Greece is not the Euro zone country which would benefit the most from an outright default

On Thursday and Friday of last week I discussed the latest economic figures from China which showed economic growth of 9.7% and consumer price inflation of 5.4%. Such signs of overheating were only partially ameliorated by a reduction in the growth of Chinese broad money supply measure to an annual growth rate of 16.6%. Yesterday continuing its recent habit of announcing moves on non-work days the People’s Bank of China announced an in crease in reserve requirements for China’s banks. This means that from Thursday 21st of April China’s largest banks will now have a reserve requirement of 20.5% which will be 0.5% higher than before. So we are beginning to learn what the Governor of the PBOC meant when he said this last week.

Our monetary policy will continue to move from moderately loose to prudent……..The trend will continue for some time.

Comment

Regular readers will be aware that it is my opinion that rises in reserve requirements are a weak policy tool and accordingly if it relies on it as a tool the PBOC may well have to keep it up for some time! Fortunately it is also raising interest-rates although as more and more stories are circulating about house price falls in some parts of China the central bank may be afraid of rising rates much more. The other alternative would be to let the Yuan appreciate but as it has only risen by 4.5% since China signalled it would allow more flexibility in it last June.

So we see that whilst China has raised interest-rates four times over the past 6 months or so it has been unwilling to let the Yuan rise by much. So it has been relying on raising bank reserve requirements as a policy tool. Now to complicate matters there appear to be signs of a weakening of her property market. So we may well be facing what these days is a crucial test for a central bank, will it continue tightening its policy in the face of falls in house prices? I know I have some readers in China and would be interested to hear their thoughts on the current state of the property market there.

Finland

Over the weekend Finland had a general election and this political development may have economic consequences way beyond Finland’s borders. The reason for this is the the Euro-sceptic True Finns ended up with 19% of the vote and the Social Democrats who oppose aid for Greece and Ireland also won 19% whilst the party of the previous Prime Minister only got 15%. Now coalition government s can take many unexpected forms after all look at what happened in the UK just under a year ago! However there is the prospect of Finland’s next government having a strong Euro-sceptic influence.

This matters for several reasons. One is the structure of Finnish democracy which requires individual votes on approval of rescue packages. The other is the way that many matters in the Euro zone are coming to a head. For example negotiations are going on right now as to what type of rescue package will be given to Portugal which lets face it will be  complicated enough by the fact that Portugal only has a caretaker government until the June 5th elections. Also the main rescue fund the European Financial Stability Facility ( has anybody else spotted that it has in fact led to instability?) requires a boost to its funds which is due soon. Also the replacement to the EFSF the ESM which is due to start in July 2013 relies heavily on AAA rated countries of which one is Finland.

This may not be the Finnish (sorry) of the current rescue packages but it does pose a few questions. And here is one for you if this did lead to them being scrapped would it be a bad thing? After all both Greece and Ireland look like they are deteriorating under these so-called rescues.

Greece’s woes continue

On the subject of Greece the situation is continually beset now by leaks from official bodies that it will need to restructure its debt which are followed by ever more hollow sounding official denials. Latest to join in is the International Monetary Fund which according to the Wall Street Journal thinks the following.

The IMF believes the debt situation in Greece is unsustainable………Senior (IMF) officials have told the parties involved that restructuring should be considered soon.

In a view that is very similar to the one expressed by George Soros that I wrote about last week the IMF is unofficially suggesting that one of the routes forward involves a substantial extension to the maturity of Greece’s exisiting debt.

How would this help?

If we look at the government bond I discussed on Friday the 6% bond which expires in 2020 it would have its maturity changed to 2030. This would mean that the principal (the amount originally borrowed by Greece) would be repaid ten years later which would obviously help her going forwards in terms of cashflow (5 billion Euros)  and would also give time for hopefully there to be a substantial amount of economic growth in the meantime which would make the repayment affordable. UK readers may think that this section sounds oddly like an Ocean Finance advertisement and the truth is that there are similarities. It is also true that there is an element of “kicking the can down the road.”

