European leaders scrambled Wednesday to quell the market instability growing out of Greece’s debt crisis, with German officials seeking legislative approval for a major contribution to an international aid package that looks as if it could reach 120 billion euros ($160 billion) over the next three years.
One day after cutting Greece’s status to junk and downgrading Portugal, a major ratings agency also cut Spain’s debt rating by a notch and the euro reached a one-year low, underscoring how difficult it will be for Europe to contain problems that started in Greece.
“Every day which is lost is a day where the situation is getting worse and worse, not only in Greece but in the whole European Union,” said Dominique Strauss-Kahn, managing director of the International Monetary Fund. “It’s the confidence in the zone which is at stake and that’s why we need to act swiftly and strongly.” After meeting here with Mr. Strauss-Kahn, Chancellor Angela Merkel of Germany seemed to find a new sense of urgency in dealing with the crisis. “It’s completely clear that the negotiations by the Greek government with the European Commission and the I.M.F. must now be accelerated,” she said. “Germany will do its part to safeguard the euro as a whole.”
Germany’s finance minister, Wolfgang Schäuble, said the government could present draft legislation on a bailout plan as early as Monday and get such legislation through the lower house of Parliament by next Friday if negotiations with Greece over the terms of the deal were concluded, as hoped, by the end of this week.
The assessment seems to be this:
What a growing number of investors suggest is really needed is a “shock and awe” figure, enough to convince the markets that peripheral European economies will not be left to fail.
For better or worse, I do not expect such a figure is forthcoming. I also do not see how such a figure would do more than postpone the basic problem, which is that several European economies have been pretending to be much wealthier than they really are and to make financial plans on that basis.
The markets have learned their lesson: now that Greece and Portugal have been downgraded, the rush to the exits is palpable: the flight to quality is on, and bond yields in the European periphery are going stratospheric.
Greece’s bonds can still be used as collateral at the ECB: Moody’s hasn’t (yet) downgraded them. But S&P’s sovereign-ceiling principles mean that all of Greece’s banks now have a junk rating, and it’s surely now only a matter of time until Moody’s and Fitch follow S&P’s lead and Greek debt becomes a speculative credit instrument rather a government bond which is safe in anybody’s eyes.
The trick about going short an imploding asset class, of course, is that it only works if you’re in the minority. If everybody is doing it, you just get overshooting asset markets and chaos — which is what we’re seeing now. As far as the financial markets are concerned, if any bailout comes now, it’ll be too late: no country can sustain Greece’s combination of funding costs and debt-to-GDP ratio, no matter how much German money it burns through. Plug 13% yields into my Greek debt calculator, and the results aren’t pretty, even if they don’t have any effect at all on all the other optimistic assumptions.
Nouriel Roubini, it can be safely said, gives good panel — especially when the subject is the eurozone and the possible disintegration thereof. He’s been bearish on the PIGS in general and on Italy in particular for many years now, but I don’t think it comes as much surprise to him or to anybody else that Greece is the first country really in the firing line.
Nouriel’s base case, then, is Argentina 2001: after all, Greece has a much higher debt-to-GDP ratio, much higher deficit-to-GDP ratio, and much higher current-account deficit than Argentina had back then. And if that’s the base case, there’s no way that Greek debt should be trading anywhere near its current levels.
Of course, this being Nouriel, it goes downhill from there: if Greece is worse than Argentina, he says, then Spain is worse than Greece. Its housing bubble and bust has left the banking sector much weaker than Greece’s; its unemployment situation, especially with the under-30 crowd, is much worse than Greece’s; and the cost of any Spain bailout would be so much more enormous than the cost of a Greek bailout as to be almost unthinkable. The only thing that Spain has going for it is that it isn’t quite at the edge of the abyss yet; if it gets its political act together and implements tough fiscal and structural reforms now, it can save itself. But clearly no one saw that happening, given Spain’s political history over the past 20 years.
There’s no good news here. The least bad course of action for Greece, in Nouriel’s eyes, is some kind of coercive yet orderly debt restructuring, which keeps the face value of the debt unchanged but which reduces coupons and pushes out maturities. And an exit from the euro. Alternatively, the ECB steps in and cuts interest rates so low that the euro gets pushed down towards parity with the dollar, which would accomplish something similar without nearly as much pain.
One member of the audience, though, had a really good question: what happens to the European system of sovereign guarantees of interbank lending? When those sovereign guarantees aren’t worth much any more, Euribor is likely to spike, since suddenly there’s a lot more credit risk involved in interbank lending. And there are hundreds of trillions of euros of debt contracts linked to Euribor, which could suddenly get very expensive and take control of short-term interest rates out of the hands of the ECB.
