5/5/15: IMF, Greece & Europe: More Bickering, Less Tinkering?

An interesting article on Greece in FT: http://www.ft.com/intl/cms/s/0/72b8d2ae-f275-11e4-b914-00144feab7de.html#ixzz3ZFOAlR4B suggesting that the IMF is now actively drifting into fall-out management mode for Greek crisis.

According to the FT: "Greece is so far off course on its $172bn bailout programme that it faces losing vital International Monetary Fund support unless European lenders write off significant amounts of its sovereign debt, the fund has warned Athens’ eurozone creditors." And this means that Greece is at a risk of failing to secure release of EUR3.6 billion worth of bailout funds - the IMF share of the EUR7.2 billion of Troika funds - that still remain to be disbursed to Athens.

Absent these funds, Greece is insolvent, full stop.

Basically, per IMF projections, debt sustainability in Greece requires 3% primary net lending / borrowing balance in 2015 (up on estimated surplus of 1.5% in 2014) and this is required to rise to 4.5% in 2016-2017 and 4.24% in 2018-2020. In Euro terms, 2015 primary surplus required is EUR5.49 billion. Instead, the IMF now estimates that the country will be running a primary budget deficit (not surplus) of 1.5%.

Primary balance is Government balance excluding interest on debt.

If true, the deterioration in Greek finances so far this year is massive. And there is no way of correcting for it, unless either Greece imposes much more severe austerity or there is a formal and significant debt restructuring for debts held by the 'official sector' - aka Troika.

Per FT report, sources close to the Eurogroup claimed that “The IMF thinks the gap between the two realities is very large right now,” said one senior official involved in the talks. A stand-off between the IMF and eurozone creditors over Greece is not unprecedented. Three years ago, the IMF refused to disburse its portion of the aid tranche because of similar fears Greek debt was not falling fast enough. The IMF only signed off after eurozone ministers agreed to consider, but never implemented, writing down their bailout loans to reduce Greece’s debt to “substantially lower” than 110 per cent of GDP by 2022. It currently stands at 176 per cent." So in other words, the IMF appears to be pushing for a debt restructuring for Greece.

In a separate report: http://www.ifre.com/imf-not-insisting-on-further-debt-relief-for-greece-schaeuble/21197177.fullarticle Germany Finance Minister Wolfgang Schaeuble denied the IMF is pressuring the Eurogroup to restructure Greek debts.

As I noted in January (http://trueeconomics.blogspot.ie/2015/01/512015-imf-on-debt-relief-for-greece.html), this is by far the most often repeated disagreement between Greece, Europe and the IMF. And it comes as the Eurogroup attempts to structure another bailout package for Greece. So far, rumours have it, the Eurogroup outlook for Bailout 3.0 needs are pitched at EUR30-50 billion. But, as FT notes, "rising deficits could change that calculation."

Meanwhile, Greece continues to stumble from one payout to next - on a weekly basis - http://trueeconomics.blogspot.ie/2015/05/1515-good-news-may-hide-bad-news-when.html

And now we have a smell of napalm in the morning - some signs of bond markets repricing peripheral risks for the euro area:

21/4/15: Greece Heading for the Bust?

With capital controls starting to creep in and with a big peak in debt redemptions looming,  as per chart below, Greece is now entering the last stage of pre-default financial acrobatics.

Source: FT.com

The country bonds yields are now re-tracing previous peaks (more on this here):

Source: @Schuldensuehner 

And as cash transfers from the local governments to the Central Bank (see link above), plus continued depositors flight are blowing an ever widening hole in Greek balance sheets, the ECB is seriously considering to cut substantially Greek banks access to liquidity.  The cut will have to be along the ELA lines (ELA governing rules are available here). Meanwhile, Greek banks' shares are tanking, down some 50% in month and a half.

Here is the end-of-day chart for Greek banks shares index, showing historical low set today

Source: @Schuldensuehner 

and the opening levels for the same:

Source: @ReutersJamie 

All of which has, as a backdrop, pretty ominous (though entirely correct) ECB talk about the options for Greek default.

This is going to be an eventful day or two, folks.

Update 2: Meanwhile in the mondo bizzaro, the ECB is reportedly looking into dual currency regime for Greece. Which sort of makes sense as a transition out of euro area membership, but makes little sense as a tool for retaining Greece in the Euro. Which, in turn, may or may not be an indicator of ECB going the Ifo way. Go figure...

