May 3, 2010

Greece's Wings of Wax

Questions surrounding Greece's solvency and the resulting fallout continue to grow. In recent days, more than one commentator has openly asked if it's the beginning of the end for European common currency.

"Not so fast," says a prominent currency fund manager, who's actually in the process of buying euros. He argues that whatever happens, it will provide needed clarity and will positively impact currency markets.

So which is it; Midas riches or Icarus flight?

We took this debate to the (thankfully) nonpartisan Peterson Institute for International Economics. The D.C.-based think tank counts a former treasury secretary, current PIMCO head and a Rockefeller as board members, so we think they know what they're talking about.

Senior Research Fellow Jacob Kirkegaard has been with the Institute since 2002. Before joining, he worked with the Danish Ministry of Defense, the United Nations in Iraq and in the private financial sector. His research focuses on European economies and reform, pension systems and accounting rules, demographics, offshoring, high-skilled immigration and the impact of information technology. He's the author of four books on the topics.

Boomer Market Advisor: Let's get right to it; will Greece default?

Jacob Kirkegaard: I think Greece will default, which will actually have a significantly negative impact on the euro in the short-run. I hope the currency manager you mentioned has strong hedging measures in place.

BMA: What happens from there?

JK: The question then becomes containing the contagion, so to speak. The 120 billion euros the IMF has committed will be brought for debate in the German Parliament next week. The Germans will attach serious conditions to their portion, because they recognize Greece's debt-to-GDP ratio will still be at 140 percent to 150 percent after three years. The IMF commitment covers debt refinancing for three years, so in essence they're simply delaying the inevitable. Does anyone believe in 2013 Greece will be offered 4 percent on a 10-year bond? I mean, c'mon.

BMA: So what does this mean for other "at-risk" countries, specifically Portugal and Spain?

JK: Both countries have it within their grasp to correct their situations. With Portugal, even if they put in a whole host of stability measures, they still need to approach the IMF in a proactive manner. Yes, this means heavy conditions will be attached to any aid they receive, but the conditions are no stricter than what they would have had to do otherwise.

This is true for Spain as well. But Spain is a much bigger situation because it's a much bigger country than Greece and Portugal, but it also has a bit more time to deal with it.

BMA: What impact will it have on the European Central Bank, and what is their next move?

JK: If one more rating agency-a Moody's or a Fitch-downgrades Greece, it sets off an automatic chain reaction within the ECB. Greece's debt, particularly Greek sovereign bonds, can no longer be used as collateral. This could cause an Argentina-like situation, where unstructured defaults will occur at a rapid pace and will be a significant hit to ECB. So the question now becomes, will the ECB throw out its own rulebook? I think it will. They don't have mark-to-market type rules, so they can sit on this paper while they negotiate the haircuts investors will have to take and ensure it's a structured process.

BMA: So rumors of the Eurozone's death have been greatly exaggerated?

JK: It will unquestionably drive down the euro in the short-term, but the Eurozone isn't going to unravel. They can't kick Greece out, and it's too expensive for them to leave voluntarily. They'd have to empty euros from every ATM in the county, and they'd experience the mother of all capital flights. Also, investors are traditionally myopic and have short memories. Three to five years after a default, Greece will be lent to again. But they would be crazy to do it in Drachmas when they can do it in much stronger euros.

If Greece goes through a structured reorganization of their debt, it will cause Portugal and Spain to own up to their longer-term problems. This is not a bad thing because at that point you have dealt with the three weakest links in the Eurozone chain.

BMA: So what should we watch for in coming weeks, both home and abroad?

JK: The key for this week, obviously, is what happens in German Parliament. They could be the trigger that creates a huge mess. If Germany balks and causes the 120 billion euros to be held up, that will cause the ratings downgrade, which the agencies will have to do if they are to maintain any kind of integrity with their ratings. That starts the ECB process that we spoke about. And Germany might balk at the fact that they will receive subordinated debt. They will probably say, "No, no, we want preferred debt." That will begin a lengthy conversation about the haircuts interested parties will have to take, and that will create even more uncertainty. At this point they've been given the gun; the question is whether they will hold off on pulling the trigger.

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