“A default is not an issue for Greece,” Jean-Claude Trichet, head of the European Central Bank, told a press conference in Frankfurt today, April 8.
The bond market begs to differ. Greek bonds sold off today bringing the yield premium to benchmark German bonds to 4.27 percentage points. That’s the biggest spread since the start of the euro. The average spread over the last decade has been 0.34 percentage points.
To be fair to Trichet, the difference of opinion could simply be one of timing. Greece does not face a default this week or month. If that’s Trichet’s time frame, then he’s correct. But the bond market is looking somewhat further out and what it sees is a process that finally, sometime in 2011 in all likelihood, results in a Greek default.
The bond market’s logic is very simple. Greece is going to be forced to pay so much to fund its debt that the country simply won’t be able, at some point, to pay the price. Remember, the bond market is saying, that this is a country that’s being asked to cut government spending and private wages to a degree that will send the economy into a recession.
And it’s not like the economy of the rest of the European Union is growing so fast that it can pull Greece out of a recession. Revised numbers show that from the end of the third quarter to the end of the fourth quarter of 2009 the EU economy didn’t grow at all.
What does this mean for investors?
No quick end to the crisis but a steady drip, drip, drip of bad news and worry that’s likely to stretch into 2011.
Continued weakness in the euro as long as the crisis lasts.
Pressure on the debt and economies of other troubled euro economies such as Portugal and Spain.
And a continued drag on global economic growth.
The basic problem is that the basic problem with Greek debt hasn’t been fixed. The country has been able to refinance debt that has come due so far this spring but at interest rates now above 7%. The yield on the Greek 10-year bond stood at 7.31% when Trichet began his press conference.
But Greece needs to refinance $15.5 billion in debt by the end of May and another $27 billion by the end of 2010. That may not seem like much until you remember that Greece has an economy only about 1/42nd as large as that of the United States. Refinancing $42.5 billion in debt for Greece is equal to refinancing $1.8 trillion in debt for the United States.
I don’t think there’s any real doubt that Greece will be able to refinance its debt this year. But the cost is only likely to rise from today’s already staggering yields.
The risk of default will just by itself keep upward pressure on interest rates.
But new lending rules at the European Central Bank will hurt too. By old pre-financial crisis rules government bonds with the kind of low credit ratings that Greece now gets from two of the three major debt rating companies would have prevented banks from using their holdings of Greek government bonds as collateral to borrow from the European Central Bank. That would have made banks even more unwilling to hold Greek government debt—driving up yields—and it would have pushed Greek banks, which hold proportionately large amounts of Greek government debt, into crisis. They wouldn’t have able to borrow to fund their own operations—and they wouldn’t have been able to sell their holdings of government bonds without taking huge losses.
During the financial crisis, the European Central Bank suspended those collateral rules. But once the crisis was over the central bank started to talk about moving back to the old rules. That would have pushed Greece into financial chaos.
The good news is that the new rules will allow Greek—and other–banks to continue to use Greek government debt as collateral for borrowing from the European Central Bank. The bad news is that the new rules will make it expensive to do so.
The bank will now impose a haircut on low-rated debt used as collateral beginning on January 1, 2011. So, if the haircut is 5% to 10% as now seems likely, the central bank will accept a Greek government debt (or other low-rated bonds) for collateral at a rate of just 95 cents to 90 cents to the dollar (or euro, actually.)
Yes, the haircut rules don’t go into effect until 2011, but if you ran a bank would you be rushing to stock up on Greek debt knowing that in 2011 you will be able to borrow just 90% to 95% of its value?
Looking at all these dynamics, the bond market is saying that it doesn’t see any way out for Greece except an eventual default. Rising interest rates will slow the Greek economy—already suffering from budget and wage cuts—lowering government revenues, making larger budget and wage cuts necessary, which will slow the economy and lower government revenues even more. That in turn will make bond buyers even more reluctant to buy except at even higher yields.
Do you see something that the bond market is missing? I don’t.