Where real relief comes in the shorter term is if the same system is applied to bonds which are to be renewed sooner than 2020. If we look at one of these the 4.5% bond expiring in May 2014 then Greece’s financial position in 2014 would be improved by not repaying it until 2020 by some 8.5 billion Euros.

The catch is what would happen to investors in these bonds. The price of the bond expiring in 2014 closed at 68.15 on Friday. This is quite chilling when you consider that not only does Greece promise you 100 in May 2014 but she also has the EU/ECB/IMF backing her up. The markets are saying, we don’t believe you! An investors buying now would expect 100 in May 2014 as the capital component of the 19% redemption yield. Moving the return of the prinicipal to 2020 would accordingly be quite a punishment compared with getting it in 2014.

What else would the IMF do?

At the same time the IMF would extend the term of its current aid package from 3 years towards 10 years. This would further help Greece by not having to repay the money the IMF has lent it. You might think it is odd that the Euro zone increased the maturity of its loans to Greece but the IMF has not so far and you would be right.

Why is the IMF acting in such a way?

The IMF is concerned about the existing holders of Greek government debt. These are the Greek banks, the European Central Bank and foreign banks. It feels that operating in this way and perhaps also reducing the interest-rate on Greek government bonds will avoid too much of an impact on them. If you look at the prices of Greek government bonds you might think that these institutions have been punished heavily already. However the Euro zone banking stress tests followed the European Central Bank convention that as sovereign default is unthinkable the prinicpal will be returned and the losses on the bonds need not be accounted for if they are held to maturity. I would give my view on this but Earth Wind and Fire got their first.

Take a ride in the sky, on our ship fantasii
all your dreams will come true, right away

The Greek government responds

On Friday the Greek government tried to dampen speculation about restructuring by annoucing some medium-term plans. These involved an extra 26 billion Euros of austerity and 50 billion Euros of privatisations although in a familiar theme there was a lack of detail as to how all of this is going to be achieved. Events, however are now showing signs of speeding up as Kathimerini is reporting that Greek Finance Minister Papaconstantinou has raised the issue of extending the maturities on all of Greece’s debts of about 340 billion Euros.

His idea of Greece returning to longer-term borrowing in 2012 is looking like it is joining his previous claims of doing this in 2011 which look firmly in the grip of the song I have quoted from above. From this we get a big factor behind the sudden talk of restructuring. Numbers in Greece are often revised but as we stand Greece needs to borrow around 27 billion Euros next year and the question that is now being asked is how?

Is outright default now possible?

Yes. When I started this blog I pointed out how expensive such a move was likely to be and that it came with quite a few problems. However the situation has been so mishandled that it is by no means inconceivable now and may even be an improvement on the alternative.

US Consumer Price Inflation

These numbers were considered to be relatively good news by the markets on Friday. Whilst the headline number hit 2.7% the annualised number for core inflation fell to 1.6%. Since core inflation excludes many of the things which are rising ( and many of the most vital parts of life……) this perhaps was not the good news it was apparently received as.

However I notice I am not the only person questioning the credibility of these numbers. My attention was drawn to some research which pointed this out. Apparel (clothing) prices fell by 0.6% on the month which followed a 0.9% fall in February according to the seasonally adjusted figures. Slightly surprising you might think considering the way commodity prices for goods such as cotton have risen.Well you might be even more surprised to learn that the raw data shows that apparel prices rose by 2.5% in March. Is down the new up?

Ireland’s Housing Market

On Friday there was an auction of 84 properties at the Shelbourne Hotel in Dublin. I understand that Jagdip Singh who follows such matters closely feels that the prices achieved were 60% below the peak. The reason why this echoed in my mind is that a house price fall of 60% was the adverse scenario that Ireland’ s banking stress tests assumed less than 3 weeks ago. In some areas at least adverse is already here.

