14 The Ongoing Saga Of Sovereign Debt Sovereign debt will continue to be the headline issue for the Eurozone. Whilst the discordant debate over Greece has certainly overshadowed concerns over Portugal, Ireland, Italy and even Spain, it is important to realize that it may only be a matter of time before markets shift their focus back to the rest of the Euro area. In this context, it is imperative that there is a clear resolution to the Greece debacle to show the market that Europe can keep its house in order. Going forward, on-off solvency risk developments promise a fair amount of volatility, in the EUR/USD. We may see occasional bouts of squeezes higher along the way, but our view is that the events out of the periphery would have an overall negative impact on the Euro-area financial system, and heightened market concerns about these problems will weigh on the Euro. As far as interest rates are concerned, the ECB decided to keep its key benchmark rate unchanged in June, following the 25bps hike in the main refinancing rate in April. However, the repeat of the key tightening code suggests that the Governing Council is likely to implement further rate hikes ahead. Clock Is Ticking For A Solution On Greece Global financial markets have been reacting to numerous streams of headlines concerning the negotiations and discussions surrounding the European Central Bank (ECB), International Monetary Fund (IMF) and the various EU governments. Much of the focus of late has been on Greece, where the review of the country s fiscal progress and prospects by the EU/IMF are ongoing. The background to these discussions has been associated with two financing issues: the first being the fifth disbursement of EU/IMF financial aid (which had been originally scheduled for June 29); and the second being how Greece can meet the expected shortfall in refinancing from early 2012. 1) The Upcoming Fifth Disbursement Of EU/IMF Financial Aid By the end of this month, the EU, ECB and IMF will have to decide whether to disburse the next EUR12 billion in loans to Greece as part of their EUR110 billion rescue package. Out of this amount, EUR3.3 billion is due to come from the IMF while EUR8.7 billion will come from the EU governments. The EU, ECB and IMF have made it quite clear that any further Greek fiscal aid will depend on whether the domestic government can push forward further reforms to reduce its debt. In a crucial obstacle towards approving the country s austerity package and restarting the flow of bailout funds that are staving off default, Greece s parliament backed Prime Minister George Papandreou s new cabinet in a vote of confidence (June 21-22). All members of the Hellenic Parliament voted along with party lines, at which out of 298 members, yea votes tallied 155 and nay totaled 143. The outcome has certainly bought PM Papandreou a little more time; but given how the bond markets rallied, one can also imagine the adverse reaction from markets had the vote not gone through. Greece And EU-IMF Drawdown Schedules IMF EU Total (EUR bn) 1st 2Q10 5.5 14.5 20.0 2nd 3Q10 2.5 6.5 9.0 3rd 4Q10 2.5. 0.0 9.0 4th 1Q11 4.1 17.5 15.0 5th 2Q11 3.3 8.7 12.0 6th 3Q11 2.2 5.8 8.0 7th 4Q11 1.4 3.6 5.0 8th 1Q12 2.7 7.3 10.0 9th 2Q12 1.6 4.4 6.0 10th 3Q12 1.6 4.4 6.0 11th 4Q12 0.5 1.5 2.0 12th 1Q13 1.6 4.4 6.0 13th 2Q13 0.5 1.5 2.0 Source: IMF, Bloomberg, UOB Econ-Treasury Research 110.0 The next crucial event for will be the passage of the budget (refer to Key Events table). Whilst the government s majority in the confidence vote suggests that the Parliament will likely pass the budget, the major risk to the budget may be the size of street protests between now and then. The passage of the new austerity budget will mean the approval of the next disbursement of aid at a special EcoFin on July 3. And from there, assuming the details of private investor participation can be worked out in time, a new bailout package for Greece could be available by July 11. However, even with this first hurdle out of the way, markets remain wary about the disbursement of the subsequent bailout payments.
