Plan B: the search for a solution to the Greek crisis

Guest post by Marcello Minenna



Yanis Varoufakis’ notorious Plan B is gaining notoriety as Greece’s ex-finance minister now faces criminal charges. Developed with James Galbraith of UT Austin, Plan B outlined the introduction of a "fiscal currency" parallel to the Euro in case of extended gridlock with the Troika. If the ECB cut off Emergency Liquidity Assistance to Greece this parallel currency would relieve Greece's tightened liquidity—and resulting social fallout—during an extended bank holiday. Some still say much ado about nothing but is this really the case?

Such supplemental currency is uncharted territory for Eurozone Treaties as it would be denominated in euro and would not represent a new currency or the return to the Drachma. Under Plan B Greece could have introduced a de facto system for accounting and transferred household debt owed to Greece’s tax authority to third parties. Once this debt is transferable, Greek citizens could use the newly issued currency to settle transactions: citizens could simply transfer debts for goods and services as they do with traditional currencies. Moreover the Varoufakis-Galbraith plan would have allowed residents to exchange new currency for funds otherwise frozen in bank accounts. Consequently, restored financial transactions would have bypassed liquidity issues and the stifling bank holidays.

The successful circulation of a fiscal currency depends on household debt owed to the tax authority. Debt-based currency issuance, which depends on substantial household debt owed to the sovereign tax authority, would be particularly effective in Greece given the high level of fiscal indebtedness of its citizens . In fact Residents have high fiscal debts and the banking system has recently been recapitalized by about 50% using € 15 billion of Deferred Tax Assets. In other words, such a plan has already been used to keep Greek banks alive and preemptively prevent the Troika from meddling with Greek bank accounts in the future. Similarly, Greece could circulate Public Administration debt owed to the private sector. It is unclear whether Syriza could extend this mechanism to future fiscal debt given the heavy haircut for converting fiscal currency to Euros.

To implement the fiscal currency the Greek government would have used taxpayer information available at the General Secretariat on public revenues. While Greece could easily access such information in normal economic conditions, the necessary management software was provided, and likely controlled, by the Troika. Greece’s creditors would obviously prevent their diffusion of a fiscal currency that would allow Athens to take control of their national monetary base. If implemented, the policy measure would both strengthen Greece’s position in the negotiations and any possible plans of last resort. such as the exit from the Euro, less daunting. Varoufakis has recently highlighted that, with a fiscal currency implemented, the return to the Dracma would been realizable with just a "round of a hat".

However the fiscal currency is not a panacea: it would preserve public order but not to amend Greece’s contracting GDP, consolidated deflation, and their much-feared consequences on debt servicing. Moreover, the fiscal currency would facilitate domestic transactions but be ineffective for international credit payments such those for public debt (about € 320 billion, 180% of the GDP).

The search for a solution to the Greek crisis needs to take a broader perspective. In particular, the Eurozone leadership should seek three goals: reduce sovereign debt spreads between member nations, encourage fiscal transfers that correct financial imbalances and the competitive gaps triggered under the Euro, and help structure effective debt relief for Greece by restructuring at market value.

Just recently, this trio helped Puerto Rico reconcile untenable debt, culminating in default. The negative effects on Puerto Rican GDP measured just one third of those on Greece. Although Puerto Rico is only a US territory but not a State of the Federation, it has benefited from federal transfers more than five times the Eurozone allocated to Greece—a member State of the European Union in every respect. While, the FDIC handled Puerto Rico’s banking crisis under the federal budget for more than $ 5 billion, the EU must help Greek banks recapitalize more than € 25 billion at the expense of depositors.

DTAs in the balance sheet of the main Greek banks (2011-2014)

Weekly Evolution of the Emergency Liquidity Assistance ceiling to Greek banks
(February – August 2015)

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Troika to extend the unsustainable Greek debt by decades

The Euorzone leadership remains uneasy with the third bailout of Greece. This unease can be seen in the recent delay to the start of the negotiations, with the Troika staff in Athens siting "technical issues". The actual reason has to do with the fact that Greece's creditors have yet to reach an agreement among themselves. Apparently some Eurozone nations are still pushing for additional requirements that go beyond the austerity measures the Greek parliament recently passed.