Whisper it quietly but if a country was to default and start again the biggest potential gains would be found in Ireland if it cut much of its banking sector adrift….

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  • Sovjohn

    Hi Shaun,

    I’d like to know your opinion regarding Greek debt:

    Do you believe that the best option would be:

    *A “lengthening” of the repayments, i.e. soft default?
    *A “lengthening” of the repayments and a haircut, at the same or different times?
    *A haircut?
    *Something else? (Perhaps the Jedi rushing to Greece’s aid?)

    As you well know, I value your opinion and experience very much, and I would be interested to know what you believe about that. I would also like to know if you propose the above to take place soon, or later on.

    Thanks,

    Ioannis

  • Mr_kowalski55313

    “Whisper it quietly but if a country was to default and start again the biggest potential gains would be found in Ireland if it cut much of its banking sector adrift…”

    I run my own blog, and the second most popular post I’ve ever written was “Iceland’s Temptation”.. what you speak of is precisely what Iceland did. Call me crazy, but one day the people of a nation will rise up and force their government to give the bankers the middle finger:

    http://themeanoldinvestor.blogspot.com/2010/12/icelands-temptation.html

  • Anonymous

    “What the S&P is doing is making a political judgment and it is one that we don’t agree with,”
    Who said this? an official of the usual Eurozone suspects?
    Nope!
    ‘Austan Goolsbee, the chief economist of the president’s [Obama] Economic Recovery Advisory Board, dismissed the change in outlook while making the rounds on US cable networks.’
    from http://www.bbc.co.uk/news/business-13118834
    ‘US warned on top credit rating by Standard & Poor’s’

  • Anonymous

    Something isn’t getting much attention in Ireland currently…

    http://www.rte.ie/news/2011/0414/aib-business.html

    The gist of this of this article is the Irish are effectively rewriting capital structures in AIB. As everyone knows getting the bond holders to take a haircut required that the ordinary share be wiped out. That is the hierarchy. This leave the Irish in a bind having forced their Pension fund to take a very large stake, to stay legal they would have had to wipe it out. So they have enacted a law which allows them to wipe out the Junior debt without wiping out the ordinary shares.

    This has huge implications people who buy debt except a lower return precisely because they are higher in the pecking order since the Irish government has unilaterally altered this I would expect Irish junior debt to loose a lot of value over the next few months.

  • Shaun Richards

    Hi Ioannis
    In my experience of the Star Wars films the Jedi have mostly been on the losing side! Although I expect the latest UK census to show again that a reasonable number of people claim to be Jedi Knights….

    The easiest bit is timing and the answer is now. The delay that has happened has weakened Greece.

    On its own I do not think that a lengthening of maturities would be enough and would likely be combined with a reduction in coupon/interest-rates on existing debt. Whilst theoretically it could work and it has worked in the past (Argentina comes to mind) it would not be my first choice.

    I would take the haircut restructuring route and as an amount is required I would go for 40%. On its own it would probably not be enough but there is another reason why I would choose it. By being obvious and getting a lot of news it would make a change that I would hope would become a bigger change in Greece in that many of her institutions need to change too. Just fixing the financial mathematics will not do as otherwise Greece may slip back into the problems that have brought here to here.

    So I am back to my suggestion from the beginning that to coin a phrase used in the UK those in Greece need to feel “we are all in it together”. So I would combine it with going after those responsible for the situation as some of the misrepresentation was so bad that it must be illegal. I know Vassillis feels that this is not possible for Greece but if not now then she needs to change I feel. In some ways towards Joseph Schumpeter’s idea of creative destruction.

    I realise that there is some psychology mixed in here with the economics but I think in any long journey you need to start in the best frame of mind that you can. And to bring in another theme of mine privatisation of profits and socialisation of losses for the banking industry has become an error. It is long past time for them to take their share of the pain.

