Greece: Time is Running Out

A difficult time for Greece

The Greek prime minister, George Papandreou, will today reshuffle his cabinet and ask for a vote of confidence from his parliamentary group. The government crisis has been caused by political pressure from both inside and outside the ruling PASOK party as the continued fiscal tightening has become increasingly unpopular.

The vote of confidence is likely to take place next Tuesday once the new cabinet has been appointed and sworn in by the president. The timing is bad as the Eurogroup plans to meet on Sunday and Monday to strike a deal on a second rescue package for Greece. The announcement of a second rescue package could drag on until the EU summit next Thursday and Friday, which is seen as a last chance for the EU to strike a deal. A deal is necessary as the IMF has set as a precondition for paying its next tranche (in July) that funding is in place for 2012 (currently there is a EUR27bn funding gap in 2012 and EUR38bn in 2013).

Will the IMF pay the next tranche to Greece?

There are now two issues that could stop the IMF from paying the next tranche to Greece: (1) if funding is not in place for 2012, and (2) if a no confidence vote results in new austerity measures including privatisation plans not being agreed.

1. With regard to the funding issue, the IMF now seems prepared to release the next tranche if it just gets a promise of future European funding rather than concrete commitments as it has previously demanded. We think that the IMF will receive such a promise on Monday when the Eurogroup is expected to reach a tentative deal for Greece. It will be difficult to reach a deal that all governments and the ECB can live with and it might well be that Greece is not in a position to deliver many promises on austerity measures. Nevertheless, we believe that the EU will find the money. The alternative is simply too scary.
2. If he wins a vote of confidence, Papandreou can go ahead with a vote on the austerity measures including the privatisation plans, which are a precondition for funding from the EU and the IMF. However, if he does not win the vote of confidence, there will probably be a general election, and austerity measures will not be agreed this month. It is uncertain whether Greece could then receive the next tranche from the IMF. But as emphasised by a senior IMF official, it is important not only for Greece, but for Europe and the world, that Greece gets its next trance, so unless it is really evident that a new Greek government would not deliver sufficiently on austerity measures, the IMF would probably go ahead and pay the next tranche. If the IMF decides not to pay the next trance, the EU could step in with more money. But in this situation, uncertainty is really high.

The most likely outcome is that the EU and the IMF will go ahead and pay the next tranche for Greece even though they now realise that it is increasingly likely that a hard restructuring will eventually be necessary.

What is the likely outcome of a Greek general election?

In the event of a general election, the opinion polls suggest that the ruling PASOK party (currently holding 155 of the 300 seats in parliament) would lose. A new government formed by the opposition would be unlikely to deliver sufficient reform progress to satisfy the EU and IMF. Any hope that the fiscal situation could become sustainable would also evaporate. Eventually a hard restructuring (haircut) would then seem unavoidable.

What will a second rescue package for Greece look like?

The rescue package is expected to include at least EUR30bn in funding from the EU. This will cover the 2012 financing gap. Another EUR50bn may be offered on the condition that the assets now up for sale are used as collateral. This would comfort the market as a commitment from the EU is a much more certain funding source than a fire sale of Greek assets. This would also give Greece an opportunity to wait with a large part of the asset sales until market sentiment has improved.

The rescue package is also likely to include intentions of private sector participation. This is the element where it has been most difficult to find common ground. Germany favours a maturity lengthening while France tends to favour a debt roll-over.

Most importantly the ECB has clearly communicated that it "excludes all concepts that are not purely voluntary or that have any element of compulsion" and "calls for the avoidance of any credit events and selective defaults or default".

A maturity lengthening cannot be purely voluntarily and it will be a default event. A voluntarily debt roll-over inspired by the Vienna initiative thus seems to be the most likely outcome.

We foresee that an agreement on private sector participation would look something like this:

The ECB, the banking associations in Germany, France and Greece (as a minimum) and the Greek pension funds all agree to 'voluntarily' buy new Greek bonds when their existing holding matures. Other investors are free not to roll over their debt (purchase new Greek government bonds), so they do not face any losses and cannot claim that it is a credit event. The banks cannot claim that this is a credit event either as they simply purchase new bonds and no haircut or reduction in net present value has resulted from this move. The rating agencies may nevertheless cry fault and downgrade Greece to default. But it is ISDA (and the wording of the CDS contract) that determines whether it is a credit event, which would trigger payment on the CDS contracts. It is our understanding that it would not.

In any case, the CDS exposure is not very big relative to the Greek sovereign debt market. According to data from the Depository Trust & Clearing Corporation (DTCC), the gross issuance is USD77.5bn while the net notional (maximum bank exposure) registered by DTCC is just USD5.5bn, or less than 2% of outstanding debt. The exposure could potentially cause problems for some banks, but is not a threat to the system. The CDS exposure is negligible compared with the CDS exposure on subprime loans that fuelled the financial crisis.

Nevertheless, the risk of contagion would remain very real. In the event of 'voluntary' private sector participation, rating agencies are likely to downgrade other peripheral countries as well. And a second rescue package for Greece does not solve the sustainability problem. Thus, the debt crisis will continue and some kind of hard restructuring (haircut) remains a likely outcome in the medium term.