Euro area: Eurogroup Has Done its Part - Now it's Up to Greece

• European Finance Ministers delivered by increasing the actual lending capacity of the EFSF and they removed the preferred creditor status for loans to countries that are already in a support programme (Greece, Ireland and Portugal).
• The main risk factor remains whether Greece's PM Papandreou can find support for the crucial confidence vote on the new Greek government. It remains uncertain, but it seems likely that Papandreou (and PASOK) will win with a narrow majority tonight.
• On June 30 the austerity package is expected to be endorsed by the Greek parliament. This will pave the way for the fifth IMF/EU tranche of EUR12bn in July.
• The final decision on a second aid facility has been postponed until July. The euro area leaders' commitment to save Greece remains intact and once Greece delivers the euro area leaders will present a second aid facility based on both official and private contributions.
• In terms of market reaction we expect some relief across euro-crosses on a government win, but also for the market impact to be asymmetrical in the sense that if the vote fails it would have a much bigger impact than if the vote succeeds.
• If the confidence vote does not pass we have sketched out both a "bad" and a "worst case scenario". In the bad scenario a new government would eventually endorse austerity measures and a second aid facility would be released.
• The "worst case scenario" would evolve to a disorderly default that would impact global financial markets and in particular euro area banks. It would be difficult to prevent contagion, but it should still be possible to avoid a euro breakdown

Euro area Finance Ministers are paving the way

At the press conference following the Eurogroup/Ecofin meeting yesterday a number key political decision were announced.

1. The ESM (European Stability Mechanism to replace the EFSF from mid-2013) will not prefer creditor status for loans to countries that are already in a support programme – i.e. Greece, Ireland and Portugal. If other countries should receive an aid package this will not apply to these countries.
2. As promised at the March summit, the lending capacity of the EFSF will be raised to EUR440bn from EUR250bn by guarantees from the euro members being raised (up to around EUR750bn from EUR440bn previously).
3. The next Eurogroup meeting will be on July 3, when a final decision on the pending instalment payment to Greece is expected. The release of this next tranche of EU/IMF aid will likely be conditional on Greece approving a new austerity package that includes privatisation measures.

In a statement released late Sunday night European Finance Ministers decided to postpone the decision on a second aid facility to early July (an extraordinary Eurogroup meeting is scheduled for 3 July). The euro area leaders' commitment to save Greece still remains intact as they promised to deliver on the "main parameters of a clear new financing strategy" for Greece (see Eurogroup statement). However, the details on a second aid facility have not yet been decided but the disagreements seem to be diminishing.

The statement says that the "Ministers agreed that the required additional funding will be financed through both official and private sources and welcome the pursuit of voluntary private sector involvement in the form of informal and voluntary roll-overs of existing Greek debt at maturity". Importantly, it was emphasised that a voluntary debt roll-over should avoid triggering "a selective default for Greece". Merkel already on Friday in a joint statement with Sarkozy said that Germany would drop its demand to extend maturities and accept a purely voluntary agreement.

All in all, at the Eurogroup/Ecofin meeting the euro area leaders managed to agree on the major hurdles confronting them. Any second aid facility would likely be endorsed either at the Eurogroup meeting on July 3 or at the meeting on July 11. The recent development shows that the euro area leaders' commitment remains intact.

It is now up to Greece

In Athens Prime Minister Papandreou is struggling to sustain support for his government's reform programme after he reshuffled his cabinet on Friday. A confidence vote scheduled for Tuesday is essential to markets, as political risks to a Greek funding solution now lie increasingly in Athens. If Papandreou fails to win the confidence vote we expect that he will announce a general election. This does not necessarily mean that Greece will not go ahead with austerity measures (remember that we had a similar show in Portugal not so long ago). In any case we believe that chances are high that Papandreou will get his confidence vote, but nothing is yet certain.

Thereafter, the next big exam for Greece is the parliamentary vote on Greece's austerity measures on June 30. The new Greek Finance Minister Evangelos Venizelos said at the Eurogroup meeting Sunday evening that: "this is great opportunity for me to repeat the strong commitment of the Greek government and the strong will of the Greek people for the implementation of the programme. We can achieve our targets thanks to the effort of our people and thanks to the cooperation of our partners". One can question the strength of the Greek commitment. An opinion poll (cited by Reuters) that was carried out prior to the reshuffle showed only 34.8% support for the new austerity measures. 47.5% of the respondents would like to see the parliament reject the new measures. The opposition has also called for early election, so the political backing seems to be vanishing, but the ruling party PASOK still hold a thin majority.

If the government wins the vote it would pave the way for the austerity package to be approved by late-June, which in turn would pave the way for the July EU/IMF money and likely a new financial aid package. If the vote fails it would bring increased uncertainty and potentially require a bridging loan from the EU, if the EU/IMF tranche is not paid, as Greece faces significant coupon payments and redemptions during July.

Market reaction on tonight's confidence vote

On the FX markets we expect some relief across euro-crosses on a government win, but also for the market impact to be asymmetrical in the sense that if the vote fails it would likely have a much bigger market impact than if the vote is a win. Risks to the euro are that we will see a "buy the rumour, sell the fact" reaction where long positions are built ahead of the vote and where profit-taking then takes the euro slightly weaker in the event that the vote is a 'win'.

Similarly on the fixed income markets. If the confidence vote does not fail is should bring some relief and send yields higher in Europe. If the vote fails, fixed income markets would surely extend the rally.

Base scenario: Greece austerity measures will pass parliament

Our base scenario is still that a solution will be reached, and most likely presented at the meeting on 3 July. It will involve:

1. More EU funds financed via the EFSF. A package lasting until 2014 would likely be around EUR40-60bn.
2. Private investor participation via a Vienna-rollover of Greek debt. This is expected to yield around EUR30bn.
3. Privatisation of publicly owned enterprises. Up to 2014 this is expected to yield around EUR30bn. In total this is expected to yield EUR50bn over the next five years.

A second aid facility will thus be in the range EUR100-120bn. However, for the base scenario to materialise it remains a precondition that Papandreou can find support for the austerity plan.

Even in this rather positive scenario, there is still a great risk that Greece will not be able to re-establish sound public finances in the medium term and restructuring involving haircuts in one to two years seem plausible.

Risk scenarios

We see virtually two different scenarios, both triggered by lagging support to the PM Papandreou's austerity plan. The triggering event could be either the confidence vote tonight or the parliamentary vote on the austerity programme of June 30. What happens from here can either be a "bad" or a "worst case" scenario. One can also imagine a scenario where it is the euro area leaders that gets tired of playing games with Greece and decides to say enough is enough.

1. 1) A "bad" scenario would imply that Papandreou due to lagging support is forced to call a general election. This would bring increased uncertainty and potentially require an additional bridging loan from the EU (EFSF or EFSM), if the IMF tranche is not paid, as Greece faces significant coupon payments and redemptions during July. Papandreou will take on a caretaker role until a new government is in place. The new government in place will decide to pass a similar austerity plan, and the EU-IMF will wait and finally endorse a second aid facility for Greece. In this scenario market volatility will temporarily be very high but should dampen once austerity measures are implemented.
2. A worst case scenario will occur if the opposition wins the elections and stands firm that the austerity measures should be renegotiated. Euro area leaders may not accept this, as it is already difficult to convince the taxpayers in the core countries that the packages in place are reasonable. If the EU and IMF do not give the next tranche (in July) to Greece this could evolve in to a disorderly bankruptcy. In this case euro area authorities will move their attention to the banking system to ensure that the systemic risk is minimised. It will be difficult to prevent contagion, but it should still be possible to avoid a euro breakdown.