The challenges surrounding the new bailout are severe. The intrusive nature of reform enforcement by the creditors is likely to worsen the already intense animosity in Greece toward the Troika institutions.

Bloomberg: - Previous memorandums committing Greece to enforce reforms on everything from the rules of bank recapitalizations to evaluating the “impact of the changes in milk pasteurization and sale procedures,” have prompted dissenters to claim that Greece has turned into a “debt colony.” Creditors argue that changes are necessary to stabilize the country’s finances and set it on course to sustainable growth.

Furthermore, the negotiations will once again be taking place "under the gun" as the next payment to the ECB of over €3bn is due on August 20th.

Assuming the deal will be completed in August as the can gets kicked much further down the road, Greece is being set up for a massive maturity wall, with little chance of principal repayment. And any form of debt principal forgiveness is off the table.

Natixis: - [Greek debt forgiveness] is unlikely to come about given the opposition of many Member States (Germany notably), the position of the Eurogroup over this issue (“nominal haircuts on the debt cannot be undertaken”) and the legal obstacle (measure would be in breach of Treaty). Under these conditions, this leaves one option, namely a re-profiling of Greek debt without touching the principal.

Out of the EUR82bn-EUR86bn lent by the ESM, part could be applied to repurchase the debt held by the ECB and to repay early the IMF (which in total would represent EUR25bn). [It] follows that the financing requirement of the Greek State, assuming there is a 20-year grace period and repayments are spread over 40 years, would correspond to the primary balances and repayments of principal and interest in respect of market debt held by private creditors (i.e. TBills, GGB PSI, new GGB and debt issued under foreign law)

According to Natixis here is what the liability term structure is expected to look like after the completion of this third bailout. How Troika lenders can possibly get comfortable leaving a small nation with this type of a debt profile is unfathomable. And yet, this is the most likely outcome of the upcoming negotiations.

Source: Natixis

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Managing Greek default risks

Many in Europe continue to believe in the permanence of the Eurosystem. The Bank of Greece is controlled by the ECB and its assets and liabilities will always be consolidated into the Eurosystem. By this argument, the collateral held by the Bank of Greece as part of the ECB's financing of Greek banks belongs to the Eurosystem. Therefore if the Greek banking system were to fail, at least the Eurozone's central banking system can keep the collateral.

Let's be clear: if Greece were to exit the currency union, the Bank of Greece and its assets would be immediately expropriated by the Greek government (making them part of the "new" Bank of Greece). Many in Europe are pointing out how such action would be illegal. There nothing "legal" about Grexit to begin with - the system was designed to have laws for "marriage" but no laws for "divorce". And with the Bank of Greece exiting so would go the collateral. To assume that the Bank of Greece is a permanent fixture of the Eurosystem is not prudent credit risk management. Therefore the Eurosystem's exposure to Greece should be added to the €323bn of other debt.

Having said that, Target2 debt owed by the Bank of Greece to the Eurosystem has no maturity and requires no immeduate payments. Therefore a standalone Bank of Greece may choose to keep the liability outstanding in order to get access to the euro payment system. The Eurozone's political leadership may however demand a timely repayment of these balances, given the size of the exposure.

Source: Barclays Research

This central-bank-to-central-bank exposure is now rising rapidly as the ECB approves a new limit increase for emergency funding (ELA) on a daily basis. This is what a run on the Greek banking system looks like.

Source: Barclays Research

While some accounts are moving abroad and into other assets (including European bonds held in foreign accounts and even into bitcoin), much of the withdrawal activity is simply converting deposits into banknotes. Anecdotal evidence suggests that many in Greece are leaving a minimal amount at the bank to keep the account open and the rest is in cash stored under the kitchen tiles, etc. Greece is quickly becoming a cash economy. Capital controls could be the next logical move by the Greek government and the population and businesses are simply protecting themselves.

Source: Barclays Research

Here is an example:

Bloomberg: - Dorothea Lambros stood outside an HSBC branch in central Athens on Friday afternoon, an envelope stuffed with cash in one hand and a 38,000 euro cashier’s check in the other.