Update 1: A handy chart summing up ECB's 'headache'

Source: @Schuldensuehner 

And as @Schuldensuehner notes: "Grexit costs rise by the minute" as country Target2 liabilities have reached EUR110.4 billion, "mainly driven by ELA for banks".

Source: @Schuldensuehner 

Greek debt exposures by countries: http://trueeconomics.blogspot.ie/2015/04/19415-greece-in-or-out-ifo-aint-caring.html and across the official sector: http://trueeconomics.blogspot.ie/2015/04/15415-official-sector-exposures-to.html.

8/5/2013: Olli Rehn Departs Reality Once Again

If one needs an example of out-of-touch, reality-denying and self-satisfied EU Commissioner, travel no further than Olli Rehn. Here's the latest instalment from Court's Favourite Entertainer of Things Surreal:
http://europa.eu/rapid/press-release_SPEECH-13-394_en.htm

The speech focuses on what went wrong in Cyprus.

In the speech, Mr Rehn commits gross omissions and conjures gross over-exaggerations.

Nowhere in his speech does Mr Rehn acknowledge that Cypriot banks were made insolvent overnight by the EU (including EU Commission, where Mr Rehn is in charge of Economic and Monetary affairs) mishandling of PSI in Greek government bonds.

Nowhere in his speech does Mr Rehn acknowledge that Cypriot banks were massively over-invested in 'core tier 1 capital' in the form of zero risk-weighted sovereign bonds (Greek bonds) on the basis of direct EU and Basel regulations that treated this junk as risk-free assets. Mr Rehn states that "The banking problems were aggravated by poor practices of risk management. Lacking adequate oversight, the largest Cypriot banks built up excessive risk exposures." But Cypriot banks largest risk mispricing took place on their Greek Government bond holdings and this was (a) blessed by the EU regulators and (b) made more egregious in terms of risks involved by the EU madness of Greek PSI.

Mr Rehn claims that "The problems of Cyprus built up over many years. At their origin was an oversized banking sector that thrived on attracting foreign deposits with very favourable conditions." Nowhere is Mr Rehn making a statement that the size of Cypriot banking sector was never an issue with the EU, neither at the point of Cyprus admission into the euro, nor at the accession to the EU, nor in any prudential reviews of Cypriot financial system. Mr Rehn flat out fails to relate his statement on deposits to the fact that the EU is currently pushing banks to hold higher deposits / loans ratios, not lower, and that higher deposits / loans ratio is normally seen to be a sign of banking system stability. Mr Rehn is also plain wrong on his claims about the nature of deposits in Cyprus. Chart below shows that Cypriot banks' deposits more than doubled in Q1 2008-Q1 2010 on foot of the EU-created mess in Greece and the rest of the periphery.

Source: @Steve_Hanke

And here's proof that Cypriot banks were running a shop with deposits well in excess of loans, implying low degree of risk leveraging, until Mr Rehn and his colleagues waltzed in with their botched 'rescue' efforts:

Source: Washington Post.

Olli Rehn could not be bothered to read IMF assessment of Cypriot economy from November 2011 (Article IV report) - despite him citing EU Commission June 2011 'warnings' - where IMF clearly states that the core problems faced by Cypriot banking system stem from Greece (page 14) and local commercial banks' loans, not depositors or foreign depositors. On deposits, IMF states (page 17 paragraph 21) "non-resident deposits (NRD) in Cypriot banks (excluding deposits raised abroad by foreign affiliates) are €23 billion (125 percent of GDP), most of which are short-term at low interest rates." Thus, IMF directly, explicitly and incontrovertibly contradicts Mr Rehn's statement about foreign deposits having been extended on "very favourable conditions".

IMF further states that when it comes to deposits, significant risk is also poised by "€17 billion in deposits collected in the Greek branches of the three largest Cypriot-owned banks could be subject to

outflows in response to difficult conditions in Greece. Outflows in the first half of 2011were close to €3 billion (nearly 15 percent of the total), although a portion of these returned to the Cypriot parents as NRD." ECB chart below confirms this risk materialising in the wake of Mr Rehn's structured disaster in Greece:

This outflow knocked out billions out of deposits cushion that Cypriot banks needed to reduce their financing needs. And Mr Rhen - the architect in charge of this disaster - has nothing to say about it.

I can go on and on. Virtually every paragraph of Mr Rehn's statement is open to critical examination. 

