Greek problems get worse before they get better?
The second wave of the Greek debt crisis seems to be focused on the technicalities of default. This time last year the EU authorities together with the ECB and the IMF were trying to find a stop-gap solution to Greek financial crisis, now the hard work begins as the EU authorities (in particular the ECB) try to wean the Greek financial system off temporary liquidity support.
To complicate matters, Greece isn’t playing ball. Its tax collection record is still dismal and its deficit cutting hasn’t happened fast enough to convince the EU authorities to give them more money. German officials have spoken out about Greece ’s short falls and it was slapped on the wrist by the IMF last week. This pushed Athens to announce a wave of privatizations of state assets, but that wasn’t enough to stop Fitch, the credit rating agency, from cutting its long-term credit rating to B+. Fitch justified its actions by saying that the risk of default had dramatically increased and that any re-profiling of debt is another form of default.
This caused a flurry of risk aversion in the markets; however this is likely to be short-lived. The market has come to expect a second bailout/ default from Greece . What is much more troublesome is the ECB’s recent rhetoric. It is steadfastly against a debt restructuring for any member states, which is what the EU authorities are pushing for. The reason for this is twofold: firstly, it believes that a default would cause contagion to other more systemically important nations in the Eurozone like Spain . Secondly, since last year the ECB has been accepting lower grade collateral in return for its loans, which means it is sitting on billions of peripheral debt.
ECB member Jens Weidman said that the Bank may no longer accept Greek bonds as collateral if there is an arranged default for Athens . This would in essence shut-off Greek banks from the capital markets, causing them to collapse and potentially triggering a global financial crisis, resulting in the 200 pip drop in EURUSD at the end of this past week.
The ECB is talking tough and has a right to voice its concerns, but we believe it will be side-lined and the EU authorities will ultimately determine the solution to the debt crisis. The ECB’s mandate is to promote financial market stability – unleashing chaos into the markets by effectively forcing Greece into bankruptcy would be a clear violation of this mandate.
The bad news for euro bulls is that the Greek situation is likely to get worse; an IMF audit into how well it is adhering to the conditions of its first bailout is due to be released next month, which has the potential to dent investor sentiment further.
The euro hinges on Spain
It is becoming a bit of a habit for investors to start selling the euro in the lead up to the European close on a Friday afternoon. The single currency was weak across the board as we ended last week and EURUSD dropped nearly 200 points on the back of the Greek story described above.
However, the euro still looks supported above 1.4000 against the dollar, that’s nearly 20 per cent stronger than it was this time last year during the peak of the Greek crisis. Today, FX traders are treating the Greek crisis as manageable; however any deterioration in Spain ’s financial situation could trigger a similar decline.
This weekend is pivotal for the single currency. Local elections in Spain are expected to hand the ruling Socialist party a hefty defeat across the municipalities. This is problematic on two fronts. Firstly, if the opposition Peoples’ Party (PP) does as well as expected at the weekend then it may call for the resignation of the government. Bond markets hate political uncertainty, and this would cause Spain ’s borrowing costs to spike. The second issue is that new local administrations are unlikely to waste any time in unveiling hidden debts or financial irregularities by the former leaders. This may push up Spain ’s official debt position thus derailing its fiscal consolidation program that is so vital to maintaining investor confidence. Right now reports suggest that these “hidden” debts could amount to EUR30bn.
Spain is the canary in the coal mine. It is the fourth largest economy in the Eurozone and so far its bonds have largely escaped the same selling pressure as Greece , Ireland and Portugal . However, the aftermath of these elections could cause that to change. If bond yields soar then this would mean that Spain is a step closer to a bailout, the size of which may exceed the size of the Greek, Irish and Portuguese bailouts combined. German taxpayers are unlikely to cough up these kinds of sums and that could bring the whole Eurozone project to its knees.
This isn’t our central scenario and there is one thing that may keep Spain out of the firing line for the time being: its public debt levels are fairly low, totally around 45 per cent of GDP – that is below France and Spain. Private sector indebtedness is the problem in Spain, fuelled by cheap loans from the now beleaguered domestic Caja lenders and a huge housing bubble.
But Spain still has the power to spook FX markets. If fears grow about the Iberian nation then it is likely to trigger safe haven flows to the dollar, weighing on the single currency even more. 1.4150 is holding as support, but below 1.4235 – the top of the Ichimoku cloud – the single currency looks vulnerable. 1.4000 is a key psychological level, and below here the next major support level is 1.3880.