She was a few minutes too late to make her deposit at the London-based bank. She was too scared to take her life-savings back to her Greek bank. She worried it wouldn’t survive the weekend.

“I don’t know what happens on Monday,” said Lambros, a 58-year-old government employee.

There is hope however for a less-than a disastrous outcome. These near-panic conditions could be sufficient to bring the nation's leftist government back to the negotiating table this weekend. However, time is fast running out as €1.6bn is due to the IMF in less than 10 days.

Moreover, there is a good possibility that Greece could default without leaving the currency union. With a strong support for the euro, Greeks could push for a referendum to form a more centrist government that would re-engage the creditor institutions. Here is a summary from Barclays Research:

Source: Barclays Research

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Bank of Greece expulsion from the Eurosystem could be especially damaging to the currency union

Risks to the euro area's ongoing economic recovery have risen recently as Greece once again takes center stage. The nation is about to become the first developed economy to default on its IMF obligation (joining countries such as Sudan and Iraq). Such outcome may also ultimately result in its exit from the EMU.

Reuters: - Cut off from markets and refusing so far to accept the terms set by its lenders, the Greek government may have to choose in the next few weeks to pay salaries and pensions or repay International Monetary Fund loans.

Its official creditors - the euro zone and the IMF - have frozen bailout aid until the new leftist-led government in Athens reaches agreement on a comprehensive package of reforms.

A deal had been pencilled in for an April 24 meeting of euro zone finance ministers in Riga, but it now seems too ambitious, officials said.

That has raised fears the Greek government will not be able to make its next payments to the IMF, which total some $1 billion over the next month. Missing an IMF payment could mean default and, eventually, an exit from the euro zone.

The fiscal situation in Greece has become untenable, with tax revenue collapsing and government cash position barely sufficient to pay government employees and cover pension obligations through the end of the month.

Reuters: - Greece will need to tap all the remaining cash reserves across its public sector -- a total of 2 billion euros -- to pay civil service wages and pensions at the end of the month, according to finance ministry officials.

Barring a last-ditch deal with its creditors, that is likely to leave no money to repay the International Monetary Fund almost 1 billion euros due in the first half of May, although Greece has said it wants to honor its debt obligations. Athens' scramble for basic funds shows how extreme the financial constraints on Greek Prime Minister Alexis Tsipras have become as he tries to convince skeptical foreign creditors to extend his country new financial aid.

Will we see a last minute compromise? Perhaps. But the Eurogroup is experiencing what many dealmakers would categorize as "deal fatigue" - the motivation to find an emergency solution is no longer there. Moreover, the political climate does not favor a compromise with Greece. While the focus has been on Germany, it is the smaller nations such as Slovenia that have argued vehemently that Greece must comply with the original bailout terms. Slovenia, who struggled through the downturn, cutting pay and shrinking expenditures, views Greece as using the bailout funds for pay increases - and then asking for debt forgiveness. Slovenia's taxpayers whose pensions are considerably lower than those in Greece will not look favorably upon such action.

The Slovenia Times: - Our exposure to Greece is 2.7% of GDP, which was in a year after we had a 8% fall in GDP and when we had to slash pay and economise in all areas."

This is why Slovenia will insist on Greece continuing with the restructuring and continuing to meet its obligations to Slovenia as well as international institutions, [Slovenia's Finance Minister Dušan] Mramor said.

"Given such an exposure Slovenia has toward Greece and such solidarity we provided, Greece has said it plans to raise pensions, raise pay, make employments in the public sector and demand an extra cut it its liabilities to Slovenia, while in Slovenia we are slashing pay and economising in all areas," Mramor said.

With little political will to provide additional financing, what happens after the IMF default by Greece? According to Bank of America, "it would trigger a parallel default to the Eurozone bail-out fund (EFSF) under the legal master agreement, and might force the EFSF to cancel its loan packages and demand immediate repayment. This in turn would trigger a default on Greek government bonds issued under the bail-out accord."

The markets are pricing the probability of default as a near certainty at this point, with credit default swap spreads blowing out.

Greek 5-yr and 1-yr sovereign CDS spreads (source: Barclays Research)

The Greek sovereign debt yield curve has inverted further, with the 2-year yield now above 25%.