That is hardly news - Mr Rehn has made so many gaffes and outright bizarre statements in the past (including his assertions at every pre-bailout junction that each peripheral country heading into bailout was fully solvent, fiscally sustainable, etc), he became not just a laughing stock of the markets, but a contrarian indicator for reality. What is of concern is that Mr Rehn is still being given the task of speaking for the Commission on Monetary and Fiscal affairs.

Olli Rehn should read something more cogent than his own speeches on what has happened in Cyprus (e.g. business.financialpost.com/2013/03/28/seeds-of-cyprus-disaster-planted-months-ago-by-eu/ and www.reuters.com/article/2013/04/02/us-eurozone-cyprus-laiki-insight-idUSBRE9310GQ20130402 or http://online.wsj.com/article/SB10001424127887323501004578386762342123182.html) and preferably do so free of charge to European taxpayers, on his own time, while up-skilling for his next job.

1/12/2012: Greek Deal 3.0

If you need to read anything at all on Greek 'Deal' 3.0 signed in November this year, go no further than this post from Yanis Varoufakis. Lethally direct & brutally correct assessment, in my view.

If you want to understand why 120% debt/GDP ration by 2020 or 2022 is not attainable absent OSI, see my note here.

Economics 09/05/2010: What sort of EU leadership?.. Part 2

Underlying the unworkable logistics of the Euro-bond that Brussels is planning to deploy to contain the spillover of the fiscal crises in PIIGS, there is a pesky issue of the past record of the currency block management of its finances.

Here are some historic comparisons from the IMF latest GFS report worth highlighting.
Now, spot the odd ones in the above chart? That's right - the non-Euro zone countries are the ones with the lowest indebtedness of households in their economy. In other words, no matter how much the Euro area leadership talks about the US being the cause of the current crisis, data simply shows that the US - despite all its problems - has had far less of a bubble in overall debt terms than Euro area. The only reasons Germany does not figure amongst the countries with the weakest households are:

1. Germany's exports oriented economy which in effect is a 'beggar thy neighbor' economy reliant on someone else assuming credit to buy German goods; and
2. Germany's costly reunification coupled with poor demographics, which assured that over the last 20 years German consumers had virtually no improvements in their standards of living.

But in assuming all this debt, were Euro area households buying productive assets (as opposed to the Americans, who, per our Europhiles' assertions were all playing a property Ponzi game)?
Oops. Not exactly. While Americans were buying homes (fueling their own bubble), Europeans were buying... homes and public sector spending goodies. But may be, just may be, Euro area members were more prudent in buying homes than the Americans, who stand accused of causing the financial crisis of 2007-2009?
It turns out that this was simply not true. Chart above shows just how far more leveraged were the Euro area states compared to the US in terms of two main parameters of house prices sustainability.

And the same is true for overall asset valuations.
Oh, and those prudent lenders - the Germans and the rest of the Euro pack banks?
It turns out the US banks were actually much better off throughout the bubble formation period in terms of their lending and profitability than... hmmm... Germany and Belgium. Who could have known, judging by Mrs Merkel's hawkish statements as of late?

Now, take a look at the total external indebtedness of the Euro area... Recall, the US and Euroarea both have relatively similar GDP...
So suppose the EU Commission issues common bonds (and assume it places them in the market) to underpin PIIGS plus Belgium, the Netherlands and Austria - the sickest puppies of the Euro area. That would require bonds issuance to the tune of 20-30% of these countries outstanding public debt. Which means that the unified bond issuance volumes will be in the region of USD1 trillion, pushing Eurozone's combined indebtedness to over USD25 trillion. Does anyone really think this is a 'solution' to contagion or a surrender?

Economics 09/05/2010: What sort of EU leadership?.. Part 1

Prepare to be afraid, ye the financial markets – those always-on-time and forever-effective super leaders of the Eurozone have concocted a Plan. A Plan to deal once and for all with the frightening levels of their own governments’ insolvency. A Plan code-named Bondzkrieg!

The troops of illiquid and insolvent PIIGS will be backed by the armies of the liquid, but pretty much nearly as insolvent the rest of EU. The attack, commencing possibly as early as on Monday next will be a two-pronged strategy: a pincers manoeuvre.

