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February 10, 2012 Topics: What a Greece deal would mean, and what it wouldnt Der Kommissar.

From the inception of the European debt crisis, EU policymakers have been trying to ring-fence Greece (whose default was practically a foregone conclusion) in order to protect other EU countries and their financial systems. IMF-appointed Greek PM Papademos announced this week that he had gathered enough parliamentary support for the new austerity measures required by the Troika of the EU, IMF and ECB1; I suppose at this point, we can refer to Papademos by function, which would be Der Kommissar for Germany. Such an agreement could pave the way for a debt restructuring and another 130 bn in aid to deal with the consequences. A deal as reported would get closer to ring-fencing Greece, but this is far from the clean slate postexchange outcome we have seen in other countries. Heres why, starting with the good news, assuming a deal happens: Positive: Greece fades in importance to banks and other bondholders. As shown, after proposed debt reduction from the voluntary bondholder exchange and increased funding from the EU/IMF (and some assumptions by us), Greece will still have an enormous amount of debt, above 130% of GDP. However, only 36% of GDP will be owed to truly private sector holders, and part of that includes holdout creditors that will be written down or paid off. The bottom line is that most of the Greek debt that investors bought over the last decade, out of the belief that EU defaults were impossible2, will be gone. Greece will now mostly be a ward of the Troika instead, which can decide at a time of its own choosing whether to forgive debt or extend it, and without triggering any events in financial markets.
Current composition of Greek Government Debt % GDP Private owners IMF / EU / EFSF ECB Central Bank of Greece Greek social security funds Greek banks Total debt
Source: IMF, ECB, European Commission, J.P. Morgan Securities LLC, J.P. Morgan Private Bank.

Transitional events and assumptions

Composition of Greek Government Debt in 2013 % GDP Private owners (holdouts get par) IMF / EU / EFSF ECB Central Bank of Greece Greek social security funds Greek banks Total debt (holdouts get par) Total debt (holdouts get exch. terms) Total debt (holdouts get zero) 36% 94% 0% 1% 6% 8% 145% 139% 135%

68% 34% 22% 3% 14% 21% 162%

1. 100% debt exchange participation by Greek central bank, Greek and EU commercial banks, social sec funds and insurers (face value 137 bn). 2. 70% participation by 70 bn held by sovereign wealth funds and other private owners. 3. Debt exchange: 60% haircut to face value. 4. Part of new package repurposed to allow Greece to buy its bonds back from ECB at cost. This is optimistic (see table below). 5. Three scenarios for treatment of holdout creditors shown in table at right.

Positive: Greece is not a large direct risk to EU growth. The additional austerity Greece agreed to will probably result in yet another round of collapsing output. The IMF and EU have consistently underestimated how bad Greeces growth and deficits would get, and there is no reason to think this has changed. The IMF strategy of forcing deep austerity in exchange for aid (80%-90% of which has been used to repay bondholders rather than promote growth) is turning out to be a fiasco. But Greece is only 2.3% of Eurozone GDP and 3.4% of its population, so the outcome in Greece does not impact aggregate data that much. Positive: Elvis has left the building. Foreign private sector ownership of Greek assets (not just govt bonds) has collapsed to levels last seen before Greece joined the EMU in 2001. As a result, there may not be a lot of foreign capital left to leave.
Foreign private sector investment position in Greece
Billions of Euros
300 250 200 150 100 50 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: Bank of Greece, J.P. Morgan Private Bank.

Assumed uses of new IMF/EU funding (130 bn total) 30 bn to bondholders to entice participation in debt exchange, such that participants receive combination of cash and new bonds 30 bn in bank recap costs; keep in mind that Greek banks have 130 bn in repo exposure to the ECB and Bank of Greece 35 bn to finance the next few years of interest payments to official sector and private creditors 35 bn which Greece borrows to purchase bonds from ECB at its cost. Not currently part of the plan; this 35 bn was supposed to repay prior bilateral loans when they mature. But given German insistence that the package not rise from 130 bn, theres no other way to resolve ECB holdings. So the package increases, the ECB takes a loss, or prior bilateral loans are not repaid. Note: money is fungible, and other needs like privatization shortfalls and the underfunded Greek social security system, might be substituted for some of those above, particularly bondholder credit enhancement.

The latest agreement requires Greece to cut another 15k of public sector employees in 2012 (150k by 2015), enact 20% minimum wage cuts, hit a 4.5% primary surplus target by 2015, end union tenure, cut substitute teachers, cut healthcare spending, etc 2 Greece will not default. In the euro area, default does not exist. EU Monetary Affairs Commissioner Joaquin Almunia, January 2010. From our Eye on the Market, The Five Stages of Greece, June 2011. Axel Webers quote in the same issue is even more amazing.

