Monday, February 1, 2010

Greece Part of Unfolding Sovereign Debt Story

Mohamed El-Erian of Pimco

Global investors worldwide are starting to pay more attention to what is unfolding in Greece. Yet most still think of Greece as an isolated case, just as they did for Dubai a few months ago.

With time, they will see Greece as part of a much larger investment theme that is a direct outcome of the global financial crisis: The 2008–2009 ballooning of sovereign balance sheets in advanced economies is consequential and is becoming an important influence on valuations in many markets around the world.

As realization spreads of this key sovereign investment theme, it is important to be clear about what Greece is, and what it is not.

At the simplest level, think of Greece as Europe’s big game of chicken, with the operational question for markets being two-fold: Who will blink first, the Greek authorities, donors or both; and will they blink in time to avoid truly disorderly debt and market dynamics that also entail significant contagion risk.

Let us start with Greece, where, under any realistic scenario, a meaningful internal adjustment is needed.

There is no solution to the country’s debt issues without a deep and sustained policy effort. Yet, given the initial conditions (including the size and maturity profile of its debt) and the existing policy framework (anchored on adherence to a fixed exchange rate via the euro), such adjustment is difficult and not sufficient.

If unaccompanied by extraordinary external assistance, it would entail such contractionary fiscal measures as to raise legitimate socio-political problems.

External assistance is needed to support the meaningful implementation of internal policies. And it has to be consequential in scale and durability, as well as timely and well-targeted.

Understandably, such assistance faces headwinds on account of donors’ moral hazard concerns (vis-à-vis Greece and beyond), of donors’ understanding that a Greek bailout would not be a one-shot deal, and of donors’ own domestic budgetary considerations.

Because of this, I suspect that at least three of the following four conditions are needed to force the hand of European donors, and that is assuming that Greece provides them at least with the fig leaf of commitment to meaningful internal policy actions.

* First, evidence that Greek markets are being severely impacted by funding concerns. With the recent surge in borrowing costs and the disruptions in the normal functioning of government and corporate markets, this condition is clearly already met.

* Second, evidence that other peripherals in Europe – such as Ireland, Italy, Portugal and Spain – are also being impacted. This is happening, as signaled by the gradual widening in market risk spreads.

* Third, evidence that other providers of capital are sharing the burden of financing Greece. Tuesday’s €8 billion bond issuance to private creditors is consistent with this.

* Fourth, evidence that the Greek financial disruptions are starting to undermine core European countries. Evidence here is limited to the weakening of the euro, which, as yet, cannot be viewed as disruptive (indeed, some view it as helpful for Europe).

Notwithstanding this last condition, we are much closer today to the point where donors’ hands will be forced. Yet investors should remain wary, as this would offer, at best, only a short-term tactical opportunity. Greater clarity as to what Greece can deliver in internal adjustment should remain the primary driver for long-term investment opportunities.

Investors should also remember that “market technicals” remain tricky and now constitute a meaningful marginal price setter. The shift in the investment characterization of Greece, from being primarily an interest rate exposure to a credit exposure, has happened in such a way as to allow for little orderly repositioning. Many investors are trapped and the phenomenon has been accentuated by the recent evaporation of market liquidity.

Where does all this leave us?

Over the next few days, we are likely to get some combination of Greek and European donor announcements aimed at calming markets, reducing volatility and reducing contagion risk. But the impact on markets is unlikely to be sustained as both sides face multi-round, protracted challenges which contain all the elements of complex game dynamics.

No matter how you view it, markets in Greece will remain volatile and more global investors will be paying attention. In the process, this will accelerate the more general recognition that sovereign balance sheets in many advanced economies are now in play when it comes to broad portfolio positioning considerations.