15 2) Refinancing From 2012 There are increasing concerns that the program (which assumes that Greece would be able to refinance itself in markets as early as 2012) negotiated last year is looking less credible and that the market does not believe any more that Greece will come to the market in the course of 2012 as stipulated in the bailout agreement. Hence, even assuming that the next tranche of payments is released, the country is only funded until early next year. What happens beyond that should be of greater concern. 180 160 140 120 100 80 60 40 EUR bn Greece s Funding Needs Greece's funding needs EU loans 20 IMF loans 0 Q2 2010 Q1 2011 Q4 2011 Q3 2012 Q2 2013 20 16 12 8 4 % 10-Year Govt Bond Yield Comparisons 0 Jan 08 Dec 08 Dec 09 Dec 10 Greece Ireland Portugal Spain Italy US Germany Besides, given the current level of yields, the probability that Greece can come back to the capital markets in 2012 is extremely low. Given the combination of high borrowing costs, weak growth prospects, sizeable fiscal slippages, as well as substantial revisions to the deficit and debt figures, Greece is certainly reaching a point where debt dynamics are unsustainable. (based on Key Redemption Schedule table, alongside the amount expected to be met by loans from the EU & IMF; cummulative totals) Underlying Economic Fundamentals 2010 Peripheral Core G3 Greece Ireland Italy Portugal Spain France Germany Japan UK US % of GDP Current Account Balance -10.4-0.7-3.5-9.9-4.5-2.1 5.3 3.6-2.5-3.2 Budget Deficit -9.6-32.2-4.6-7.3-9.2-7.7-3.3-9.5-10.4-10.6 Public Debt 142.0 96.1 119.0 83.3 60.1 84.3 80.0 220.3 77.2 91.6 US$ bn Public Debt 458 207 2,580 202 895 2,295 2,798 13,194 1,796 13,419 Nominal GDP 305 204 2,055 229 1,409 2,582 3,315 5,458 2,247 14,657 Source: IMF World Economic Outlook; OECD Economic Outlook;
16 Rising Government Debt (% of GDP) General Govt Balance General Govt Gross Debt Projections Projections 2008 2009 2010 2011F 2012F 2016F 2008 2009 2010 2011F 2012F 2016F Greece -9.5-15.4-9.6-7.4-6.2-2.1 110.3 126.8 142.0 152.3 157.7 145.5 Ireland -7.3-14.4-32.2-10.8-8.9-3.8 44.4 65.5 96.1 114.1 121.5 121.5 Italy -2.7-5.3-4.6-4.3-3.5-2.9 106.3 116.1 119.0 120.3 120.0 118.0 Portugal -3.0-9.3-7.3-9.6-5.5-5.9 65.3 76.1 83.3 90.6 94.6 97.5 Spain -4.2-11.1-9.2-6.2-5.6-4.6 39.8 53.2 60.1 64.0 67.1 76.0 France -3.3-7.6-7.7-6.0-5.0-1.5 67.5 78.1 84.3 87.6 89.7 86.7 Germany 0.1-3.0-3.3-2.3-1.5 0.0 66.3 73.5 80.0 80.1 79.4 71.9 Japan -4.2-10.3-9.5-10.0-8.4-7.4 195.0 216.3 220.3 229.1 233.4 250.5 UK -4.9-10.3-10.4-8.6-6.9-1.3 52.0 68.3 77.2 83.0 86.5 81.3 US -6.5-12.7-10.6-10.8-7.5-6.0 71.2 84.6 91.6 99.5 102.9 111.9 Source: IMF World Economic Outlook; What Are The Likely Scenarios? Will Greece default? The answer is not yet ; So long as they are able to draw down the EU/IMF tranches. Moreover, we doubt if the market can afford the shock, given the implications for its banks (which rely on the system of collateral to fund themselves) over and above the considerable amount of public debt held by these institutions. In addition, the cost of bailout might be lower than the cost of default. Hence, it would only make sense if the EU/IMF, along with Germany and France, avoid that route at all costs. Furthermore, due to the strong political view to keep the Eurozone intact, the possibility of Greece exiting the Eurozone also remains very remote. But what this means is that further down the road, a Greek restructuring or reprofiling (what the Germans like it to be called) of some form looks unavoidable. Yet, the question of whether, when or how a Greek debt restructuring could take place is a really complicated matter. The most market positive outcome for Greece would be a soft-restructuring, where the EU will agree to give Greece more money to cover the financing gap in 2012-2013 which will please the IMF, and the IMF will in turn continue with its commitments to the bailout package. Greece is able to change the terms of its debt (i.e. soft restructuring) in that Greek bondholders voluntarily agree to extend the maturities on these debt while maintaining both interest payments and interest rates. So while there is no explicit haircuts taken on the facevalue of the bonds, extending the maturities would imply a lower net present value of Greek debt, and therefore, an implicit haircut taking place unless there is compensation for the change in its debt terms. And with the additional time given to Greece by the maturity extension, it is hoped that Greece will be able to narrow the deficit with further austerity measures and asset sales. Our understanding of the EU-IMF drawdown schedule is that Greece will probably have to be back in the market sometime in 2013, even assuming they qualify for additional IMF-EU aid. Question is what happens after that. Will Greece have to take the avenue of default? Well, kicking the can down the road will at least allow the market to work through their Greece exposures, set aside capital and work out the necessary provisioning. Hopefully, by then, the market will also be able to distinguish the differences between Greece and the other European peripherals, thereby limiting the contagion risk. Implications On The Other Periphery The Bank for International Settlements estimated European banks held about US$130.1 billion in loans to Greece at end-2010, and more than US$2 trillion to Ireland, Italy, Portugal and Spain. And while Greece was the first member of the single currency bloc to fall in May last year, when it accepted the EUR110 billion rescue package; Ireland followed in November 2010 with EUR85 billion of external help; and Portugal had just last month (May 2011) agreed in principle to a EUR78 billion bailout deal.
