Greece owes the European Central Bank a thank you

After the excitement surrounding the so-called rescue plan for Greece last week that was launched by the Euro zone it would appear that Greece wishes to react quickly to events and issue some new funding. This will be a test for Greece on various levels and will give us a clue as to how she will get through the rest of this year. The head of the Greek debt agency Petros Christodoulou was quoted by the Financial Times as saying ““We would like to return to the market within March” and he estimated that the issue would be 5 billion Euros in size.

Those in charge of Greece’s finances have something of a dilemma in my view as their country needs funding whilst this new package has only improved her bond yields at the shorter end. So they are likely to be forced into a choice between cheaper short-term issuance and the stability of a longer-term issue. Also if one is to believe the public statements of Petros Christodoulou that the aid package “should tighten the spreads materially” then it would be logical to wait as long as possible. Of course the truth is he probably doesn’t believe that either!

Market Position

Amidst all the talk of a positive response to the Euro zone rescue plan for Greece the truth is that ten-year bond yields have not fundamentally improved. On Friday Greek ten-year bond yields closed at 6.18% which is +3.02% over Germany’s so virtually double Germany’s bund. If we go back to the beginning of this month they closed at 6.27% and have climbed as high as 6.4% on a closing basis during it. This morning the yield has risen a little to 6.21%. Hardly a ringing endorsement.

For shorter-dated instruments there has been a more significant improvement. If one looks at two-year Greek government bonds the yield closed on Friday at 5.2% which when compared to a close of 6.11% on the 1st March does show an impact from the rescue deal.

Borrowing short must be tempting for Greece however it is something of  a Faustian pact because it would have to be refinanced itself in short order. In itself such a move would betray a lack of confidence so whilst Greece might love to issue as cheaply as possible she knows that it is risky.

NB

Whilst looking at the numbers I was reminded of something quite revealing. If you look at Germany she can borrow up to February 2015 so virtually five years at 2.20% assuming she could refinance at Fridays close. She has a 20 month bond yielding 0.90%! Now look again at Greece’s 5.20% for a two-year bond. What it shows us is a measure of how Greece’s government had lost control of financial markets. You see governments and central banks can control and have a lot of influence over shorter-dated paper and yet Greece still has to pay a high (if improved) yield. For those interested in the UK our we have several two-year government bonds and a typical yield on them is in the range 1.3/1.4%, so here is some good news for us we have retained some discipline here.

The Cost to Greece

Let us say that Greece does issue a ten-year bond and has to pay 6.18% on it. If she issues 5 billion Euros she would have to pay some 309 million Euros a year in interest. By comparison Germany would pay 158 million Euros a year in interest. Over this life of the bond she would currently pay around 1.5 billion Euros less in interest. Ouch.

If we go to shorter-dated issuance paradoxically whilst Greece can issue more cheaply in outright terms the differential with Germany is nearly 4%. So a 5 billion government bond issue would cost Greece around an extra billion Euros over its lifespan when compared with Germany.

In reality Greece has had to pay more than her current yields when she has issued government bonds this year and the size of this excess has been in the range of an extra 0.25/0.5% per annum. In another form this too is a sign of her crisis. Also I wish to make clear that Greece simply cannot afford these interest payments and have written on this subject in previous articles. She will have to spend 11% of her public spending on financing her debt and in a time of austerity this will be felt.

Issuance Required Going Forwards

By the end of April Greece needs to issue some 12 billion Euros worth of debt as she has bonds maturing worth around 8 billion Euros and short-dated paper (Bills) of 4 billion Euros. In May a ten-year bond matures and the cost of financing it will be 8.5 billion Euros. Once we get into June then a sigh of relief may be due as there are no further major refinancings due in 2010.

To pay for new borrowing will cost 2 billion Euros a month on average.

Conclusion

Having considered the way that events have unfolded since the announcement of a rescue plan for Greece there really only is one conclusion. Any improvement in her circumstances fits exactly the change in collateral rules that the European Central Bank announced last week much better than the so-called rescue plan which has been trumpeted by Europe’s politicians. Now that Greece’s government bonds will be accepted as collateral by the ECB in 2011 there is a clear and direct link in my view to the improvement in her shorter-dated government bonds. If you think about it the immediate future for the profitability of Greece’s banks looks much better too. After all if you can borrow at 1% from the ECB and deposit a government bond yielding much more in return then we have found an example of what those in the markets call “free money”. A credible rescue plan would have improved longer-term yields too.