It is not at all clear what will happen after the default, but the so-called Grexit becomes increasingly likely. Most analysts now believe that unlike in 2012 the Eurozone will be able to weather this storm due to its better capitalized banks, the ongoing quantitative easing by the ECB (coupled with other measures such as TLTRO), well established bailout mechanism (the ESM), and the OMT backstop facility designed to allow the ECB to support any state that is having liquidity problems. The Eurozone should be able to absorb the losses on some €330bn government exposure to Greek public debt.

French Finance Minister Michel Sapin (via Reuters): - "We have learned to build walls to protect ourselves, to protect the banking system, to protect other countries which could become fragile, if something happens in Greece. So Europe is much stronger. Europe has sheltered itself from turbulence. The danger is for Greece."

However, as discussed before, the nation's divorce from the European Monetary Union will be complex and fraught with more uncertainty than many realize. It's not just about Greece defaulting on on the public debt but also about extracting the Bank of Greece from the Eurosystem. By the time Greece imposes capital controls - which seems increasingly likely - the run on Greek banks will have taken its toll. Deposits have already declined sharply since late last year.

Source: Barclays Research

The Greek banks are replacing these lost deposits with emergency funds (ELA) from the Bank of Greece, who is in turn borrowing from the Eurosystem via TARGET2. With these banks increasingly dependent on central bank support, valuations are collapsing as the need for more bailouts becomes clear. This is especially the case if Greece defaults on its bonds which are widely held by Greek banks.

Greek banks share index

So if the Bank of Greece is borrowing, who is doing the lending? The funds come from the other euro area central banks (via the Eurosystem), particularly the Bundesbank. We can see the increase in this exposure to Greece on Bundesbank's balance sheet. As the Greek citizens are removing funds from their banking system (including taking out bank notes), this balance sheet item at Bundesbank rises further.

Source: the Bundesbank (the latest increase is almost entirely due to Greece)

In a Grexit scenario, as the Bank of Greece is expelled from the Eurosystem, it will default on its TARGET2 obligations. That in turn will force Bundesbank (and other core euro area central banks) to take a write-down. Of course a nation such as Germany should easily absorb such a loss and recapitalize its central bank. But at that point the Germans will surely want to know just how much more of such exposure their central bank holds.

The answer at this point is that nearly 70% of Bundesbank's assets are in TARGET2 claims - a half a trillion euro exposure to periphery nations' central banks. How much support for the EMU will the Germans have once they realize that a large portion of their central bank's assets could be at risk? After Grexit, the TARGET2 exposure will no longer be some abstract concept - the risk levels will become quite real and German politicians and the media will surely drive that point home.

Moreover, as Greece imposes currency controls, depositors in other periphery nations are likely to also begin shifting capital out of their domestic banking system - as they see the writing on the wall. Portugal, Spain, and Italy are particularly vulnerable. Such actions will of course end up increasing TARGET2 imbalances further (as was the case in 2012), putting more of Bundesbank's balance sheet at risk. Contagion could become a major problem again. We already see some early signs, as periphery bond yields rose last week in spite of all the QE buying efforts.

Certainly Grexit related damage can be managed by the national central banks and the European Stability Mechanism. These institutions will be promptly recapitalized. Such actions however will anger citizens of some member states, whose taxpayers' funds will be used to fix the damage caused by Greece. Given the chaos and the political backlash such an outcome will generate, it's unclear when - if at all - confidence in the currency union will be restored. As discussed before (see post), history is not on the Eurozone's side.


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The Eurozone: on the road to recovery with a lingering risk

Posted by Walter

Back in September the idea that the Eurozone's economy could potentially undergo a recovery (see post) was met with some skepticism. And yet here we are. The EuroStoxx50 index is up 14% for the year while the Dow is up 2.5%. We now see plenty of indicators showing strengthening economy in the euro area.

To begin with, the area's credit conditions continue to improve as loan growth is about to turn positive for the first time since the middle of 2012.

Source: ECB, Investing.com

Corporate and household loan expansion, while still terrible relative to the US, is on the right path. This is particularly true after the conclusion of the ECB's stress tests (which were a major source of uncertainty in 2013).

