Building Hedges around Greece?

By Claus Vistesen: Copenhagen

While Macro Man opted to present a po(p)etic styling on the ongoing hardship in Greece (or was that Grease?) today came with a couple of notable developments in the story and would seem to be honourable and real efforts to calm down markets. Obviously, it is difficult to tell whether this is a true attempt to save Greece from what increasingly looks inevitable or whether it is an attempt to make sure the debacle does not turn out to be a Eurzone rout. In any case, action it seems is entering the stage on the cost of fiddling.

Firstly and as is customary in these kinds of situation, the Eurozone group of finance ministers gathered Sunday to approve the whopping € 110 bn aid package which had been rumoured last week. Euro-region governments are betting 110 billion euros ($146 billion) in economic medicine for Greece will be enough to inoculate the rest of their region from contagion.

(quote Bloomberg)

Finance ministers approved the unprecedented bailout yesterday for Greece after a week that saw the country’s fiscal crisis spread to Portugal and Spain. At the same time, they refused to say how they would help other indebted nations if the need arose, calling Greece a “special case.”

The risk is that investors will shift focus to other euro nations in the absence of a clear aid plan for the 16-nation bloc’s weakest members. The extra yield investors demand to buy Portuguese debt over German bunds surged to the highest since at least 1997 and Spain’s IBEX 35 stock index fell the most in three months last week. The euro fell against the dollar today. “It is far from assured that this program will forcefully counter contagion risk,” said Mohamed El-Erian, co-chief investment officer at Pacific Investment Management Co. in Newport Beach, California, which runs the world’s biggest bond fund. “Heavily exposed creditors” may try to head off potential losses and sell bonds, “increasing the pressure on core European governments to also provide a backstop for Portugal and Spain.”

Greece yesterday pledged to push through 30 billion euros ($40 billion) of budget cuts, equivalent to 13 percent of gross domestic product, in return for loans at a rate of around 5 percent for three years. The EU and the International Monetary Fund, which is co- financing the bailout, also agreed to set up a bank stabilization fund. With downgrades threatening to render Greek bonds ineligible as collateral for its loans, the European Central Bank today said it will accept all Greek government debt when lending to banks.

Two questions immediately arise here. One is the extent to which the bailout put up front as it were is enough to avoid contagion to Spain and Portugal (or god forbid Italy). Basically, it was this very issue which raised the stakes last week as the S&P moved in to downgrade both Spain and Portugal and where markets began to play the dreaded spread game as yields on Spanish and Portuguese government deb widened alarmingly. The second is the more technical question of whether this will be enough to avoid an eventual default in Greece. This depends both on the real scale of the situation (i.e. how many more skeletons can we expect to rattle out of the closet) as well as whether Greece has the actual capacity to carry through the austerity measures demanded. I am not talking about in principle here, but more in reality and with all the practical issues of having to fight your own citizens with water canons three days a week as well as accounting for the loss of production when Greece turns to the street in stead of to the offices and factory line. I am an optimist by nature, but it looks difficult, very difficult.

However, perhaps the second news coming in today might help a little bit even if it was not unexpected. Consequently and in light of the fact the Greek government bonds has long been fairing below the pedigree otherwise needed to act as collateral at the ECB (well de-facto, if not de-jure yet), Trichet and his colleagues extended a helping hand today by specifically making Greek govies eligible as collateral at the ECB's asset facilities.

“The ECB is a key player in the rescue package designed to help Greece and it is clearly buying insurance against the likelihood of further multiple downgrades of the Greek debt, something that might lead to a halt of ECB financing to the Greek banks,” said Silvio Peruzzo, an economist at Royal Bank of Scotland Group Plc in London.

Further downgrades from credit-rating companies had threatened to render Greek bonds ineligible for collateral for ECB loans after Standard & Poor’s last week cut the nation to junk status. Had Moody’s Investors Service and Fitch Ratings followed suit, Greece’s debt would have no longer been accepted under the previous rules, threatening to inflict further pain on the economy and its banks.

This will definitely help, but it was also a foregone conclusion. Consequently, had the ECB chosen to stand aside as Greece was further downgraded by the rating agencies the yields would almost surely have risen to levels not only inconsistent with proper debt management but also ultimately to levels forcing an instant default. The point I am making here is simply that if the ECB had chosen not to do this, they would have explicitly sent the message that it is ok for the market to discriminate markedly and decisively between Eurozone debt issued by different countries and presumably, it is exactly the opposite message that they want to be sending at this point in time.

So where does it go from here.

Well, to me Greece is doomed and while this may sound excessively alarmist I see no way out for this economy. The real nutbreaker will be whether Portugal and Spain are the next one to follow. One default and you blame the defaultee, three and you blame the system and it is exactly the imminent risk of the second (almost unthinkable) scenario that I recently dealt with in a more lenghty format.

Don't get me wrong, I salute the effort and I sincerely hope that the Eurozone will make it through in one piece, but at this point in time I need to be building hedges around my erstwhile optimism.