Part 1 will, per latest reports from the EU16 summit, require an issuance of Euro Commission Bonds. These will be backed by the EU16 states’ guarantees and something that is called ‘an implicit ECB guarantee’. Sounds terrifying, folks:

1. What is exactly an ‘implicit ECB guarantee’? A sort of ‘we might print mucho Euro notes, should Brussels default’ stuff? What kind of nonsense is this? The best the ECB can do is promise to monetize the EU Common bond in the same way it monetizes Greek junk bonds. Yet, the latter has not stopped contagion, only accelerated it by undermining the ECB credibility.
2. What will back these Common bonds? The solvency of the EU nations guaranteeing them? But wait – isn’t the problem the EU is facing is precisely the very lack of solvency? How is it going to work then? A severely indebted and deficit ridden pack of nations issues new debt to cover up the old debt problems? Well, that did work for the Russian Government a miracle back in 1998. Without actually resolving the problem of excessive and long-running deficits, and without either restructuring (default) or deflating (devaluation which is a de facto default) the existent pile of debt, the new EU-wide bond issue will simply transfer Greek-style problems of the PIIGS to the rest of EU. Given that we are talking about roughly a €1 trillion worth of junk, the entire pyramid scheme concocted by the EU is going to collapse unless Germany is good for underwriting the entire EU16 with its economic might. Trouble is – Germany can’t. It has little prospect of growth and its’ current economy simply cannot carry the burden of the rest of EU16 obligations.
3. What will be the seniority of these bonds? If the new bond is subordinated to the existent state bonds (as implied by a ‘guarantee’ proviso), these bonds will have no meaning. If it will be senior to existent member states’ debt, then issuing them to pay down sovereign debt will be equal to deflating seniority of sovereign issues already outstanding. Which, in common English, is called defaulting on existent debt.
4. How can these bonds be priced? Normally a bond is priced by a combination of factors. Some are exogenous – such as global liquidity and portfolio driven demand. Some are endogenous – such as analysis of what the sovereign deficit is for the issuer, what debt burden the issuer is paying and what prospects for economic growth (and other components of future default probability) does a sovereign face. Finally, expected Forex positions for sovereign currency in which the bond is denominated are taken into account. Care to guess what any of these endogenous variables might be for the EU16? Right – they are totally meaningless. Will EU bond be written against EU own debt (which is nil) or against guarantors’ debt (sovereigns already overloaded with debt)? Will the Forex rates relate to the ECB rate which the ‘sovereign’ issuing the bonds (the EU Commission) cannot control (due to ECB independence)? Will EU ability to repay these bonds rest on Euroarea economic growth? If so, what does this mean, since the EU Commission collects revenue from EU27, of which 11 member states are not a party to issuance of the bond! Will, for example, UK government assume liability to the Eurozone-issued bonds by committing its own economy to the risk of a call on the bond should, say, Belgium decide to default?

The second prong of the EU attack on the markets is the incessant blabber about the need to set up an EU-own rating agency. Here, the promised might is clearly unmatched by any sort of internal capability:

1. The EU itself cannot certify own annual accounts, despite having only in-house own auditors. Even these are refusing to sign off on EU accounts for over a decade now. How can the same institution produce a credible rating agency that will be entrusted with providing assessment of the EU credit worthiness?
2. Can the EU-imposed metrics be seriously treated as fundamental benchmarks for solvency? Give it a thought – the EU oversees a union of member states bound by own sovereign treaty to uphold the Maastricht Criteria targets. The EU has failed to enforce these in the case of Greeks, Portuguese, Spaniards, French, Italians, Belgians and so on. In other words, the EU cannot enforce its own rules, let alone police economic and fiscal performance parameters required to issue any sort of risk assessments. In fact, this year Euroarea deficit is expected to reach 6.6% of GDP and in 2011 -6.1% - way above the 3% the block set as its own rule. Debt to GDP is heading for double digits, before we add banks supports. Letting the EU run a rating agency is equivalent to letting an alcoholic run a bar!
3. The entire idea of an EU rating agency traces back to Merkel’s and Sarkozy’s desire to shift blame for the Greek (and indeed PIIGS) debacle off the shoulders of the European governments and Brussels and onto the shoulders of ‘speculators’ and the Big-3 rating agencies. Of course, the logical inconsistency of the EU attacks on the Big-3 is painfully obvious. The Big 3 are accused for failing to properly recognize and publicize risks to the systemic solvency of financial institutions in the case of ABS/MBS and so on. Yet, the minute the rating agencies actually do their jobs – as in the case of PIIGS in recent months – they are standing accused of… well… doing the jobs only to well? Can anyone have any trust in a ‘rating agency’ set up by the very people who are simply and evidently incapable of a simple logical argument?