And in any case it’s worth remembering that even though Greece’s debts are small in relation to Spain’s, they’re still large in relation to, say, those of Lehman Brothers. And given that there is no formal mechanism for leaving the euro (or for defaulting on sovereign euro-denominated debt, for that matter), there will almost certainly be a range of unexpected and chaotic events somewhere down the line. That’s why I feel that although Greek bond yields are certainly going to be volatile for a while, we’re going to see higher highs and higher lows — there’s pretty much nothing, at this point, which could reassure the markets and turn Greece back into an interest-rate play rather than a credit play.
Even a massive IMF bailout, which is probably the best-case scenario for Greece right now, wouldn’t suffice to bring yields back down to their pre-crisis levels. As Nouriel pointed out, the IMF, as a preferred creditor, would make sure it was repaid, in the event of default, long before bondholders. And as a result, even if the probability of default dropped, the recovery value on Greek bonds in the event of default would drop as well. And so yields wouldn’t come down as much as you might think.
Tony Barber at Financial Times:
Nothing captures Germany’s anger and frustration with Greece better than the story – if you can call it that – in Tuesday’s Bild, the mass-circulation German tabloid. “Goodbye, euro. Bild gives the drachma back to the bankrupt Greeks.” Beneath the headline is a picture of a well-dressed, bespectacled young man, presumably German, handing a wad of drachmas – a defunct currency – to a rather frightened-looking, middle-aged Greek lady. The message is brutally clear: we Germans don’t want to share the same money as you lot. Drop out of the eurozone and leave us alone.
Does Bild speak for the entire German nation and, specifically, for German policymakers? Clearly not. But here and there in government circles the sentiments are shared. Consider the remarks of Jürgen Koppelin, a budget expert in the liberal Free Democratic party, which is part of Germany’s coalition government. It cannot be ruled out, he said on Tuesday, that “Greece would have to leave the eurozone for a time… The Greek currency could be depreciated. That could even help them with exports.”
The irresponsibility of these comments is mind-boggling. Exporting more products would no doubt help Greece’s economy in the medium and long term. But what we are seeing is an emergency in which Greece has effectively been shut out of the bond markets. The yield on two-year Greek government bonds hit 16.22 per cent on Tuesday, and the 10-year bond yield hit 9.77 per cent. This tells you that the markets have no faith that Greece can meet its refinancing needs without massive external assistance. Even the roughly €45bn promised by Greece’s 15 eurozone partners and the International Monetary Fund will not be enough.
The choice is simple. Either Greece gets a much bigger loan package, or it restructures its debt, dealing a shock – but not a fatal shock – to the European banking system. But as the Bild story and Koppelin’s remarks make clear, the political conditions for extra financial help from Germany just do not exist.
The real risk here is to Eurobanks. They ran with even higher leverage ratios than US banks, they are believed to have recognized less of the losses thus far on their books than their US peers. Even worse, readers report that the major dealers (and the Eurobanks were part of this cohort) are carrying toxic assets at prices that are vastly above likely long-term value. Eurobank exposure to Greece is over $190 billion, and total periphery country exposure is roughly $900 billion.
In the subprime crisis, many pundits and the Fed itself thought the losses would be contained, unaware that for every $1 in BBB subprime bonds, another $10 in CDS had been written, and that many of these exposures sat with highly levered firms, namely insurers and dealers, who were not able to take much in the way of losses. The gross level of exposures looks much worse here and the banks most at risk have not done much (save take government handouts) to rebuild their balance sheets.
So the whole idea that the financial crisis was over is being called into doubt. Recall that the Great Depression nadir was the sovereign debt default phase. And the EU’s erratic responses (obvious hesitancy followed by finesses rather than decisive responses) is going to prove even more detrimental as the Club Med crisis grinds on.
The VIX posted its biggest one-day increase since 2008 but its level of 22 is positively tepid compared to crisis norms. Portugal, whose total debt to GDP is higher than Greece’s, is under pressure as bond spreads continue to widen. Hungary’s premier-in-waiting stated that the country, which was bailed out last year, will not be able to meet IMF fiscal targets and should widen its deficit even more to stoke growth. Traders went into risk-aversion mode, with emerging market and junk bonds also suffering. And as we mentioned, quite a few people in London expect a significant devaluation of the pound after their elections.
A further source of trouble is political. If the euro continues on its expected slide and the pound is devalued, the dollar’s strength will put a major dent in the US ambitions to increase exports. Moreover, the rise in the greenback relative to other currencies will no doubt make China much more reluctant to revalue the renminbi against the dollar.
Japanese markets are down over 2% at this hour, with the rest of Asia faring better.
At any rate, the question now is what kind of way forward exists. It appears that either Europe’s monetary union needs to be undone or else a fiscal union needs to be forged. But neither is possible! And as I’ve been trying to emphasize, the Eurozone is a more important trade partner for the United States than the much-more-discussed China. A meltdown over there seems sure to have consequences here and not good ones.
I know that the Senate and the mainstream media would be shocked to hear me say this, but what is going in Greece and elsewhere could turn out to be more significant than the Goldman ABACUS deal.
UPDATE: Megan McArdle
UPDATE #2: Paul Krugman