Do I See Movement In The Greek Trenches?

This isn’t about economics anymore, this is now about who does what, when, and how everyone else reacts.

Certainly the news that Greek bonds hit another post-EMU record high yesterday can hardly be said to have come as a surprise. 10-year bond yields reached 7.76 per cent at one point and closed up 26 basis points on the day. This morning Greece comfortably sold 1.5 billion euros worth of 3 month Treasury Bills – in the end they sold 1.95 billion euros of them – but the yield on the bonds more than doubled to 3.65 percent, from 1.67 percent for a sale of similar debt on January 19. And the the extra yield investors demand to hold Greek 10-year bonds instead of German bunds, the euro-region’s benchmark government securities, rose again today – to as much as 472 basis points – the most since Bloomberg records began in 1998. The average spread over the past 10 years has been 61 basis points. Greek two-year notes also fell, pushing the yield 23 basis points higher to 7.51 percent.

On the other hand, Bundesbank President Axel Weber was out there yesterday telling a group of German lawmakers that Greece was going to need more, not less money.

Greece may require financial assistance of as much as €80 billion ($107.92 billion) to escape its debt crisis and avoid default, Bundesbank President Axel Weber told a group of German lawmakers Monday, according to a person familiar with the matter.

The estimate, considerably more than the €45 billion that European countries and the International Monetary Fund are currently prepared to extend Greece this year if it needs a bailout, suggests that a rescue of the country may come in several stages and reach beyond 2010.

Why, I ask myself, is a conservative, and normally discreet, figure like Axel Weber out there stressing precisely this point at this moment in time, when German voters are notably nervous about any sort of aid to Greece. Reticence on the part of Angela Merkel’s coalition partner makes a parliamentary debate on a loan difficult. And voices are even being raised about whether it would not be a better idea for Germany simply to put the losses down to experience and go back to the Deutsche mark?

Germany might consider exiting Europe’s current monetary union to create a smaller bloc as the Greek crisis threatens to turn the euro area into a region of “fiscal profligacy,” Morgan Stanley said.

Greek rescue measures “set a bad precedent for other euro- area member states and make it more likely that the euro area degenerates into a zone of fiscal profligacy, currency weakness and higher inflationary pressures over time,” said Joachim Fels, co-chief global economist at Morgan Stanley in London, in an April 14 note. “If so, countries with a high preference for price stability, such as Germany, might conclude that they would be better off with a harder but smaller currency union.”

All these statements can be read as bargaining postures, attempts to get people in the South of Europe to focus their minds on the problem in hand, but they can also be read as warnings of what could happen if they do not.

Certainly, nothing at this point is very clear. Especially, as the FT reminds us this morning, when we live in a world where the unthinkable has finally become thinkable. So we could now ask ourselves whether the financial markets are not in fact, and before our very eyes, gearing themselves up for an event which many had not previously been factored into the realms of the possible: Greek debt restructuring.

Even as Greek bail-out discussions continue – talks between representatives of the European Commission, European Central Bank and IMF were delayed on Monday by the volcanic ash cloud – market watchers are starting to question whether, in the long term, Greece can avoid a restructuring of its debts or even an outright default.

“Investors and analysts are now running the numbers to see what a haircut to Greek bonds would be,” says Steven Major, global head of fixed income research at HSBC. “One way to do this is to compare restructurings for emerging market sovereigns. Based on the defaults over the last 12 years the average long-term recovery rate is close to 70 per cent. Ultra-long Greek bonds currently trade at a price below this.”

The Financial Times also reports that the IMF is likely to raise the question of debt restructuring at their forthcoming meetings with the Greek finance ministry – you know, the ones that have been delayed by the symbolic intervention of all that volcanic ash. According to the FT source, it is not likely to be a detailed discussion “just a pointed reminder of the debt forecast”.

The IMF has already told the finance ministry informally that Greece’s debt will reach 150 per cent of GDP by 2014, according to this person. Greece’s debt to GDP level – 113 per cent in 2009 – is already the highest in the eurozone. The IMF calculates that Greece will need to find €120bn ($162bn) over the next three years.

Of course, the term “debt restructuring” does sound a lot better than default, and the expression does cover a wide range of possible outcomes, running from unilaterally changing the terms of the bonds one the one hand, to voluntary renegotiation to ease refinancing pressure at the other.

One proposal which has been advanced (most recently by Wolfgang Munchau) is for recourse to some form of Brady bond:

Restructuring is a form of default, except that it is by agreement. It could imply a haircut – an agreed reduction in the value of the outstanding cashflows for bond holders. The Brady bonds of the late 1980s, named after Nicholas Brady, a former US Treasury secretary, worked on a similar principle. An alternative to restructuring would be a debt rescheduling, whereby short and medium-term debt is converted into long-term debt. This would push the significant debt rollover costs to well beyond the adjustment period.

Brady bonds were initially issued to ease the debt difficulties of a number of Latin American countries in the late 1980s (and they are modeled on the earlier Japanese par bonds – you can read more about them in Wikipedia here). The essential idea in the Greek case would be that current debt instruments would need to be swapped for some longer term bond with a lower than market rate coupon (or implied interest rate).

Of course, as Munchau points out, in order to get the existing bondholders to trade their debt on a voluntary basis, they would have to be put under some sort of pressure:

One way to force the debate would be to attach super-senior status to the EU loan to Greece. I understand this is still an unresolved issue. Super-senior means this loan would be repaid before existing debt. Should Greece ever get into a liquidity squeeze, bondholders would be put in a back seat. In such a situation, they might prefer rescheduling.

Which makes this little detail about the form of the EU loan rather more interesting than it might seem at first sight:

Any aid to Greece would come in the form of pooled loans from the euro-zone countries and not the purchase of Greek bonds, German Deputy Finance Minister Joerg Asmussen said Tuesday.

He also said that Greece will be an issue at the meetings of finance ministers and central bankers from the Group of Seven leading industrial nations and the Group of 20 industrial and developing nations this weekend in Washington.

“Of course, Greece will be an issue,” Asmussen told reporters Wednesday. He also said that “if financial aid for Greece will be given, then the pursued path will be to provide pooled loans.” Germany would provide its share of such loans through the state-owned KfW Banking Group and the loans would be guaranteed by the government.

Plans to purchase bonds “is off the table,” he said. The advantage of providing pooled loans is that there can be stricter conditions to paying out such loans, such as demanding the implementation of fiscal reforms.

So we could imagine that the forthcoming loan would have super-senior status (German voters would settle for nothing less), and, if this interpretation is correct, it will be existing bondholders, and not the EU governments, who will be being invited to “bail Greece out”. Well, maybe we won’t have to wait too much longer to find out, since the Greek Finance Minister George Papaconstantinou stated today that the country could call on loan backup from the EU and the IMF by as early as next month depending on loan conditions and the progress of talks with the EU, ECB and IMF joint mission, which is composed of around 20 people according to reports. Plenty to talk about, and plenty of people to do the talking. Too many, perhaps?

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Edward Hugh also blogs at A Fistful of Euros.