Greek Rescue Plan and the Euro

April 12, 2010

EU finance ministers over the weekend announced an agreement to loan Greece up to EUR 45 billion for three years at a maximum rate of about 5.0%.  IMF money represents a third of the total, and money promised by Germany constitutes 28% of the rest, which is roughly 3/16ths of the total potential package.  Pundits have been quick to identify the numerous shortcomings of this latest gesture.  However, markets responded positively.  The euro is trading at $1.3583, some three cents or 2.3% above its low on April 8, and the ten-year Greek bond yield of 6.53% is about a percentage point lower than on the 8th.  Who’s right, the pundits or markets?  Before turning to the considerable drawbacks of the rescue, let’s start with what’s different about this latest EU initiative.

The euro was in crisis because of the substantial risk of a Greek default this spring, not as a result that no way can be seen out of Greece’s economic difficulties in the longer term.  Had investors been reacting to long-term problems instead, Japanese government bond yields would also be sky-high instead of at a lowly 1.40%, and the yen would be on the weak side of 100/$.  The immediacy of bankruptcy is a game changer, unlike the festering danger that a possible bankruptcy a year or two down the road.   How global markets behaved before and after the Lehman Brothers’ collapse in September 2008 exemplifies this distinction.  Two other elements of the EU announcement also made the latest policy gesture very significant.  First, Germany agreed to terms it previously had rejected, namely a maximum interest rate, not a market-determined rate which had been 200 basis points higher and, without a cap, had seemed headed for even higher ground.  Minus the participation of Germany, no deal would have flown, and if Germany had had its way on the interest rate, no deal would have been credible.  A second ground-breaking facet of this weekend’s EU announcement is that it tuned out much larger in size than the EUR 25 billion magnitude mooted previously.  EUR 45 billion appears large enough to convince investors that Greece will not default this spring or any later time in 2010 for that matter.

The deal leaves considerable unfinished business. 

  • Nothing has been said about applying the points agreement on Greece in a more universal way to other governments in serious deficit positions, notably Spain and Italy, which are the fourth and third largest economies sharing the euro.  Investors in the euro got to harbor reservations about whether staving off a default in Greece may lead to a contagion attack on other perceived weak links in the monetary union.
  • The announcement remains fuzzy about when money would be passed on to Greece.  Any flows remain contingent upon need.  Athens still hopes that the back-stop of loan commitments will end speculation against Greek paper and enable the government to borrow what it needs from the market at rates in can afford.  This still looks like wishful thinking.
  • A related issue involves the reaction of Greek and German voters.  Neither will be happy.  Pictures of Greek unionist protesting in the streets are unsettling, and German Chancellor Merkel has made U-turns before after grass-roots protests in her country.  Indeed, the euro had suffered in part from a view that the spoken word of European leaders could not be trusted.  All that happened over the weekend was more verbal promises that could prove unenforceable.
  • The Greek economy is in very bad shape, and austerity will make conditions worse.  Real GDP fell 3.1% in 4Q09 at an annualized rate, more than the 2.5% on-year drop since 4Q08.  Unemployment is at 10.2%.  CPI inflation is 3.9%.  There is a current account deficit of some 8.5% of GDP.  Last year’s budget gap was 12.9% of GDP.  Industrial production fell 9.5% in the year to February, and the manufacturing PMI printed at 42.9 in March, down from 44.2 in February, 48.8 in December and 51.1 last August.  Greek long-term interest rates have fallen sharply today but only to their average level last month. 
  • The austerity that Greece will be authorized to undertake as quid pro quo for the loan money and to meet a budget gap target of 8.7% of GDP in 2010 will push the economy even more deeply into recession and thereby undercut its intended purpose.  Countries in a currency union lack the one policy option, devaluation, that gives fiscal austerity a chance a success.  Greece is too small for the ECB to override an eventual increase in interest rates.
  • Greece’s dire circumstances as time goes by will put pressure on Euroland’s other structurally weak economies even if that doesn’t happen immediately.

There is enough substance in the above points to make the euro’s respite brief, but that will only happen if the plausibility revives of a near-term Greek default, or if one of the union’s other bond markets suffers a major contagion attack.  Some analysts clearly disagree with these conditions, pointing out that the euro will continue to depreciate whether or not the common currency with all its participants has been saved for now.  Their main point is that U.S. growth prospects remain better than Euroland’s, and I do not disagree with that assertion.  So what?  Faster U.S. than Ezone or Japanese growth has not prevented dollar depreciation in the past.  Since the creation of the euro at the start of 1999, U.S. real GDP has advanced 2.1% per annum on average compared to annualized growth of 1.4% in the euro area and 0.6% in Japan.  But at the end of 1998, the dollar/yen rate was 113.5, more than 21% stronger than now, and the greenback was worth almost 16% more against the euro then than now. 

Euro momentum has been downward, and enough uncertainty persists to disbelieve that weekend events ended that trend.  But I believe the scope for how much further the euro might decline has become more contained.  Certainly the possibility of euro depreciation turning disorderly depends critically on whether a default in 2010 by Greece or some other member of the currency union has been as squelched as such seems.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.



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