Investment Strategies

The Eurozone Survives To Live Another Day - JP Morgan Comment

25 July 2011


Editor’s note: As readers can imagine, this publication, like its peers, has been deluged with commentary about the implications of the eurozone crisis and in particular, last week’s €109 billion rescue package for embattled Greece. At a time when parts of the domestic UK media have been obsessed by the Murdoch media scandal, the eurozone’s problems are a reminder that the debt default risks pose arguably a far greater concern to citizens in Europe and beyond. Here are the views of David Tan, who is global head of rates for fixed income at JP Morgan Asset Management.

The extension of maturities of official loans made to Greece, Ireland and Portugal from 7.5 years to at least 15 years is another indirect step towards fiscal transfers and common bond issuance in all but name. Official loans extended by the EFSF (European Financial Stability Facility) to these debtor countries will now carry a reduced 3.5 per cent rate of interest that is close to that of an AAA rated country.

Banks will swap bonds maturing between now and 2014 for new Greek government bonds of up to 30 years maturity. (Once done, Greece’s debt maturity profile will increase from an average of 6 years to 11 years.)  The four exchange options being offered to banks will be priced to produce a 21 per cent net present value loss based on an assumed discount rate of 9 per cent. Assuming a participation rate of 90 per cent (it is not known what the assumed 10 per cent non-participants will get), estimates of the long run reduction in Greece’s debt/GDP ratio are of the order of 15 per cent to 30 per cent points.

 The rating agencies will most likely move Greece’s credit rating to SD.

The use of EFSF, following ECB input, to buy bonds in the secondary markets (presumably at close to market prices) is an essential element of this package but did not quite go far enough. We would have preferred to see a formal programme of buy-backs via reverse auctions (at close to market prices) to specifically retire debt and drive down debt/GDP ratios.

Likewise, the use of EFSF funds, via loans to governments, to recapitalise the banks is a strong positive. Importantly the EFSF will also be able to recapitalise banks in non-programme countries. This could include banks from non-programme countries that failed or marginally passed last week’s stress test.

The availability of EFSF Precautionary Lines of Credit to countries not in the programme is, for the first time, a pre-emptive move by the authorities to not merely react to market stress, but to prevent market stress from overcoming more and more countries. Clearly this measure was aimed at trying to ring fence and protect Italy and Spain from being dragged further into the crisis.

Implications for the European Central Bank

Credit enhancement through posting of collateral or guarantees will ensure continued access to Eurosystem liquidity for Greek banks. This gets round the ECB’s refusal to accept defaulted securities as collateral and means that Greek banks will not be deprived of their life blood of ECB funding.  This was very important.

Market reaction

In the markets last Thursday, Bund yields were 12 basis points higher on the day and almost 25 bps higher since the start of the week. Peripheral spreads were sharply tighter. 10 year Greece was 100bps tighter on the day, and Italy and Spain about 35bps tighter. Greece is a further 150 bps tighter again on Friday. This short covering rally is likely to continue in the near term as peripheral bond yields have widened to astronomical levels in terms of the negative carry cost of running short positions.

Are these measures enough?

"We expected an increase in the size and scope of the EFSF but in the event only got the latter. We believe the former will occur later.  In any case, the IMF’s strong lending capacity give must not be forgotten.

We have always maintained that a workable solution must show a decline, or projected decline, in the stock of debt for highly indebted sovereigns and in addition, policies must be put in place to enable their economies to grow. Current best case estimates show Greece’s debt/GDP falling by 30 per cent in the long run based on yesterday’s [Thursday's] measures.  This will put it at around 120 per cent. A more aggressive message would have been to half it to 80 per cent.

"Overall we believe yesterday’s package went much further than previous measures.  They contain some very positive pre-emptive elements including bank recapitalisation and lines of credit that can be extended to non-programme countries before funding stresses become too acute.  The relief rally will continue and some more time has been bought.

Moreover, although it is not as aggressive as we would have liked, the plan has a chance of working. Explicit fiscal transfers or bond haircuts are the only means to get debt/GDP down sufficiently to serviceable levels. What is critical here will be the actual extent of private sector involvement as this will not be known for sure until the actual exchanges occur.

In addition, once debt/GDP has been forced down, these countries must undertake sufficient supply side measures to promote growth. Implementation risks of austerity measures previously announced remain high. That will still concern peripheral eurozone markets in the longer term."


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