Source: ECB

The area's bank deleveraging is ending (see post) and the strongest evidence of that can be seen in the acceleration of the broad money supply growth. The M3 expansion trend has been fairly consistently beating economists' forecasts.

Source: ECB/

Both business and consumer sentiment surveys, which soured significantly after the Russia sanctions went into effect, showed marked improvements recently. Part of the reason is the decline in fuel prices.

Source: TradingEconomics

Source: Investing.com

Moreover, the labor markets are exhibiting signs of stabilization. Just to be clear, the declining unemployment is highly uneven across the various states and nobody claims the job situation in the Eurozone is in good shape.

By any measure, the job markets in some of the periphery nations are dreadful. But on a relative basis, hiring across the euro area has been improving.

RBS: - Baby steps. The Spanish labour market has enjoyed its best year since 2007 - a start on a 23.4% unemployment rate.

Source: RBS

A number of these surprises to the upside are reflected in the Citi Economic Surprise Index, which shows the Eurozone diverging from the US.

Source: ‏ @sobata416, @valuewalk, @HedgeLy 

Going forward, the sharp deterioration of the euro and the ECB's expected massive bond buying program should halt deflationary pressures (although just as the case in Japan, inflation is likely to remain below the ECB's target for a while). Weaker euro may also help the area's exporters.

Source: Investing.com

But the euro area's economy is not out of the woods yet. The greatest and the most immediate risk to the recovery remains the developments in Greece. While the Eurogroup has kicked the can down the road, the situation could deteriorate quickly even before the bridge financing matures. Depositors are continuing to withdraw money out of Greek banks.

Source: @Schuldensuehner

Nobody wants to get caught with a Cyprus type situation where people's property was confiscated by the state via deposit haircuts. An even worse scenario would be having deposits forcibly converted into drachmas that will find no bid in the FX market. The Greek government is already taunting the Eurogroup with creative drachma notes designs (Greece will need take lessons from Zimbabwe and add a few zeros to some of these notes).

Source: @AmbroseEP

As these deposits leave, Greek banks lose their limited sources of private funding and increasingly rely on the Bank of Greece for the emergency liquidity assistance (ELA) loans. In fact investors have little confidence that the banks are sufficiently capitalized after the last bailout to withstand this transition. That's why today alone, the banking sector took a 10% hit.

Why does this relatively small nation present such a risk to the Eurozone's nascent recovery? The ELA loans are financed via Target2 as the Bank of Greece borrows from the Eurosystem. In a Grexit scenario the Bank of Greece will be unable (or unwilling) to repay these loans, forcing the Eurosystem (the ECB) to take a significant hit.

There is no question that the EMU will easily withstand such an event - it's not a great sum of money in the larger scheme of things. But the loss of confidence and the political nightmare associated with recapitalizing the ECB as well as the fears of contagion to other periphery nations may send the euro area back into recession. Will depositors in Italy, Portugal, and Spain begin to move their deposits out as well in order to avoid being "drachmatized"? Economists often forger, it's less about the specific euro amounts and more about the psychology of fear.

If however the Eurogroup manages to somehow stabilize the Greek situation, a steady economic recovery could be in store for the Eurozone. The next few months will be crucial.

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The harsh realities of the Greece-Eurozone game of chicken

Posted by Walter

The Greece-Eurozone dispute has received a great deal of attention in the media in recent weeks. It seems however that contradicting statements and polarized views -  many tainted by various political agendas - have created a great deal of confusion around the subject. As the parties resume negotiations this coming week, lets look at what each has to lose if a solution is not reached in time.

The damage to the euro area

First of all it's important to point out that the so-called "Grexit" is equivalent to a complete failure to pay on obligations by the Greek government, its banks, corporations, and households. While everyone is focused on the €315 billion Greece owes to the Eurozone, the IMF, and others, the damage to the euro area would actually be much greater.

Source: Bloomberg

What nobody wants to talk about is the fact that internally most Greek loans - including mortgages - are in euros (some are even in Swiss francs). Greek banks hold €227 billion of loans and €12.4 billion of Greek government debt (plus roughly another €25 - €50 billion of Greek-based private sector bonds). Under a Grexit scenario, most debt (including government debt) will be converted to the new drachma at a preset exchange rate.

