Long investors in Greek sovereign debt may prepare to fight back

The spread of Greece’s problems to other eurozone members with weak public finances and the lack of a response so far on the part of policymakers have highlighted cracks in the European Monetary Union (EMU) architecture. Greece is no longer alone, which makes a bailout more likely, if needed. Nevertheless, one should expect market pressures on the country to continue for quite some time. Undoubtedly, the EU authorities have made a serious mistake in their handling of Greece’s fiscal problem. They insisted that Athens come up with a credible three-year stability and growth program to bring the general government budget deficit below 3 percent of gross domestic product (GDP) in 2012. It should not be forgotten that this is the most demanding fiscal adjustment of any country in the eurozone in such a period. However, the EU authorities made the mistake to let the markets become the guardians and take disciplinary action in the form of much higher Greek bond yields and spreads. By doing so, the EU essentially assigned a role to the markets, thereby losing control of the situation. Since the markets are made up of generally rational players, the latter immediately identified the cracks in the eurozone architecture and, in particular, the lack of any structural mechanism to deal with such a crisis. The next step was to take advantage and start testing other countries with large budget deficits, such as Portugal and – to a lesser degree – Spain. At this point, it looks as if they have put about 20 to 30 percent of the eurozone’s GDP under stress. To the Greek government and many local commentators, this is mainly the work of speculators, some of whom try to undermine the euro project by taking a shot at countries they perceive to be the weak links of the eurozone. To some extent this is true, but there may also be another reason: It helps mask some of the administration’s policy mistakes, namely its underestimating of the markets and the reaction of international credit rating agencies to the announcement that the budget deficit had reached about 12.4 percent of GDP, plus the lack of any – albeit unpopular – measures, such as indirect tax hikes, which should have been taken last October or November. It is true that many hedge funds, some large foreign banks and other investors have bet in favor of wider Greek bond spreads and subsequently the spreads of Portuguese bonds and of other eurozone countries with fiscal woes. The same guys may have shorted the local equities in these countries and the euro against the dollar. However, one should not forget that there are other investors with much bigger stakes in Greek, Portuguese, Spanish equities and bonds, who lose much more by seeing the prices of their holding go down. It should be noted in this respect that more than 200 billion euros in Greek sovereign debt is in foreign hands. It is therefore in the best interest of these long investors to fight back. At this point, they seem reluctant to do so, because they obviously estimate that the fiscal and economic fundamentals are not in their favor. In other words, speculators may rule the day at this point but this is because the investors have doubts about the ability of Greece, Portugal and other countries to put their public finances in order. They also put the euro in their radar for two reasons. First, they see the lack of an EU structural mechanism to deal with the crisis. Second, they also know that the euro is overvalued and many eurozone governments and the European Central Bank would be quite happy to see it weaken in order to boost European exports and the economy. Is this speculation? Perhaps. Even so, it is what one would expect from forward-looking rational players who dominate the markets. From the Greek point of view, it is definitely better to be in the company of Portugal and others rather than alone, as it increases the chances of EU help if markets dry up for Greek bonds. However, one should not forget that rational players, speculators or not, will continue to monitor Greece’s efforts to stick to its budget deficit reduction plan and its efforts to raise another 40 billion euros plus for the year, knowing that it is in the worst fiscal shape of all. This means markets may ease the pressure on Greece somewhat by demanding lower spreads to lend money to the country but they will remain high as long as no concrete results are evident. This may go on for a few more months according to market optimists and 12-to-18 months according to pessimists.

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