Roubini on Greece

By Felix Salmon
April 28, 2010
panel -- especially when the subject is the eurozone and the possible disintegration thereof. He's been bearish on the PIGS in general and on Italy in particular for many years now, but I don't think it comes as much surprise to him or to anybody else that Greece is the first country really in the firing line.

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Nouriel Roubini, it can be safely said, gives good panel — especially when the subject is the eurozone and the possible disintegration thereof. He’s been bearish on the PIGS in general and on Italy in particular for many years now, but I don’t think it comes as much surprise to him or to anybody else that Greece is the first country really in the firing line.

One of the most interesting things about the status quo post-downgrade is that no one seems to have a clue what the base-case scenario is. Are the markets still expecting Greece to get bailed out, but adding on an ever-increasing yield premium to account for the possibility that it won’t be? Are they, like panelist James McCaughan, expecting an orderly debt restructuring later this year, with an effective haircut in the 20-40% range? They certainly don’t seem to be expecting anything worse than that — Greece’s bonds are trading at high yields, yes, but not at distressed levels, and there’s still room to lose a lot of money on those 2-year bonds if they end up defaulting.

My feeling is that the base case is one of muddling through for the next 2-3 years, with Greece scrounging up enough money from the EU and IMF to avoid a default, and Europe’s banks meanwhile staying profitable enough thanks to the ECB’s monetary policy that they build up their solvency for when the inevitable default does occur a few years down the road.

But it’s not clear that the markets are going to let that happen. It’s all well and good for the Germans and others to cover the Greek fiscal deficit for the next three years, and even to insist on tough fiscal adjustment at the same time. But if Greek yields stay anywhere near their current levels, there’s a good risk that would be politically unacceptable in both Germany and Greece. Sweden’s Bo Lundgren was also on the panel, and he helped explain how the Swedish population has the crucial and decidedly un-Greek ability to unite behind unpopular yet necessary policies once their political leaders have set a certain course. Greece, which is already seeing riots at any hint of fiscal austerity, just isn’t the kind of nation which is likely to decide that five years of wage cuts in a painful and deflationary recession is a price worth paying to stay current on the national debt.

Meanwhile, Tony Barber has already come to the conclusion that as far as Greece is concerned, “the political conditions for extra financial help from Germany just do not exist”.

Nouriel, of course, takes that kind of thinking to its logical conclusion, and kicked off the panel by announcing that it was just in time: “in a few days,” he said, “there might not be a eurozone for us to discuss.” There’s no way that Greece can implement the 10% spending cut it needs to do in order to stop its debt spiralling out of control at current interest rates — and even if it did, the economic effects would be disastrous.

Nouriel’s base case, then, is Argentina 2001: after all, Greece has a much higher debt-to-GDP ratio, much higher deficit-to-GDP ratio, and much higher current-account deficit than Argentina had back then. And if that’s the base case, there’s no way that Greek debt should be trading anywhere near its current levels.

Of course, this being Nouriel, it goes downhill from there: if Greece is worse than Argentina, he says, then Spain is worse than Greece. Its housing bubble and bust has left the banking sector much weaker than Greece’s; its unemployment situation, especially with the under-30 crowd, is much worse than Greece’s; and the cost of any Spain bailout would be so much more enormous than the cost of a Greek bailout as to be almost unthinkable. The only thing that Spain has going for it is that it isn’t quite at the edge of the abyss yet; if it gets its political act together and implements tough fiscal and structural reforms now, it can save itself. But clearly no one saw that happening, given Spain’s political history over the past 20 years.

There’s no good news here. The least bad course of action for Greece, in Nouriel’s eyes, is some kind of coercive yet orderly debt restructuring, which keeps the face value of the debt unchanged but which reduces coupons and pushes out maturities. And an exit from the euro. Alternatively, the ECB steps in and cuts interest rates so low that the euro gets pushed down towards parity with the dollar, which would accomplish something similar without nearly as much pain.

One member of the audience, though, had a really good question: what happens to the European system of sovereign guarantees of interbank lending? When those sovereign guarantees aren’t worth much any more, Euribor is likely to spike, since suddenly there’s a lot more credit risk involved in interbank lending. And there are hundreds of trillions of euros of debt contracts linked to Euribor, which could suddenly get very expensive and take control of short-term interest rates out of the hands of the ECB.

And in any case it’s worth remembering that even though Greece’s debts are small in relation to Spain’s, they’re still large in relation to, say, those of Lehman Brothers. And given that there is no formal mechanism for leaving the euro (or for defaulting on sovereign euro-denominated debt, for that matter), there will almost certainly be a range of unexpected and chaotic events somewhere down the line. That’s why I feel that although Greek bond yields are certainly going to be volatile for a while, we’re going to see higher highs and higher lows — there’s pretty much nothing, at this point, which could reassure the markets and turn Greece back into an interest-rate play rather than a credit play.

Even a massive IMF bailout, which is probably the best-case scenario for Greece right now, wouldn’t suffice to bring yields back down to their pre-crisis levels. As Nouriel pointed out, the IMF, as a preferred creditor, would make sure it was repaid, in the event of default, long before bondholders. And as a result, even if the probability of default dropped, the recovery value on Greek bonds in the event of default would drop as well. And so yields wouldn’t come down as much as you might think.

I covered emerging market sovereign bonds for many years, but I’ve never seen anything like this: a country trading at levels where the bear case is terrifying, the bull case is very hard to articulate, and everybody is talking about a possible default even when the country has an investment-grade credit rating from two agencies and is only one notch below investment grade at the third. Maybe the only thing which really explains what’s going on is that both yields and ratings are sticky. Which would imply that Greece has a long way to deteriorate from here.

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