Tuesday, April 26, 2011

Why Greece Won't Be 'Allowed' to Default Until the Irish Bond Market Settles

by Rebecca Wilder

Seeking Alpha

April 25, 2011

Just look at Tracy Alloway's imagery at FT Alphaville, and you'll know what's expected: An imminent Greek default. I still argue no, although European policy tactics are quite enigmatic and their next move is really anyone's guess. Alas, here's mine.

Assuming that Greece does not secede from the euro area, I give you three reasons why Greece will not be allowed to default soon (at least during the next 12 months, given current market conditions). I say "allowed" because, true to the IMF legacy, EU/euro area officials very likely see restructuring as a "gift" for good fiscal behavior.

(1) Moral hazard is an important issue in Europe, and Greece has only begun its austerity program. We'll need confirmation that it's not on track in order to assess the timing of default, in my view. Ironically, the EU/IMF/euro area are sticking to the "exports will grow the Greek economy" story. I say "ironically" because Greece was exporting a larger share of GDP before the recession -- an average 22.6% spanning 2005-2007 -- than it is now, 19.8% in 2010 (average Q1-Q3).

(2) The banking system's not ready. Unless the Germans want to instantly recapitalize the Landesbanks this year, I'd argue that the euro banking system remains overly exposed to mark-to-market accounting (i.e. holding the assets at fair value, not wishful thinking) for all of the debt that it holds on balance. In fact, the German banks purchased 11bn euro in Greek sovereign bonds in January. That's the most current data available, but I bet they're simply moving debt out of the Greek banks and corporates and into the sovereign as the probability of default rises (see chart below).

(3) This one's critical: Policy makers must shore up Ireland and Portugal in order to avoid a quick contagion across the European banking system. They haven't done that yet. In fact, the Finnish election results exposed the tenuous negotiation process overall.

See, the Greek yield curve is inverted; so are the Portuguese and Irish yield curves, albeit to a much lesser degree. The point is that Portugal and Ireland are very close to the Greek brink.


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