17 Total foreign claims Banks Exposures To PIIGS (US$ bn Of Reported Assets) European Austria Belgium France Germany Greece Ireland Italy Holland Portugal Spain Switzerland banks UK US Greece 160.9 130.1 3.1 1.8 53.0 34.0-0.7 4.2 4.5 10.2 1.1 2.7 13.1 7.4 Ireland 650.2 462.8 3.0 45.6 36.8 118.2 0.5-14.2 19.1 22.2 11.1 14.7 152.4 65.4 Italy 1,096.6 783.4 22.2 23.7 389.1 162.3 0.5 13.3-45.4 2.9 30.7 14.2 66.7 36.0 Portugal 225.5 194.3 1.6 1.6 27.0 36.4 0.1 2.5 4.1 5.3-86.0 3.1 24.4 5.4 Spain 846.4 641.6 6.8 20.3 141.5 181.9 0.3 13.9 29.9 77.0 25.9-14.6 112.1 41.1 Total 2,979.6 2,212.2 36.7 93.0 647.4 532.7 1.4 30.5 52.3 151.3 61.2 128.9 49.3 368.7 155.3 Source: Provisional figures at end Dec-2010 from BIS; The raucous debate over a possible debt restructuring in Greece has certainly overshadowed concerns over Ireland, Portugal and even Spain in recent weeks, it is important to realize that it may only be a matter of time before markets shift their focus back to the rest of the Euro area. In this context, it is imperative that there is a clear resolution to the Greece sovereign debt quandary to show the market that Europe can keep its financial house in order. Sovereign Debt Issues Will Continue To Play Havoc With The Euro 1.70 1.60 1.50 1.40 1.30 1.20 EUR/USD 1.10 2008 2009 2010 2011 Going forward, on-off solvency risk developments will promise a fair bit of volatility, with occasional bouts of squeezes higher in the EUR/USD along the way. We expect the EUR/USD to gradually depreciate on the back of existing solvency risks and upcoming Eurozone credit downgrades. Our view is that these events out of the periphery would have a negative impact on the Euro-area financial system and the policy response, and that some of that news would heighten market concerns about the problems. ECB Likely To Hike Rates As far as the ECB is concerned, the Bank decided to keep its key benchmark rate unchanged at 1.25% in June, following the 25bps hike in the main refinancing rate in April. What was crucial, though, was the ECB press statement, which saw the inclusion of the phrase strong vigilance. When questioned about this signal, Trichet confirmed that they are in a mode where there might be a rate rise at the next meeting, but they never pre-commit. Indeed, getting through the next couple of Greece obstacles would be crucial and there are always risks and uncertainty from both an economic and policy standpoint as far as the peripheral woes are concerned. However, with the ECB s objective of keeping inflation below, but close to 2 percent in the medium term, this suggests that the Governing Council is likely to implement another 25bps increase in July. We are expecting the ECB to hike rates by 50bps through the remainder of this year.
18 Keep Watch By and large, we had previously argued that the sovereign debt crisis will continue to fester. Even with the anticipated measures being put through, the issue of debt overhang in the Eurozone is still far from being resolved; and this is not the end of the road for Greece and the other periphery. A major risk is that the country s sovereign debt may still be unsustainable even with a new loan package or extending the debt maturity; and if so, a default then becomes unavoidable. Enclosed are key dates in the PIIGS countries, which are likely to trigger market volatilities given the level of uncertainty with regards to the longer-term solvency issues: Date Key Events * 29 Jun 30 Jun Parliamentary approval of the new austerity package Parliamentary approval of the implementation of the new austerity package 3 Jul Eurogroup meeting 5 Jul German constitutional court hearing on lawsuit against bailout packages 7 Jul ECB Governing Council meeting 8 Jul 1-13 July Disbursement of the next tranche of EUR12 billion to Greece, subject to parliamentary approval of the measures in Greece Eurogroup (Euro area finance ministers) meeting. Decision on the second Greek bailout package and private sector involvement 4 Aug ECB Governing Council meeting Aug IMF-EU visit 8 Sep ECB Governing Council meeting Sep Germany: Regional elections Ireland: IMF-EU visit Spain: Deadline for banks to raise capital G7 finance ministers meeting in Marseilles Source: Bloomberg; * Tentative dates Key Redemption Schedule * EUR bn Greece Spain Italy Portugal Ireland 3Q/2011 12.7 23.1 69.4 0.5 0.0 4Q/2011 9.4 17.8 0.0 1.5 5.8 1Q/2012 16.5 7.0 56.8 0.2 6.6 2Q/2012 10.8 15.3 23.1 12.6 1.6 3Q/2012 13.3 19.9 42.2 0.5 0.0 4Q/2012 3.3 23.3 43.8 1.5 1.2 1Q/2013 7.3 19.9 35.4 0.2 0.9 2Q/2013 16.0 17.8 40.0 1.9 7.6 3Q/2013 11.9 21.4 39.2 10.2 0.0 4Q/2013 3.0 18.5 43.4 1.5 1.2 Total 104.2 184.0 393.3 30.6 24.9 Source: Bloomberg; IMF; *Amount in EUR bn includes principal and interest Key Auction Schedule * Spain Italy 7 July 27 June 21 July 28 June 4 August 14 July 18 August 28 July 1 September 12 August 15 September 30 August 6 October 13 September 20 October 29 September 3 November 13 October 17 November 28 October 1 December 14 November 15 December 29 November 14 December 29 December Source: Bloomberg; * Tentative auction dates for PIIGS countries in 2011