Merkezy, PSI, Taliban Taxes, Conditions for Default. 15 Sep 2011

·         Merkezy statement on Greece

·         PSI

·         New taxes in Greece

·         Default cui bono

·         Conditions for expecting default

Anyone expecting some big announcements after yesterday’s Sarkozy, Merkel and Papandreou videoconferencing, does not comprehend how the EU works and functions. The principles of opaqueness and secrecy are adhered religiously. Why, was it only Merkel and Sarkozy versus all European leaders? After all, this is a European problem. Is this a new EU body that I missed? In any case, what was really said and decided we will find out in the next few months. Afterwards, they stated the obvious i.e. that Greece would remain in the Eurozone and that Greece would stick by the medium term plan. Most importantly of all, they reiterated the resolve to proceed with the PSI.

It is obvious that some kind of political deal was struck but we would not risk speculating. One however, could infer that the threat of disrupting the instalments the past few days was directed at Mr Papandreou and not at the markets. There are no significant bonds maturing till December 2011, so any delay in the instalments would have meant bringing down the Papandreou administration by October end, without risking default. So, by saving his job for now, it is natural that the Germans got something in return.

One should expect some major announcements from Greece in the next few days possibly even today that aim to convey the message.

PSI

Unconfirmed reports suggest that so far the participation is around 75-80% versus the target of 90%. The threat of default in the last few days may have convinced (conspiracy theorist may believe that it was intentional) “hold outs” to join the scheme. Two Greek banks, the Postal Bank and the Agricultural Bank of Greece, suddenly “decided” to join the scheme, even though they were originally exempted from it, due to restructuring.

Is the PSI the answer to Greece’s debt problems? Not at all if rationality and financial logic prevails. In fact, one can be certain that given time it would be restructured probably more than once. The PSI does not reduce significantly the debt burden of Greece and contrary to claims, it increases the total Greek indebtedness by more than 40bln Euros. This is the additional borrowing needed in order to buy the AAA zero coupon guarantee. This figure probably moved up to 45bln now as 30Y zero rates have rallied making the Zero more expensive. In addition all the new instruments are under English law making them more toxic for the future generations of Greeks.

It is doubly bad for the Greek banks as they are forced to exchange their bonds with 30Y illiquid and non-tradable (for 10y) instruments and thus lock valuable balance sheet. It is rather unfair for the Greek banks, who after all, had little choice but buy Greek debt, as opposed to the German Landensbanks who bought it for speculative reasons. Nevertheless, it is now too late to go back and the EU is right to insist compliance with this first restructuring attempt.

New tax raids

The original Troika plan had the standard philosophy. Reform the tax system, restructure and liberalise the sclerotic Greek economy, reduce the public sector from its soviet proportions and given time and money from the EU, growth would return. The new plan apparently is much simpler, just tax indiscriminately and if they don’t pay the tax the electricity would be cut off. This is the essence of the new property tax levied on all Greeks apart from the Church! Clearly, the government ministers are concerned by the effect this tax would have in their afterlife. I also have my doubts whether it is legal­-proof to cut a basic commodity such as electricity for non-paying an unrelated tax. Why not cut off water supply if you don’t pay parking fines?

These tax raids betray the incompetence of the Greek government to effect any kind of reform and their total panic. If they deal with the crisis with Taliban tax raids why expect the taxpayers to behave properly?

Orderly or Disorderly Default. Cui bono?

When looking for the culprit of a crime especially a financial one it is usually to ask “To whose benefit” or Cui bono. Let’s apply this principle to the recent game of chicken between the Troika and the Greek government that resulted in rumours of default and possible exit from the Euro.

α) Would the Greeks benefit if they declared a moratorium on payments and default now? Since Greece is still running a primary deficit (deficit even with no interest rate payments), it would mean no pensions or salaries or even money for hospitals and schools. The easy answer is no.

β) Would the European banks benefit from such a move? Most European banks struggle to incorporate the 21% NPV loss assumed in the PSI. They would most certainly be unhappy with a 50% or more haircut. It would also mean that the Greek bonds would drop from the list of acceptable collateral with the ECB and a replacement would need to be found. All Greek banks would have to access the Emergency Liquidity Assistance (ELA) and possibly many more in other European countries. In addition, the ECB is the reluctant owner of 45bl of Greek bonds the majority probably maturing in the next 2 years. A default would seriously impair the credibility of the ECB and its balance sheet. With equity of only 10.8bln some more extraordinary measures would need to be taken. Thus, the consequences of default would be grave for the stability of the European financial system. This situation would probably change in a couple of years.

γ) Would the CDS holders benefit? Indeed they would. But the current volume of CDS contracts on Greece is not enough to explain it. In fact, CDS holders need only challenge some of the clauses in the Greek Eurobonds (Negative Pledge, Moratorium) to get the credit event they need. I am surprised they have not done it as yet.

δ) Could it be that the Greek government was trying to increase the participation in the PSI by spooking the markets. The hitherto actions of the Greek government do not point to such an intelligence, ability and understanding of how the market works. I therefore discount such a possibility.

ε) The most probable explanation is that the Germans and some other northern European politicians tried to make domestic political kudos out of the recent Troika-Greece fight and it got a bit out of hand. This is not unusual, as the EU does not speak with one voice and does not have a coherent policy on the crisis anyway. Furthermore, time and time again they have shown how little they understand how the markets behave.

ζ) Finally, the possibility of a Euro-holiday (exit from the Euro for some time) is not really an option. Anyone, advocating this as a solution has lost touch with reality. It would spell the death of the Eurozone and it would also create a failed state in Europe and totally destabilise the South East part of it at a time of increased geopolitical tension. We all remember what happened to Yugoslavia. Why default and leave the Euro, when you can default inside?

In conclusion, talk of default orderly or disorderly is premature for Greece. There are three conditions that need to be satisfied before a default becomes a viable option:

                                 I.         Greece runs a primary surplus and thus can sustain itself even with no EU help.

                               II.         The banking system and especially the ECB has found ways to mitigate or minimise the impact of a default/haircut.

                            III.         The risks of crisis metastasis to Italy or Spain are minimised. Currently, with downgrades on the cards and political uncertainty it is not the case.  

Until and unless the above three conditions are satisfied any default would have unpredictable consequences for the euro and the Eurozone and as such would be avoided by Europe’s politicians. Thus, one should view any such rumours as buying opportunities rather than as black swan events.