? How much money has Greece actually received from the IMF or other European sources? The answer, so far, zero. In fact, the structure is exactly the same as with the "previous" package. Somebody throws a big number in order to calm the markets hoping to scare the pernicious buyers of Greek CDS's into taking profits and forcing Greek yields down. At this point, everyone in the global market is glued to their CDS screen. Except the truth is to be found elsewhere.

The columns on the right above (source: Bloomberg) show the bid-ask yield for Greek government bonds. As one can see, the curve for maturities longer than 2 years is inverted (higher yields for shorter maturities). In general, a non-risk free credit shows an inverted yield curve when the bonds trade by price and no longer by yield. In other words, unless the risk free rate is also inverted (not the case as shown by the swap curve on the left) the inverted curve signals that the market is concerned about default. In this case, apparently more concerned after 1 year.

This curve became inverted a couple of weeks ago and it is still inverted this morning as I write this. The question is: Why wouldn't European investors rush to buy 2-year paper at 12.7%? I mean, the difference between Greece and Germany can give you an extra 10% per year. Not a bad deal if you believe that Germany will bailout Greece. Same credit, much higher yield. The answer is partially explained in the NY Times today ("Already Holding Junk Germany Hesitates").

German institutions already own US$50B of Greek paper, which brings us back to the inverted curve. I do not know about you, but if I was the treasurer at a German bank sitting on a pile of Greek debt accumulated during the boom years, not only am I not buying more but I am also, quietly, looking to sell some. Maybe I am even trying to hedge my risk by hiding a few Greek CDS' in the closet.

There are more than a couple of players in this Greek Tragedy (sorry, I couldn't resist). The IMF, with Brazil becoming a financial powerhouse, has been out of a job for a while. Thus, they would love a center stage engagement monitoring Greek finances. The Germans, knowing how much Greek debt they already own, would love for the market to rally behind the Greece-IMF team one last time so that they can unload their bonds (How do you say: "never again" in German?) without having to actually lend Greece much money (Remember Hank Paulson's bazooka?).

If History is any guide, the Greeks will never deliver on the austerity packages. You can look this up, there is no precedent for an adjustment of this size (Deficit > 10% of GDP) without a devaluation.

The bottom line is that if the Greek economy could not raise the tax revenues to balance their budget and service their debt in good times with rates under 3%, I do not see why one should expect them to close the gap with higher rates and a weakening economy. The IMF and Germany may be able to refinance the Greek debt and keep creditors happy for a long time but it is unlikely that they will ever be able to make the Greeks balance their budget. Maybe Greece will show that this time is different, but in my opinion, this is all about buying time until the Germans can find a solution for their banks.

caveat emptor