Generous aid mechanism for Greece should cause bond spreads to drop

The Greek public debt crisis seemed to have peaked last week, with bond yield spreads over Germany reaching their highest levels since 1998-1999, prompting the response of the other European governments yesterday with a rescue package of 30 billion euros in loans. The main question now is whether the Greek government should choose to activate the aid mechanism or stay the course for political reasons. There is no doubt the other eurozone governments, including Germany, were forced into action over the weekend as abrupt bond market moves highlighted Greece’s fiscal crisis and threatened to undermine confidence in the euro. It was the eurozone’s response to the market challenge that is best expressed by the phrase «show me the money.» Greek bond yields rose above 7 percent last week as investors and others demanded much higher premiums over similar German bonds for compensation, pointing to an increased likelihood of a default. At some point, the widely watched 10-year yield spread over Germany exceeded 440 basis points as the Greek bond yielded more than 7.50 percent, going back to figures reminiscent of 1998. It should be noted that one percentage point is equal to 100 basis points. Undoubtedly, yesterday’s development will be most welcomed by the Greek side because the country can fund its remaining borrowing requirement for the year, estimated at more than 32 billion euros, at a more reasonable interest rate. In other words, the specter of a default has been removed for at least a year or more as eurozone countries are willing to provide more loans next year. Greece will gain access to the 30-billion-euro EU loans at a fixed rate of around 5 percent or a floating interest rate of around 3.75 percent at present according to officials and other sources. The floating rate will likely be based on the 3-month Euribor plus a premium of 300 basis points and a fee of 50 basis points. The International Monetary Fund’s contribution to the aid mechanism is seen as being as high as 15 billion euros at lower rates, bringing the total up to 45 billion euros. Greece could have paid a fixed rate of around 5 percent or less to borrow via three-year bonds in March, following the successful sale of 10-year bonds worth 5 billion euros. This did not happen as the government thought these interest rates were too high at the time, hoping to bring them down by having the EU commit to an aid package. It turned out that the EU rescue package announced on March 25 was not clear enough for the markets to appreciate. On top of this, Greece did its best to undermine its own position by engaging in conflicting statements from anonymous official sources to the international press and pricing the key 7-year bond below market rates for domestic political reasons. The government will have to think very hard about what to do next. From a political point of view, the obvious choice is not to ask for help as the aid package will most likely come with some heavy strings attached from the IMF, namely more unpopular spending cuts and structural economic measures. From the market’s point of view – especially Greek banks, the primary victims of the silent sovereign run we spoke of last week – the country cannot experiment and should opt to ask for the loans as soon as possible. According to this logic, the state will be able to fund itself at reasonable interest rates for all of 2010, the country will recede from the global limelight and markets will calm down. By all accounts, the aid mechanism is generous and will act on the market even better than a bazooka. It may even be nuclear, according to a banker. Thanks to this, one should expect a sharp drop in Greek spreads over Germany today, especially in the short run, with 3-year bond yields converging to around 5-5.5 percent. Greece’s planned Treasury bill auction tomorrow will be a key test of market sentiment after the latest developments and the government clearly hopes to be able to sell 1.2 billion in 6-month and 12-month T-bills at a lower rate than 5 percent without support from Greek banks. However, the T-bill auction is not a bond auction and therefore one cannot draw safe conclusions about foreign investors’ appetite for Greek debt paper even if local banks abstain. Moreover, the government has made a number of mistakes in managing this debt crisis and cannot afford to make another, so it would be better to ask for aid before a failed auction occurs rather than afterward. What does it come down to? If market pessimists are right and bond spreads come down on the assumption Greece will ask for aid soon, one can expect spreads to go back up, even if Athens signals it has no desire to resort to the EU-IMF funding. If optimists are right, and there are few, spreads will come down anyway with the aid package and will stay down, making it possible for Greece to fund its borrowing needs of about 12 billion euros by the end of May at more expensive rates than those in the EU-IMF loan package but ones that would be reasonable. If we were to bet, we would side with the pessimists – the government must ask for aid in the next few days or weeks, leaving aside all other political considerations.

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