Mrs Merkel have stated this Friday: "Those who created the excesses on the markets will be asked to pay up -- those are in part the banks, those are the hedge funds that must be regulated ... those are the short-sellers and we agreed yesterday to implement this more quickly in Europe." Obviously, over a decade of fiscal recklessness across the PIIGS was never a problem for Mrs Merkel. And she is supposed to be the reasonable one?

All I can say, folks, forget any hope for growth in Europe with this sort of leadership.

Economics 16/04/2010: The incoming train II

It is a good feeling to be ahead of the curve, especially when the curve is drawn by the likes of FT. Per today's FT Deutschland report: the ECB is warning about a new crisis, a return of global imbalances in the coming years. In its monthly report the ECB warns: “At the current juncture, global imbalances continue to pose a key risk to global macroeconomic and financial stability . . . The stakes are high to prevent a disorderly adjustment in the future that would be costly to all economies.” Jurgen Stark is predicting that we have entered a new stage in the financial crisis – a sovereign debt crisis which means that “dealing with [the resulting severe macroeconomic imbalances] will represent one of the most daunting challenges for policymakers in modern history.”

My own take on the same topic was published here.

Another issue, also raised repeatedly on this blog, is discussed in Joachim Fels' (Morgan Stanley) piece on FT Alphaville (here). Fels makes a claim that countries with a high degree of inflation aversion (Germany) might have an incentive to quit. Fels suggests three warning points for the crisis to develop:

• First, any signs of moral hazard emerging in the fiscal policies in the euro area
• Second, ECB failure to raise interest rates on time to cut inflationary pressures, and
  
• Third, the political pressure rising against the Euro in Germany.

Hell, by these metrics, we are already in the midst of the euro collapse by 2 out of three measures (first and third). Alas, the second metric is a bogus one. There is plenty of evidence to show that ECB has not been an 'inflation hawk', acting often pro-cyclically before and targeting the likes of PMIs instead of hard inflation and monetary parameters. So the real question here is: What's the potential trigger for an exit?

Greece asking for the pledged money won't do. If you think in terms of game theory, once that happens in earnest (and it might be today or over the weekend), Germany will face the following two options:

1. Grant request for assistance in full and thus pre-commit itself to the common currency at the sunken cost of an exit of ca 10-12 billion euro that it will commit to Greek deficits financing;
2. Exit now, saving the aforementioned money, but destroying its political capital within the EU.

The problem is that the net cost of (1) is much smaller than the net cost of (2). And this means there has to be another - non-Greek - trigger. Italy or Spain?

Economics 15/04/2010: Greece problems back to the frontline

So, as I have predicted in the interview with BBC World Service (excerpt here), the markets have little faith in the Greeks and, indeed, in the EU’s ability to effectively underwrite Greek crisis.

Greek bond yields are now rising again on the investors’ view that German, French and Irish legislators might veto the deal. And in Germany there is a growing movement to challenge the Greek deal in a constitutional court, as being an illegal subsidy. The yield on Greek two-year bonds jumped 66bps yesterday reaching 6.99% and 5-year CDS rose 56bps to 436bps.

And FT’s Daniel Gros argues that the EU package is unlikely to solve anything, as the country needs about €30-50bn annually, depending on the future deficits path assumptions. Either way, 3-year package of up to €45bn won’t cut it. And the interest bill savings are also too thin – under the EU proposed deal, Greece will be facing an interest rate of ca 5%, which will provide the country with only €900mln in annual savings relative to market rates. Going lower to 4% - something opposed by Germany – will raise savings to ca €1,350 million per annum – still short of what is needed. Per Gros: the Greek problem is not one of liquidity but of insolvency.

And the IMF is severely constrained in what it can do in Greece by the fact that it can only lend 10-12 times the reserves position that Greece holds with IMF. And this means, at a maximum €15 billion.

So here we go – for all who thought the story is over, the most likely thing is that the actual story is just beginning.

Economics 05.03.2010: Greeks are paying the price

So you've heard by now that Greece 'escaped' the wrath of the market yesterday by placing €5bn worth of 10-year bonds. But don't be fooled - Greek's escape was nothing more than a respite: Greek taxpayers are now on the hook for paying a 6.3% yield on the 10-year paper - in line with near junk status of the bonds. This marks the highest spread for Greek debt since 2001.