February 10, 2012 Topics: What a Greece deal would mean, and what it wouldnt So whats the problem? There are a lot of them. Biggest Negative: Greece as a paradigm for other EU countries is still troubling. The EU/IMF are focused on structural reforms and reducing unit labor costs, which are supposed to help in the long run. However, these kinds of reforms often cost a lot in terms of near-term growth. By the end of 2013, the cumulative decline in real Greek GDP may hit 20%, almost three quarters of the US Great Depression. While the Troika is trying to soften the austerity a bit, we are still left with the failed paradigm of revenues and output falling faster than tax revenues and other reforms can catch up. The human costs are considerable; the impassioned letter from Athens Archbishop Ieronymos to Papademos is one window into how it looks from the inside (http://tinyurl.com/7bpk6rc). History shows a strong preference for adjustments that do not rely too much on nominal wage declines. This is something that Mervyn King at the Bank of England has referred to: it is preferable to effect real wage declines through a combination of devaluation, inflation and stagnant wages (rather than falling ones). This is precisely what the European Periphery has opted not to do by staying in the Euro. Consider Spain: its current account has improved, but unemployment is well over 20%. What would Spains full-employment current account deficit needs be, and how would it finance them? Or is Spain consigning itself to a decade of massive unemployment? Negative: theres a risk that Papademos either cannot deliver the pro-austerity votes in the parliament, or cannot hold the coalition together long enough to implement promised changes. Recall that the first TARP vote failed, and something similar happened in July 1998 in the Russian Duma when they voted on spending and tax reforms. Deputy Labor and Social Security Minister Koutsoukos resigned as a sign of a protest against government austerity; will others follow? Separately, Germany appears to have objections to what the Troika and Greece agreed to, and is asking for commitments by all Greek parties to agree to the austerity plans jointly, and in writing. These negotiations require decisions which may run counter to each countrys respective political systems and procedures3. One can make the argument that Germany is ratcheting up the austerity pressure so that Greece decides to leave EMU on its own, rather than being forced out. Negative: what about the holdouts that do not participate in the bond exchange? If participation in the exchange is not high enough, Greece will face the decision of litigating against a large group of bondholders, or paying them off to avoid trouble. If they end up litigating and using retroactive collective action clauses to punish holdouts, it could get very noisy, particularly if the holdout group is large. As a marginal positive, I am willing to assume that the risk of a mismanaged outcome by ISDA regarding Greek CDS is low, given the clear precedent that the use of CACs is an event of default (yes, this is jargon overload). Negative: EU taxpayers may believe that the official sector will not have to take a large hit on its existing exposures to Greece, and/or that this 130 bn Greek outlay will be the last one. They are likely to be wrong on both fronts. Positives + Negatives = if Greece sticks to the agreed upon path, it will fade in importance as far as markets are concerned, given fewer owners of its debt. Its collapse would stand like Ephesus, a constant reminder of the massive public and private sector imbalances ushered in by the European Monetary Union. Investors would more closely follow developments in Italy and Spain, given their larger size. Spanish and Italian spreads and manufacturing surveys are now improving (see next page), thanks in part to ECB money-printing. But if Greece exits the EMU since it cannot breathe, or if the trajectory of Spanish or Italian growth starts to mimic Greeces downward spiral, the Greek paradigm may not be, as Mario Draghi suggests, so unique. Next up for Europe: the French elections, with Socialist candidate Hollande in the lead. Hollande appears to be spoiling for a fight with Germany: renegotiating the late 2011 budget agreements (by referendum if needed), and calling for Eurobonds, joint and severally guaranteed. In recent comments, he appeared to imply that he would issue them unilaterally, with other countries on the hook. In a world of retroactive collection action clauses, I suppose anything is possible. One last note: the ECB announced that it would loosen collateral rules last year as part of its long term refinancing operations, specifically allowing pledging of illiquid loans for banks in dire need of financing alternatives. Of 17 countries, only a few opted to allow their banks to participate: the countries in the headlines (Ireland, Spain, Portugal and Italy)..and France. Michael Cembalest Chief Investment Officer
French presidential candidate Hollandes campaign manager suggested the use of a referendum to unwind the debt brake treaty agreed to by France last year. The French minister for European affairs then warned that if Hollande tried to renegotiate the treaty, he could face the same fate as Greek PM Papandreou, who was deposed last year: There has been a European leader who has challenged a treaty, it was George Papandreou. Franois Hollande is the French Papandreou. And we know how it ended. http://tinyurl.com/7uhb245. Perhaps, its just politics, but I would expect more respect from a French cabinet minister regarding the democratic use of a referendum.

February 10, 2012 Topics: What a Greece deal would mean, and what it wouldnt After the rally in credit spreads, the focus shifts from government debt auctions to whether Spain and Italy will grow:
Italian and Spanish 10-year government bond yields
7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 2005 2006 Source: Bloomberg. 2007 2008 2009 2010 2011 2012

PMI manufacturing surveys

Purchasing Managers Index, sa
65 60 55




50 45 40 35 30 25 2005 2006 2007 2008 2009 2010 2011 2012


Source: Markit.

The Hollande conundrum, and a reminder of the private sector imbalances ushered in by the Euro
Could Hollande cope with a 3% deficit constraint?
French budget deficit, percent of GDP
0% -1% -2% -3% -4% -5% -6% -7% -8% 1980 Source: IMF. 1986 1992 1998 2004 2010 -6% -8% 1975

The Euro ushered in large private sector imbalances

Current account deficit, % of GDP
4% 2% 0% -2% -4% Greece, Italy, Ireland, Portugal, Spain France, Germany, U.K. Euro exchange rate fixed

Proposed Maastricht 2.0 ceinture de chastete







Source: OECD, J.P. Morgan Private Bank, U.K. Office of National Statistics.

ISDA = International Swaps and Derivatives Association; CDS = Credit Default Swaps; CAC = Collective Action Clause; PSI Private Sector Involvement
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