  • Anonymous

    Hi Ioannis
    In my experience of the Star Wars films the Jedi have mostly been on the losing side! Although I expect the latest UK census to show again that a reasonable number of people claim to be Jedi Knights….

    The easiest bit is timing and the answer is now. The delay that has happened has weakened Greece.

    On its own I do not think that a lengthening of maturities would be enough and would likely be combined with a reduction in coupon/interest-rates on existing debt. Whilst theoretically it could work and it has worked in the past (Argentina comes to mind) it would not be my first choice.

    I would take the haircut restructuring route and as an amount is required I would go for 40%. On its own it would probably not be enough but there is another reason why I would choose it. By being obvious and getting a lot of news it would make a change that I would hope would become a bigger change in Greece in that many of her institutions need to change too. Just fixing the financial mathematics will not do as otherwise Greece may slip back into the problems that have brought here to here.

    So I am back to my suggestion from the beginning that to coin a phrase used in the UK those in Greece need to feel “we are all in it together”. So I would combine it with going after those responsible for the situation as some of the misrepresentation was so bad that it must be illegal. I know Vassillis feels that this is not possible for Greece but if not now then she needs to change I feel. In some ways towards Joseph Schumpeter’s idea of creative destruction.

    I realise that there is some psychology mixed in here with the economics but I think in any long journey you need to start in the best frame of mind that you can. And to bring in another theme of mine privatisation of profits and socialisation of losses for the banking industry has become an error. It is long past time for them to take their share of the pain.

  • Shaun Richards

    Thanks Martyn for this. I will follow it.

    This isn’t the first time in this saga that Irish law has been found wanting. But my main thought on reading this is the damage that has been done to the National Pension Reserve Fund. Future Irish pensioners are likely to rue the investment decisions made and in my opinion the last Irish government exceeded its authority in this area.

  • Anonymous

    Thanks Martyn for this. I will follow it.

    This isn’t the first time in this saga that Irish law has been found wanting. But my main thought on reading this is the damage that has been done to the National Pension Reserve Fund. Future Irish pensioners are likely to rue the investment decisions made and in my opinion the last Irish government exceeded its authority in this area.

  • Mises ghost

    Unfortunately the article lacks some details:

    TARGET2- as most central banks, not only the PIGS but also FRANCE and Austria…, lack the funds to keep their banks liquid, they resorted to ripping off the Bundesbank by increasing their TARGET2 account deficit from 6 billions in 2007 to over 326 billions as of april 2011. Ireland alone has some 145 billions of target2 deficits on their account with the Bundesbank….

    Current accoint deficits: Greece has some 11% GDP deficits… after a restructuring of debts, less orwellian economists talk about “technical default”, there would be no chance to finance this deficit, ergo the economy would have to shrink ( 33% of the greek GDP is imported, assume imported goods as superior in factor 2: 11/0.33:2=16.) 16% of shrinkage would diminish the tax receipt of the greek government by some 25%!!! Talk about finacial consolidation or rather about a civil war in such a prime example of civic behaviour as Grece.

    Spain: some good news are that their export sector seems seems to be capable to generate growth. OTOH the banking sistem is in far worse conditions than any official admits: more houses on the property market than in the whole US, housing prices still inflated AND part 2 off the scandal are the 120 billions of bankloans collateralized by now worthless land—- the property bubble was partially to be attributed to an inflow of 7million immigrants in the last 10years, now we can expect large scale emmigration creating an even higher supply of housing.

    And so on..

  • Shaun Richards

    Hi Martyn
    The story has gained more publicity today as Abadi & Co Securities and Aurelius Capital Management have challenged the legislation/ruling and I understand that the case will be heard on the 9th of May. It will be hard for this story to end well….

  • Anonymous

    Hi Martyn
    The story has gained more publicity today as Abadi & Co Securities and Aurelius Capital Management have challenged the legislation/ruling and I understand that the case will be heard on the 9th of May. It will be hard for this story to end well….

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