Sovereign debt crisis: What traders are talking about

Here’s what I am hearing. At the end, I will tell you how far-fetched I think these things are.

1. Greece will default. Greek default is now priced as a near certainty (now 99%, judging from 10-year bonds and credit default swaps).
2. Contagion is the concern. Greece is relatively small, however – less than 3% of euro zone GDP. So Greece matters because of the direct exposure of a few banks, but mostly because of potential knock-on effects, especially in Spain and Italy which are too big to fail. But France is now an issue as well.
3. Greek default means euro zone break up. What happens when Greece defaults then? Rumour: when the Greek default is announced, simultaneously Greece will announce it is leaving the Euro and the Drachma will start trading on FX markets immediately.
4. The Drachma means wealth loss for Greeks. As in Argentina, traders believe cutting the implicit ‘Drachma peg ‘ with the euro means huge devaluation. “Traders believe the Drachma will have to be competitively devalued immediately by forty to fifty percent, meaning that Greek middle classes will see their savings held in domestic banks depreciate by the same amount in value within twenty four hours. This could then precipitate a “run” on the banks causing the Greek economy to collapse even further.”
5. A partial run is already happening. We have already seen this in Ireland (although the situation there has stabilised). Felix Zulauf pointed to Italian bank deposit loss in May. The Siemens move was an indication that not just Greek banks but French banks with Greek exposure are being targeted as well.
6. Capital flows from Europe are increasing US money supply. “in relation to the recent surge in the US money supply,… the argument would seem to be that a silent run on European banks is in the works as money is moved into perceived safe USD liquid assets.”
7. The ECB will not provide liquidity to Italy and Spain. “It’s a question of what incentives we create with our decisions. Interest rates in the capital market have a disciplinary effect. And if monetary policy intervenes in the markets, the pressure on the affected governments to introduce the necessary reforms is reduced.”

One source: Traders Prepare For “Run” on European Banks.

Another source: ekathimerini.com | Greeks to vote on future in eurozone?

Here’s what I think. Many European policy makers want more than anything to preserve European cohesion. In Germany, policy makers feel pressure as the largest country to promote this cohesion. German history tells them that Germany would bear the lion’s share of the blame for a collapse of the euro zone. So despite anti European noises from the Germans, there is a lot of support for Europe still left. I recommend the following two articles on this (I know these are both Spiegel articles – and Spiegel has a ‘sensationalistic flair that makes some Germans wary of it as a source; but the information here is good):

• The Euro Crisis Hits Berlin: Merkel’s Authority Is on the Wane – SPIEGEL ONLINE – News – International
• Interview with Former German Finance Minister: ‘Germans Will Have to Pay’ – SPIEGEL ONLINE – News – International

My sense is that the Germans will not let Italy or Spain go down. They do want their quid pro quo in terms of ‘structural reforms’ for offering aid, however. Moreover, the ECB will not buy Italian and Spanish debt without this quid pro quo. We first heard this via Morgan Stanley’s Elga Bartsch and now Bundesbank head Weidmann is saying exactly the same thing (see the link in bullet #7 above). And if you read the Interview with Peer Steinbrück above, you will see that even the SPD which is out of power is saying the same thing. So the consensus is aid in exchange for structural reform.

The question is default. Germany is preparing for Greek bankruptcy, yes. This is just contingency planning because the official German position on Greece is to avoid talk of default and to push forward with structural reforms until it is clear that Greece cannot make the grade. Allowing Greece to default lessens pressure on it for reforms and that is what the Germans want. While German Chancellor Merkel’s authority is being questioned, she is still following this line and I believe the Germans will do for some time to come.

Even if Greece did default (which I believe they will eventually), Eurozone default is not synonymous with breakup. So I think the concept that Greece will default and then go immediately to the Drachma is far-fetched. How does that happen? You would have a run on Greek banks. This would spread to Italy and Spain at a minimum. The Greek economy would collapse. In short, this would be an unmitigated disaster.

Merkel recently said:

"The top priority is to avoid an uncontrolled insolvency, because that would not just affect Greece, and the danger that it hits everyone – or at least several countries – is very big.

"I have made my position very clear that everything must be done to keep the eurozone together politically. Because we would soon have a domino effect"

On the money supply issue, a friend reminded me that “capital flows into a country with a flexible exchange rate do not change the stock of money. They change the exchange rate. In a fixed exchange rate nation, money stock would be effected, but that is not what the US has, at least with respect to the eurozone.” In theory the exchange rate effect is true, but only over the medium-term. The ECB/Fed swap lines are in place, so perhaps you don’t see as much pressure on the Euro as you might expect but indeed the euro has sold off somewhat. If the Europeans are getting into the USD, then you would expect to see money supply changing (Euroland shrinking, US rising) and eventually the exchange rate pressure should come too. That’s why the euro should be under pressure.

I think I will leave it there. I will say that all of this strikes me as panic – a liquidity crisis with huge potential for deadweight economic loss. Agricole, SocGen and BNP Paribas have shown much more transparency about their exposure to Greece. That’s a good thing. In retrospect, yesterday’s post on the European Bank Run strikes me as unduly alarmist because I should have stressed that this could well be just a liquidity crisis and not a solvency crisis for the French banks. Before we start talking about recapitalisations and the like, we must recognise this.

Above all, however, we need to take pressure off the ECB to do the heavy lifting. Europe suffers a lack of democracy. We want the ECB to provide lender of last resort liquidity but first we want democratically-elected national governments to make the hard choices instead of the ECB. The whole EU apparatus is seen by many Europeans as deeply undemocratic and so when they see these schemes, they recoil in revulsion. It is this revulsion which is driving the politics and makes the situation unpredictable. Minimising it by taking decisive action on a credible solution to Europe’s debt crisis is the only way out of this successfully.