The EU Has Rescued Greece From the Bond Vigilantes,,, April Fools!!!

On March 26, EU endorsed the proposal of extending aid to Greece (in case it faces shortage of funds to meet the refinancing and new debt requirements) wherein each euro nation would provide loans to Greece at bend over market rates based on its stake in the European Central Bank. EU would provide more than half the loans and the IMF would provide the rest. The official estimates for the size of the planned assistance have not been disclosed since it would depend on Greece's actual need. Erik Nielsen, Chief European Economist at GS, estimates Greece will need an 18-month package of as much as €25 billion, with the IMF providing about €10 billion of that. The French newspaper Le Figaro reports that German officials are estimating the total assistance of nearly €22 billion.

Taking advantage of the positive market response to the announcement of EU-IMF taking up the role of the lender of last resort, the government issued 7-year bond with no premium over the market rates. However, the euphoria was short-lived. The 7-year bonds which were issued at yield of 6.0% were trading at 6.27%, the next day. The sentiment was also weakened by the poor response to the surprise auction of 12-year bonds which attracted demand or order book of just €390 million against the offered amount of €1 billion. Judging by the fashion in which the market has accepted Greek debt as of late, even after announcement of EU/IMG support, it is quite feasible that the EU's offering of market rate loans is akin to shoveling money down a black hole in terms of market valuation.

Greece's order book has been shrinking and reflects the waning market demand for Greek bonds. The 7 year bond auction received orders of just €6 billion, 20% higher than the offered amount of €5 billion. This compared with orders of nearly €15 billion for the auction of €6 billion of 10 year bonds on March 4 and orders of nearly €25 billion for auction of €5 billion of five year bond on January 25.

According to the government estimates, it needs to raise nearly €53 billion in 2010 to meet its refinancing needs as well as fund its negative primary balance and interest expenditure. Out of this, the government has so far issued bonds of only €18.5 billion through:

€8 billion of five-year notes on Jan. 26 at yield of 5.93% (381 basis points more than benchmark German debt of similar maturity)
€5 billion of 10-year bonds on March 4 at yield of 6.44% (325 basis points more than German debt of similar maturity)
€5 billion of 7-year bonds on March 29 at yield of 6.0% (310 basis points more than German debt of similar maturity, immediately traded underwater)
€390 million of 12-year bonds on March 30 at yield of 5.9% (auction effectively failed)

The next round of short term refinancing requirement consists of about €12 billion in April and about €8.5 billion in May.

Market Reaction

While the initial reaction to the EU-IMF assistance announcement was positive in the Greek government debt market and sovereign CDS market, the optimism is receding. The yield on Greek 10-year bond dropped to 6.20% (spread of 305 basis points over German 10 year bond) on March 26 from 6.44% (spread of 337 basis points over German 10 year bond) on March 22. However over the last three days, the yield is again trending upwards and is trading at 6.52% on March 30 (spread of 343 basis points over German 10 year bond). The 5 year Greek sovereign CDS spread dropped to 295 basis points on March 26 from 341 basis points on March 22. However, the same has been lately drifting up again and reached 333 basis points on March 30.

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Increased interest burden - According to the data compiled by Bloomberg and Credit Agricole, Greece may pay about €13 billion more in interest on the debt it raises in 2010 than it would have if yields had stayed at their pre-crisis levels relative to Germany's. Interest on the three bonds it sold this year will amount to €7.7 billion over the life of the securities, compared with €3.8 billion if they had sold them at the average extra yield, or spread, over German debt that prevailed between 2000 and 2008, the data show. Greece will incur a further €18.9 billion of interest on this year's remaining issuance, compared with €9.4 billion before the crisis began.

We have (correctly) assumed such under our Greek public finances projections of last month and have already built the increased interest expense due to increased spreads against government expectations of decline in interest rates. Subscribers, see Greece Public Finances Projections .I also recommends the Greek Banking Fundamental Tear Sheet for a list of affected banks and pro subscribers should reference Banks exposed to Central and Eastern Europe.

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Conclusions - The sustainability of Greece's public finances is seriously hindered by the piling government debt and widening fiscal deficits which were a result of poor fiscal policies. While Greece has announced drastic fiscal consolidation measures, serious concerns float around the implementation (after which, they will still have to content with internal deflation and increased social unrest). The Greek government's loss of credibility in the markets is reflected in the rising sovereign spreads and dwindling credit availability. Further, Greece competes for funds with other distressed sovereigns scrabbling to fund their fiscal deficits and refinancing requirements. Greece is walking the tight rope of arranging funds from the market to sustain its public finances and has one of the highest probabilities of failure.

Tied together with the common currency, the EU has been forced to provide assistance to Greece. Although the assistance would be invoked only when Greece fails to garner funds from the market, the implications of the assistance package will be the increased contagion effect of Greek's sovereign risk to other EU countries (some of which are already struggling with their domestic issues). The EU nations will be forced to accumulate debt on their books to finance Greece's requirements at a time when EU nations debt are already approaching historical proportions. Greece's rescue would send strong signals about how the sovereign risk of a member can be perceived as the risk of the EU, which has failed to maintain oversight and regulation of the members' public finance policies and has become jointly responsible for the poor governance in a member country. Greece is not the only EU country in trouble and the rescue can set a wrong precedent that can literally redefine the concept of moral hazard in Euroland! If this short term solution to the Greek crisis is applied to other troubled nations, sovereign debt accumulation in the region would be become a serious concern that would haunt the region for many years to come. Germany and, to a much lesser extent, France (as of very recently) have been, therefore, resisting the idea of putting the entire burden of Greece's rescue on EU and have proposed IMF collaboration.

EU-IMF assistance would entail a series of strong conditions for fiscal consolidation through reduced public expenditure, increased taxation etc. which will have deeper macro-economic impacts and undermine economic recovery for Greece.

For the complete Pan-European Sovereign Debt Crisis series, see:

1. The Coming Pan-European Sovereign Debt Crisis - introduces the crisis and identified it as a pan-European problem, not a localized one.

2. What Country is Next in the Coming Pan-European Sovereign Debt Crisis? - illustrates the potential for the domino effect

3. The Pan-European Sovereign Debt Crisis: If I Were to Short Any Country, What Country Would That Be.. - attempts to illustrate the highly interdependent weaknesses in Europe's sovereign nations can effect even the perceived "stronger" nations.

4. The Coming Pan-European Soverign Debt Crisis, Pt 4: The Spread to Western European Countries

5. The Depression is Already Here for Some Members of Europe, and It Just Might Be Contagious!

6. The Beginning of the Endgame is Coming???

7. I Think It's Confirmed, Greece Will Be the First Domino to Fall

8. Smoking Swap Guns Are Beginning to Litter EuroLand, Sovereign Debt Buyer Beware!

9. Financial Contagion vs. Economic Contagion: Does the Market Underestimate the Effects of the Latter?

10. "Greek Crisis Is Over, Region Safe", Prodi Says - I say Liar, Liar, Pants on Fire!

11. Germany Finally Comes Out and Says, "We're Not Touching Greece" - Well, Sort of...