This week’s theme post will be exclusively about Greece because I think the Greek bond deal is emblematic of trends we see in markets and the real economy. And of course, the big news in the past few days is Greece. Its 5-year government bond deal was over six times oversubscribed, even after a 50% increase in the allotment. The bonds are trading down in the after market though. The yield is up to 5.13 as traders are reporting widespread selling. Overall, however, I would say the deal is a success as it marks a turning point for Greece in terms of acceptance in public markets.
The question is why would anyone buy a bond at 4.95% when it is rated Caa3 by one ratings agency, Moody’s and B- by another, Standard and Poor’s. I think there are a number of reasons here and not all of them are defensible but some of them are.
First, of course there is the reaching for yield dynamic that this high coupon means. Greece is a Caa3 country risk. There’s no way it should be trading at 4.95% for 5-year money given that rating. For example, Ukraine is also Caa3 rated and its 10-year dollar bonds are trading near 9%, whereas the Greek 10-year bond trades at just under 6%. That’s a huge difference. And you have to wonder if having Greece 300 basis points inside Ukraine for 10-year money makes sense. Greece’s government debt ratio is much higher than Ukraine’s ratio which will be less than a third of Greece’s at year end at 55-60% of GDP versus 176% in Greece.
However, in the wake of Mario Draghi’s whatever it takes message and the ECB’s outright monetary transactions gambit, it is clear that the ECB will act as a backstop in exigent times as a quid pro quo for structural reforms and budgetary discipline. This means that any government that could reasonably be seen as putting its public finances in order will always get a backstop from the ECB. That doesn’t mean there won’t be defaults and haircuts. We saw that in Greece. It just means that the loss to creditors will come only as a result of an unsustainable debt burden and solvency crisis rather than because of a liquidity crisis.
With liquidity crises off the table, investors can look at deals based upon solvency risk. With Greece, there are a few factors which make the deal more attractive than one would assume given the 176% debt to GDP burden.
There is the fact that the official sector – i.e. the Troika has the lion’s share of Greek debt now. The Troika has an infinite ability to take losses via extending maturities and pretending Greece is solvent by rolling over loans. This means that to the degree there is a haircut, the Troika is likely to be first in line for those. And to the degree the Troika takes a hit, it is likely to extend maturities and reduce coupon payments rather than take outright haircuts. The Troika’s presence means that the public market bonds have greater value.
Then there is Greece’s primary surplus. What this means is that Greece has the money to pay coupon interest payments in the short-to-medium term. Effectively, there is no rollover risk with Greece because the ECB is backstopping liquidity concerns and the solvency issue is mitigated by all of the bonds in the official sector. The remaining new issues then, only have coupon risk, which goes away given Greece’s primary surplus. Investors in Greece’s bonds are willing to take on these risks – potency of the ECB liquidity backstop, official sector’s willingness to take on solvency problems via extend and pretend maneuvers, and Greece’s continued fiscal improvement – in exchange for a coupon payment that is much higher than German bunds.
So that’s the case for Greece.
And the question then goes to the real economy and Greece’s ability to remain in the eurozone. I believe slow growth and permanently high unemployment and debt within the eurozone will eventually erode the political value of the euro for Greece. The country has done the heavy lifting so far, given the loss in output and wages. So, at this point one could argue that, with this behind them the Greeks will remain in the euro. T
he problem is that not only are we likely to see slow growth in Greece, hampered by significant debt burdens, but we have to ask ourselves what happens to Greece in a recession. Will the eurozone’s fiscal and banking union be ready to take on the pressures that a cyclical downturn would bring? All of the issues that are dormant now will come back: liquidity and solvency, deficits, unemployment, debt deflation, protests, nationalism.
Right now, the picture looks brighter for Greece. But Greece’s economy is still in a world of hurt and without greater fiscal and banking union, we have to fear what happens in the next downturn. The way it looks now, Greece cannot go through another recession and remain a part of the euro.