Despite the issue being covered at 3x, there is a possibility for prices to tumble in the secondary markets (as happened with their 5-year paper last month) and there is an added concern that demand was underpinned by speculative investors with short-term horizons, as 'hold-to-maturity' types of investors (e.g insurance companies and pension funds) are cutting back on their holdings of PIIGS bonds. If the latter is true, then we can expect a serious pressure on yields to emerge in the next few days, with subsequent noises from the EU authorities about 'speculators' profiteering.

Big - albeit artificial - test for the euro will be March 16th when the EU Commission will rule on Greek fiscal consolidation plans. Expect approval, enthused speeches, and backroom talks on how to proceed forward with the country that

• plans to cut 2% of its GDP-worth off the deficit this year, but
  
• is unlikely to deliver on this target, whilst
• needing to cut a whooping double the planned amount just to stay afloat toward the 3% deficit goal for 2014-2015.
  

Meanwhile, Jean Claude Trichet went out of his way yesterday to tell the Greeks not to invite the IMF. During his press conference, Trichet repeatedly stressed that Europe has its own safety net for defaulting states (well, not quite in these terms) so no need to call in the big boys from the IMF. One wonders, what is Mr Trichet talking about. Papers quote Trichet saying that it is absurd to envisage scenarios of Greek exit from the euro.

All of this resembles the debates in the Afghan government in 1979 - to invite the Soviets or not... And the really, really, really funny thing is - IMF is EU-led organization (of the two supernationals: the World Bank is traditionally reserved as the leadership game for the Americans, while the IMF leadership goes to the EU appointees). While the Greek taxpayers are now set to pay over ten years €184.22 per each €100 borrowed last night - a steep price for not calling in 'Your Own Bad Guys' from Washington.

Now, put the Greek pricing into a perspective. On 14 January 2010 the NTMA issued €5 billion of a new bond, the 5% Treasury Bond 2020. If Irish debt was priced at Greek yields, the total cost to Irish taxpayer from this deficit financing would have risen €21.33 from €62.89 per €100 borrowed. In other words, our expected annual deficit for 2010 alone would be some €4,050 million more expensive over 10 years.

Economics 24/02/2010: Greeks, Germany and the euro

There is a fine mess going on in Athens. And it is both

• detrimental to the Euro; and
• predictable (see here).

Exactly a month ago to date, I have predicted that Greece is going into a Mexican standoff with EU. We now arrived at exactly this eventuality (see this link to a good summary of Greek Government views - hat tip to Patrick).

Back on January 24th, I wrote:

"The EU can give Greece a loan – via ECB... But the EU will have to impose severe restrictions on Greek fiscal policy in order to discourage other potential would-be-defaulters today and in the future. That won’t work – the Greeks will take the money and will do nothing to adhere to the conditions, for there is no claw back in such a rescue.

Alternatively, the EU might commit ECB to finance existent Greek debt on an annual basis. This will allow some policing mechanism, in theory. If Greeks default on their deficit obligations, they get no interest repayment by ECB in that year. ...but what happens if the Greeks for political reasons default on their side of the bargain?

If ECB enforces the agreement and stop repayment of interest, we are back to square one, where Greece is once again insolvent and its insolvency threatens the Euro existence. Who’s holding the trump card here? Why, of course – the Greeks. And, should the ECB play chicken with Greeks on that front, the cost of financing Greek bonds will rise stratospherically, and that will, of course, hit the ECB as the payee of their interest bill.

Thus, in effect, we are now in a Mexican standoff. The Greeks are dancing around the issue and promising to do something about it. The EU is brandishing threats and tough diplomacy. And the problem is still there."

There are three possible outcomes from the standoff:

• Greece backs down and Germany accepts an apology - which pushes us back to square one, with Greeks still in the need of funds and EU still without a plan;
• Greece goes for the broke and remains within the euro, implying a rapid and deep (ca 30%) devaluation of the euro; or
• Greece is forced out of the euro (there is, of course, no mechanism for such an action).

The first option is a delay in the inevitable; the last one is an impossible dream for fiscally conservative member states. Which leaves us only with the second option.

And incidentally, the only reason German bunds are still at reasonably low yields is because Germany is linked to Greece (and other PIIGS) only via common currency. Imagine what yields the German bunds might be at if a full political union was in place?

This, of course, flies in the face of all those who preach political federation as EU's answer to structural problem of hinging desperately diverse economies to common currency.