As the drachma collapses - and there is little question that it will - Greek banks, who would now have drachma assets and euro liabilities, will quickly fail as well, leaving the Bank of Greece holding the bag. The Bank of Greece which is currently part of the Eurosystem will therefore default upon exit. But before it exits, the Bank of Greece will draw on Target2 from the rest of the Eurosystem as Greeks quickly move their deposits out (see how the mechanism works here with the Bank of Spain example). And there is no question Greeks will try to move a great deal of their deposits out before they are converted to drachmas. In December alone they pulled €4.6 billion euros out of Greek banks - and that's before the Syriza victory.

The default by the Bank of Greece could cause even more damage to the system than the losses to EFSF and to other entities such as the IMF. Between the government bonds the Eurosystem holds and the Target2 losses, the ECB may need to be recapitalized - a political disaster. Market anxiety alone could push the euro area back into recession as credit conditions tighten again (potentially similar to the Lehman situation).

In the long run, if Grexit becomes a reality, the whole EMU could become unstable. History certainly isn't on the euro area's side.

Source: @RBS_Economics

Of course the Greek membership in NATO and the nation's ports on the eastern Mediterranean that are strategically important to the West could be in jeopardy as well. In particular, Greece's recent interest in establishing a stronger relationship with Russia (see story) is scaring a number of NATO generals.

The damage to Greece

Greece is quickly running out of time. And it's not just the debt maturity wall in 2015.

Source:  @Eurofaultlines

We are talking about hitting the wall at the end of this month. Greek citizens are in the street these days with a new slogan "Bankrupt but Free". Of course it's all fun and games until pensioners line up at the soup kitchens and move into the homeless shelters because they can't get their retirement checks. It's a matter of weeks before Greek government employees no longer get their payments. Why is the situation so dire all of a sudden? Part of the problem is that the tax revenue is falling sharply now.

WSJ: - Government income has declined sharply in recent weeks as many Greeks have stopped paying taxes in hope that the country’s new, leftist government would cut taxes. Tax revenue dropped 7%, or about €1.5 billion euros, in December from the previous month and likely fell by a similar percentage in January, according to Economy Minister George Stathakis.

“We will have liquidity problems in March if taxes don’t improve,” Mr. Stathakis said.

Other officials warned the country would have difficulty paying pensions and other obligations beyond February.

And if the new government thinks their tax collection abilities will improve after Grexit, they are kidding themselves.

Furthermore, in the face of such uncertainty, Greek businesses will demand bags of drachmas for any goods and services they offer. And there is little chance that foreigners will accept drachmas for shipments of food, fuel, etc. With Greek government euro accounts frozen abroad after the default, access to hard currency will be cut off as the Bank of Greece will be forced to sell off its gold holdings. It's a humanitarian crisis in the making.

The compromise

Given such enormous risks to both parties a compromise will probably be reached. A bridge loan of some kind is likely in the nearterm. Beyond that we have some great unknowns and multiple rounds of "game of chicken" between the two parties.

One can sit around and pass the blame (see post) for the situation in which these parties find themselves today. But these are the harsh realities we are faced with and a longer term solution that softens the fiscal constraints on Greece while changing its liability structure will need to take shape. Otherwise the story of the European Monetary Union will enter its darkest chapter yet.

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Greece's fight against "fiscal waterboarding" will halt economic recovery

We are about to witness a historic showdown between the major euro area institutions and Greece. Greece's newly appointed finance minister Yanis Varoufakis, a staunch bailout critic, will lead the negotiations on debt haircuts. On the other side will be the creditors: the International Monetary Fund and the European Commission - with additional support from the ECB. Private bondholders may get dragged into the fight as well (although many of them are Greek banks who will do what the government tells them). A number of Eurozone politicians have already expressed skepticism about any debt forgiveness for Greece. But Varoufakis is likely to focus on the argument that Germany has to take a great deal of the blame for the situation in which Greece now finds itself - calling the imposed austerity measures "fiscal waterboarding". Here is a good quote from Strafor:

Stratfor (via Forbes): Another version, hardly heard in the early days [of the Eurozone crisis] but far more credible today, is that the crisis is the result of Germany’s irresponsibility. Germany, the fourth-largest economy in the world, exports the equivalent of about 50 percent of its gross domestic product because German consumers cannot support its oversized industrial output. The result is that Germany survives on an export surge. For Germany, the European Union — with its free-trade zone, the euro and regulations in Brussels — is a means for maintaining exports. The loans German banks made to countries such as Greece after 2009 were designed to maintain demand for its exports. The Germans knew the debts could not be repaid, but they wanted to kick the can down the road and avoid dealing with the fact that their export addiction could not be maintained.

The debate will also focus on the fact that Greece has done an amazing job in cutting its debt/GDP ratio - in spite of the falling GDP.

Source: @RBS_Economics 

Greek government bond yields spiked on Syriza's escalating rhetoric as well as on the right-wing anti-austerity party (Independent Greeks) becoming Syriza's new coalition partner. Think about it - the only thing the two parties have in common is their hatred for the Eurozone and the fiscal pain that was imposed on Greece.

The Greek government bond yield curve has become more inverted as markets price in principal reductions that are likely to apply evenly across the curve (which is what typically causes such inversion).

It is expected that if such haircuts are applied, they would hit both official and unofficial accounts (including bonds held by the ECB). Debt forgiveness would also cut principal on the government bonds held by Greek banks - who are some of the largest holders. That's why shares of Greek banks got decimated today. New bank bailouts will be required if there is any hope for credit availability to the private sector. For now most credit activity will come to a grinding halt - and with it any hopes for economic recovery.

Source: @WSJGraphics

The overall equity market fell over 9% today as government officials halt privatization and extend an olive branch to Russia (see story).

The newly elected government may ultimately get its debt forgiveness. But in the process the damage done to the nation's private sector will be severe - just as Greece begins to come out of a deep depression that rivals some of the worst downturns in global history.

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Draghi now has all the ammunition he needs for QE. Implementation still a problem.

If Mario Draghi was lacking ammunition to initiate an outright quantitative easing program in the Eurozone, he certainly has it now. Even the staunchest opponents will have a tough time arguing against the need for a more aggressive approach to monetary easing. Here are five reasons:

1. The take-up on ECB's TLTRO offering (see post) fell far short of the ECB’s goals. Indeed the demand in the second round of the offering came in at €130 bn, putting the total take-up at €212bn - well below the €400 billion allowance. Since the TLTRO financing is linked to bank lending, the program to some extent relies on demand for credit from businesses and consumers. And that demand has been lackluster in the past couple of years. Therefore the initiatives announced by the ECB last summer, including ABS and covered bond purchases, are simply insufficient for the type of monetary expansion (of about €1 trillion) the central bank would like to see in the Eurozone.

Eurosystem consolidated balance sheet (source: ECB)

2. Some Economic data out of the Eurozone shows recovery stalling. Italian industrial production and French labor markets are just two examples.

Source: Investing.com

Source: Investing.com

3. With the collapse of oil prices, the Eurozone is bracing for deflation. German 5-year breakeven inflation expectations are now at zero. And Europe's central bankers are fearful of repeating Japan's decade-long struggle with deflation.

Source: @PlanMaestro

4. While the euro has declined significantly against the dollar, it remains quite strong on a trade-weighted basis. This is putting downward pressure on prices (via cheaper imports) and is disadvantaging some of the Eurozone-based exporters. A more aggressive easing effort would force the euro lower.

TWI = "trade-weighted index" (source: @TenYearNote)

5. Finally, the euro area's sovereign risks are resurfacing once again - triggered by new political uncertainty in Greece.

The Guardian: - Mounting concerns over Greece’s ability to weather a presidential election, brought forward in a surprise move by the prime minister, Antonis Samaras, continued to unnerve investors ahead of the first round of the vote in the Greek parliament next week.

Under Greek law failure to elect a new head of state by the ballot’s third round on 29 December could trigger a general election. The stridently anti-bailout main opposition party, Syriza, is tipped to win that poll. The radical leftists have made a debt writedown and the end of austerity their overriding priorities if voted into office.