You are probably wondering what Greece should do if she does issue a bond this week (which is not guaranteed as Mr Christodoulou has contradicted himself already once or twice which is quite an achievement considering his length of tenure in his job). In my view if logic applies she should borrow short in say the 3/4 year sector and cross her fingers for better days. If you take the official view that rates should fall due to the impact of the rescue plan then they should also borrow for a shorter time.

The rescue plan itself has been changed somewhat over the weekend. Presumably it was pointed out that it was very unwieldy and inflexible (rather a weakness for something which should be flexible) and now we are being told that should the crisis develop the International Monetary Fund would take the lead if help is required. I think that it speaks for itself that a self-styled long-term rescue plan could not get past one weekend without being modified!

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  • Ian

    So the “plan” and the ECB’s moves help provide Greece with liquidity in the short-term. The problem, however, is that Greece is insolvent. And no-one has any solution to that problem. Have I understood correctly?

  • andy of yarm

    The European response throughout has matched that of Greece, which is delaying tactics. Long term it has to be either an IMF led rescue or a straight up default. I would advise Greece to default. Can anyone tell me how that course of action would be worse for its citizens than the current predicament?

  • zak

    Andy makes a good point. Has a country ever defaulted before? I havnt heard of one. What would the repercussions be for that country and for the world economy I wonder?

    On another matter, (sorry to digress), any chance of an update on Japan. Their budget announcement last week was enormous by anyones standards. Couple that with their demographic timebomb and they would seem to be heading for a much bigger fall than anything the Eurocrats could put together. Just wondered what your views were?

  • concernedresident

    Unfortunately, it already begins to look like the Greek politicians are finding the heat in the kitchen too hot to handle. This quote from the front page of an English language newspaper today is revealing:

    “No more austerity measures will be adopted by the government, which is expected to turn to the international markets to borrow money again this week through a new bond issue, even if Greece has to be rescued by its eurozone partners and the International Monetary Fund (IMF), Deputy Finance Minister Filippos Sachinidis told Sunday’s Kathimerini.”

    In view of the uncertainty about the interest rate that Greece will have to pay, surely no-one can make such a comment with certainty, so we seem to be returning to the popularist stance that has helped put Greece in the position she now finds herself. Very disappointing.

  • Mac

    It would seem paradoxical to lend Greece the money it needs to invest and build its infrastructure at levels which jeopardise the needed growth to repay? Austerity measures are only one part of the changes and Greece needs to trade into profit to repay these loans. Looks to me like Greece should consider withdrawing from the euro and going down the strictly IMF route if only to get away from the self serving machinations of the rest of the euro members? At the very least that should take the needed fiscal and economic decisions out of the hands of her own leaders who seem hamstrung for political reasons.

  • concernedresident

    Zak,

    I have read that throughout the last 200 years, Greece has been in default for about 100 so, if this is true, Greece is no stranger to default. In view of my previous post, it seems that default is not so unlikely!!

  • http://notayesmanseconomics.wordpress.com notayesmanseconomics

    Hi Zak

    Over history there have actually been a lot of defaults but mostly in the past. France for example defaulted several times around the period of her Revolution. Some consider President Roosevelts moves away from the gold standard in 1933 as a type of default and others think of the way that War Loan and Consols were not repaid in the UK as a technical default. I guess the most recent significant one was Argentina in 2001. We may be going into a phase where they become more common..

    As to Japan it is on my mind too! However its problems are more slow-burning than Europe. I do have a section on her and intend to write again on her soon.

  • zak

    Wiki on the Argentine crisis makes quite a read. Thanks for the pointers.
    Back to Greece.. short term, I can’t see any problems in the funding of their debts. Last time they asked for 5bil there were more than enough buyers. Some reports said that the offering was oversubscribed twice over. However, much of that is probably due, as you point out, to the yeild. Where else can you get a return that high today? I think I have to agree with Mac and think that Greece’s best interests lay outside of the euro and in the hands of the IMF. Provided the IMF acts appropriately (in the interets of Greece and not for its own benefit) and sets a preferential rate of return on its funding.