Sunday, 14 November 2010

The Return of the Bond Vigilantes … and Financial Common Sense?

This past week saw the return of the bond vigilantes in force, as Irish yields were pushed up to nearly 9% on Thursday, driving up yields in Spain and Portugal as well. In Greece, Prime Minister George Papandreou’s threats to hold an early election resulted in Greek yields rising to over 11%. His retreat from this position last Sunday, after extensive and well-merited criticism from Eurozone partners, was made under the cover of what could only be described as anemic results in the first round of regional elections.

This coming week will see a likely exacerbation of the public sector funding crisis, at least on the Eurozone periphery. On Monday 15 November, Eurostat announces the revised Greek debt levels for 2009 and presumably for earlier years. Ireland is being pressured to take action by announcing plans to access the European financial stability mechanism before the Eurofin meeting on Tuesday, 16 November.

In Greece, the crisis illuminates the worsening stage of the country’s public finances. New measures on public expenditure and revenue will have to be announced given the shortfall in revenues in 2010 and the fact that many financial and policy measures have so far not been implemented.

Concealed by the election furor is the fact that the European Commission has called upon Greece to pay back illegal state aid or improper disbursements in Common Agricultural Policy subsidies, agricultural insurance, investments in rail terminals and a range of other projects, which may reach a level of EUR 650-800 mln in 2010 alone.

In 2010, the Troika has decided to add OSE’s EUR 10 bln debt to the central government’s books (presumably over several trailing years) as well as the debt of other semi-governmental organisations. I forecast these additions driving Greek public debt to a level of 150-152% of GDP by end-2010.

This level may even be overshot, as media sources announced yesterday that, according to initial reports by the Hellenic Statistics Authority, 2009 GDP was probably lower than expected, at EUR 233 bln rather than EUR 240 bln.

Adding the 2011 expected deficit level brings the 2011 Greek public debt to at least 160% of GDP in 2011, and 168-170% of GDP in 2012.

The greatest threat, therefore, will be in 2012-2013, as I have already stated in a number of posts here. In 2013, Greece will have to pay back the first installment of the EUR 110 bln bail-out package which, together with rollovers or repayments (impossible to imagine given the current budget levels) of remaining private sector debt, will reach EUR 70-80 bln.

It is impossible to assume this level of funding will materialise. There will be three likely scenarios which emerge:

a.       The loan term of the current bail-out package will be extended to 6-8 years, with a second bail-out package of at least EUR 80-100 bln to cover bonds maturing in the next 2-4 years. In this case, we can anticipate an austerity programme in place to 2020.

b.      A rescheduling of the bail-out package will take place, together with an orderly restructuring of Greek debt to private sector organisations. In this case, the haircut will have to be on the order of 45-50% for this to have any real impact. A condition for this will be a budget surplus in Greece, enabling it to at least service part of the EUR 110 bln bail-out package.

c.       A total collapse of funding for Greece, leading to a disaster scenario where no further bail-out packages are possible, and where no further private sector loans are forthcoming.

We should not discount the third option. Our tendency at present is to focus on investor sentiment turn-around in individual markets on a time scale of months. Yet the public finance situation in most OECD countries is deteriorating rapidly, and by 2013 will have reached crisis levels absent the successful implementation of major austerity packages.

In this category, I particularly place Italy (likely public debt 128% GDP in 2013) and the United States (likely public debt 118% GDP in 2013).

Official Italian debt-to-GDP was already over 115% in 2009, with a 2010 deficit forecast at 5%. Given the likely impending collapse of the Berlusconi government and the fact that there is no clear political majority or political will for public sector reform in that country, it is difficult to understand why Italian bond yields are so far below Spanish ones.

In the United States, the total public debt limit was lifted to $ 14.3 trillion earlier this year. While President Obama’s Fiscal Responsibility Commission recently recommended $ 3.8 trillion in debt reduction, the divided Congress makes it highly unlikely that any rational decisions will be taken. Together with the QE2 package of $ 600 bln announced by the Federal Reserve and underlying economic weakness in unemployment, housing prices and foreclosures, we should expect that the risks of future lending to the US government will rise. Perhaps these will be offset by a currency decline or yet another “safe haven” flight to “quality”, but I would not place too much hope in this.  

We may, however, find ourselves in a “new normal”, where public debt levels of over 100% GDP are the norm, and where bond yields rise by 1-2 percentage points, without an adverse economic impact. This scenario would be similar to boiling a frog by slowing increasing the temperature in the pot, rather than pitching it directly into the boiling water. Either way, the frog gets boiled.

To summarise: there is nothing on the intermediate-term horizon which suggests to me that Greece will be able to repay its debts in 2013 as predicated by the EUR 110 bln bail-out. The quality of the regional election campaigns ending today, and of the general political debate over the last 6 months, has been abysmally low, with political parties refusing to accept reality and engaging in immoral electoral promises which have no hope of being realised.

Regrettably, exactly the same political climate exists in the United States or Italy. There is a total lack of political will to focus on the root causes of economic problems, and implement solutions. I have a higher regard for the economic reform being undertaken in the United Kingdom or Ireland, despite the major risks of the size of the fiscal adjustment being planned.

Together with the Franco-German proposal for making financial institutions bear a share of responsibility for future public finance defaults, and all the ingredients appear to be in place for major problems ahead.  

(c) Philip Ammerman, 2010

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