So hold on to your pockets - after the Exchequer raided through them via higher taxes; Greek default will prob their depths through devaluation. And then you'll still be on the hook for our banks claiming their share in an exercise of rebuilding their margins.

Economics 20/02/2010: Greeks ahead

Want to understand the extent to which politicians and the public sector workers are failing to understand the fundamental principles of the markets? Look no further than Greek debt issue looming on the horizon.

Some background first. Less than a month ago, Greece put on the market an €8 billion 5-year bond package at a 6.1% interest rate. Seemingly, it was able to attract initial interest of investors - the early bidders were keen on taking high yield paper. Of course, the country bond issuers had no idea why institutional investors had sudden interest in Greek bonds. And this led to a bottleneck emerging in later days of the placement.

Institutional investors, especially diversified portfolio managers, might want a bond for its default risk-adjusted returns. This hardly constitutes a significant proportion of the demand for Greek bonds in recent months. Alternatively, they might down-weight the consideration of the default risk and use the bond purchase to simultaneously hedge their FX exposure elsewhere and earn high returns. It is the second component of the market that drives most of the demand for Greek bonds, aka portfolio management side of demand. This second source of demand is by its nature extremely shallow – there are fewer investors in this complex hedging space and those that are in it have many alternative (to Greek bonds) strategies available to them. It does, of course, help the Greek bond issuers’ cause that their yields are the highest in the Eurozone, making their bonds a solid target for single risk hedging on FX side. But it does not help them that the Euro is at risk of substantial devaluation going forward against the dollar and sterling.

In short, the demand for Greek bonds is not fundamentally driven (i.e not based on pure default risk v yield analysis). Adding insult to the injury, if one should rationally anticipate that Euro is going to continue falling against the dollar in the current scenario of contagion from Greece to the rest of PIIGS, then less faint-hearted amongst us might want to take a short position against the Euro. This can be done by not hedging existent non-Euro exposures. The effect of such implicit shorting is to further reduce demand for Greek paper. The folks at the Greek Treasury have missed these simple points. Thus, the aforementioned issue was simply too large for the markets and failed to sustain prices achieved on placement – within just two days after the issue, price fell 3.5%.

Which brings us to the next week – it is expected that the Greeks will be at the markets again, this time with a €5 billion of new 10-year paper. Even to have a go, the Greeks will have to push spreads on their paper over the German bund to a stratospheric height. Currently – 10-year Greek bonds are yielding 6.5%, up from 5.8% back in the end of December 2009 and 1.5 percentage points above their levels in November 2009. But this will have to rise. 7% anyone? Possible.

Short positions in Greek bonds are also signaling that the demand for new issue will be weak. Shorts in Greek bonds have risen to 9.82% up 0.24 percentage points in the first two weeks of February and 1.58 percentage points relative to the end of December 2009. But now they are being closed off. Closing the short means that demand for bonds rises, artificially, in the market – as bonds are being withdrawn for a return to the lender. But this demand is not about market appetite for bonds. Instead it is about a technical need for a re-purchase. With this demand pathway becoming more exhausted in recent days, there will be added pressure on new bond pricing – another aspect of the market the Greeks seemingly do not take into account.

But politicians and their public servants, ignorant as they may be of the markets, might have something else on their minds. Greek’s reckless and silly issuance patterns are driven by more than markets considerations. They are driven by gargantuan deficits and debt overhang – with €20 billion of maturing debt that needs to be rolled over around April this year alone - and the willingness of the Greek Government to sacrifice its own taxpayers (remember – higher yields mean higher cost of borrowing, to be carried by the future taxpayers) in order to force the EU to bailout the country. This strategy, similar to the game of chicken in which both participants hold equivalently credible threats, but one faces asymmetrically higher costs in the case of ‘no bailout’ outcome) is something that the EU leaders themselves do not seem to comprehend.

While the EU is sitting on its hands and issuing conflicting and irresolute statements on the matter, the Greeks are heading straight into a fiasco, should they fail to place new bonds at yields proximate enough to the current 6.5%. At the same time, failure to place this issue will push the Greeks even closer to a direct default on debt, imposing even more pressure on the EU to urgently deal with the matter.

If the EU fails to bail out the Greeks on this round, the Euro will be equivalent to the Titanic grinding against the iceberg. The Greeks will always have an option to walk away from the common currency and default outright – the consequences will be tough, but more palatable than the ones which will hit the country should it go down alongside the Euro. First move advantage is real in the game of chicken.