Comment by Stuart Thomson, Ignis.
"The next episode of the Greek tragedy takes place on Thursday. Resolving the issues affecting Greece is no longer sufficient to improve overall European sentiment, but it is still a necessary condition and attention tomorrow will be focused on reaching at least another temporary solution.
"The scale of this funding requirement and the opposition of important groups of Finnish, German and Dutch politicians - as well as the fact that these secondary debt purchases will not have a material impact on Greece's debt to GDP ratio - means that the European Commission is currently working on more than two dozen possible debt restructuring plans in order to comply with German suggesting that debt relief should amount to €70bn. The problem is that plans are likely to fall foul of the ECB determination not to accept bonds in default which cannot be accepted by the ECB under its constitution. There have been two suggestions to circumvent this restriction. The first is the hardline proposal to force the default and challenge the ECB to refuse these bonds as collateral, since it would contravene the requirement to ensure the smooth operation of the monetary system and monetary policy. However, we don't believe that politicians are willing to play chicken with the central bank. An alternative is to allow selective default in the hope that this will be short-lived. In this scenario, the success of the debt exchange leads to sharply lower spreads allowing the rating agencies to upgrade the rating within three months. This is wishful thinking since the ECB rules would not allow it to wait for any improvement in the ratings.
"The desperation of politicians caught between the ECB and single currency constitutions and market chaos is evident. And the longer politicians' prevaricate, the greater the widening of peripheral spreads in the near-term. It is possible that they will act now and seek forgiveness, rather than ask permission, from politicians and the German Constitutional Court. Indeed, the Court has a history of allowing past misdemeanors and imposing conditions on future behavior. This policy would require common issuance of Eurobonds. This policy has the obvious attractions of reducing interest rate volatility and would be the natural progression from eliminating intra-regional exchange rate volatility to eliminating intra-regional interest rate volatility. However, in the absence of a political union and optimal currency, volatility will eventually be transferred to politics and the economy.
"The simplest action on Thursday would be to avoid all of the difficult default and constitutional issues and provide more debt for Greece. The opposition Social Democrats in Germany have expressed willingness, provided increased loans at lower interest rates for longer maturities. The private sector involvement in debt restructuring is derived from a tax imposed upon European banks. This would provide a fig leaf for German demands of private sector involvement without causing selective default and annoying the ECB. The European Commission and parliament have been seeking a number of pan-European opportunities to raise revenues and escape the confines of national funding of its deficit. The problems here are that non-€urozone economies are likely to object to higher taxes to pay for these €urozone transfers (most notably the UK). Moreover, this may be less painful in terms of the cost to core economy voters. However, its economic costs in terms of tighter financial conditions and slower capital growth within the European economy would exacerbate the slowdown we expect in the second half of 2011 and into 2012. Nevertheless, it would impose fewer performance targets on Greece and therefore fewer flash points when these targets are not met. But they would also increase the moral hazard for the single currency and reduce further incentives for fiscal austerity or compliance with these targets.
"We believe that even in the event of any resolution to the Greek crisis on 21 July, the focus would then shift to additional packages and debt relief for the next two candidates - Ireland and Portugal. They would expect the same favorable loan conditions as Greece and would undoubtedly require additional funding. We believe that spreads would have to widen further to force this provision on European politicians. More importantly, adding debt on top of debt is not a lasting solution. We continue to believe that in the absence of currency devaluations, debt devaluations are the next best alternative. Debt devaluations are necessary to provide fiscal relief, but they do not materially improve competitiveness. Supply side reforms are essential and there has been important reforms amongst the peripheral economies over the past couple of years. They are not sufficient and more importantly, the payback for these reforms in terms of their impact on productivity and productive potential growth takes several years. This means that the focus will remain on competitiveness and the lack of growth amongst the peripheral economies.
"The most important shift over the next few months will be the deterioration of economic conditions within the core economies. The combination of global economic slowdown in the second quarter, coupled with the ECB's misguided interest rate hikes and the heightened interest rate and financial market volatility is expected to lead to further slowdown for this week's key economic data.
"Our central view on Europe remains that the sovereign debt crisis with strong growth in core Europe is difficult but manageable as long as politicians continue to extend and pretend. But all pretence is lost when activity amongst the core economies slows to zero. The lack of volume and high volatility means that aggressive positions are dangerous, but we remain underweight Greece, Ireland and Portugal as well as holding underweight positions in Italy, Spain, France, Belgium and the €uro."
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