Although Samaras called the election in a bid to expunge the political uncertainty engulfing Greece, the slim majority held by his government, compounded by the leader’s repeated warnings of Greece leaving the eurozone if Syriza assumes power, has accelerated investor nervousness.

The nation's stock market is down 20% over the past 5 days as investors flee.

red = Euro STOXX 50, blue = Athens Composite

And Greek sovereign debt sold off sharply. In fact the 3-year government paper yield went from roughly 3.5% in September to 11% now. This situation alone would make most central bankers consider some form of monetary easing.

Mario Draghi now has five solid reasons to argue for QE and many expect the central bank to announce such an initiative in the next 2-3 months. However, while most economists covering the euro area agree on the need to take a more aggressive monetary action, the problem of implementation remains. Since the Eurosystem's (ECB's) balance sheet is in effect owned by member states, many in the core economies are worried about having to become the proud owners of large quantities of their pro rata share of periphery nations' debt. For the Germans in particular, the ownership of such debt is a major issue. A solution that is even remotely politically palatable across the Eurozone remains elusive. The ECB's independence and the euro area's legal structure is about to be tested once again.

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Moody's upgrades Greek government debt

Yesterday the Eurozone received some positive (though largely symbolic) news. Moody's decided to upgrade the rating on Greek government debt from C to Caa3. It's an important psychological step for the area because Greece was the flashpoint for the Eurozone crisis. Here is the rationale for Moody's action:

Moodys: - 

(1) The significant fiscal consolidation that has taken place under Greece's structural adjustment program despite low growth and political uncertainty. As a result, Moody's expects that the government will achieve (and possibly outperform) its target of a primary balance in 2013, and record a surplus in 2014 in accordance with the adjustment program.

(2) The improvement in Greece's medium-term economic outlook supported by a cyclical recovery in the economy and also the progress made in implementing structural reforms and rebalancing the economy.

(3) The significant reduction of the government's interest burden following previous restructurings and official sector repayment assistance.

To be sure, most economic data out of Greece continues to resemble a full-scale depression. The unemployment rate is at 27% and youth unemployment is at 57%. Credit to the private sector has fallen 56% from the peak and continues to decline. Manufacturing, new orders, industrial production, retail sales, etc. are all contracting (though the rate of contraction has slowed). Moody's nevertheless is betting on the following:

1. The country's debt to GDP ratio, while still horrible, seems to be moving in the right direction.

2. With the domestic demand in shambles, the nation's current account is in the black. To the extent some of the planned reforms are implemented, the economy could benefit from this trend. Also as discussed last summer (see post), Greek businesses have been showing surprising optimism. Moody's is hoping that all this will eventually translate into a "cyclical recovery in the economy".

3. As discussed last year (see post), the restructured Greek government debt (including the EU/EFSF loans) carries extraordinarily low interest burden and extended maturities, giving the Greek government a great deal of flexibility. This is Moody's third reason for the rating upgrade.

The bond markets have been reflecting these improvements for some time and the upgrade should have relatively little impact on yields.

Greek 10y government bond yield (source: Tradingeconomics.com)

While the upgrade comes as welcomed news, major risks to Greek economic recovery and fiscal stabilization remain. Apart from some nasty political risks (see story) as well as pressure from the Eurozone leadership and the IMF, Greece is facing two key concerns that are tied into the rest of the Eurozone periphery:

1. The banking system remains all but frozen, with nonperforming loans, undercapitalization, and poor deposit base hampering credit creation. Achieving a sustainable economic recovery will be extraordinarily difficult unless this issue is addressed.



2. Persistent strength in the euro (in spite of tepid economic data) is believed to be detracting from the overall economic growth across the Eurozone. Strong currency is particularly painful for the more vulnerable nations that depend on exports. Further increases in the value of the euro could make the situation worse.

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From our sponsor:

Better economic news out of Greece masks clouds on the horizon

The latest GDP number out of Greece looks more promising than in the past (assuming it is to be trusted). The GDP contracted by only 0.2% (SA) from the previous quarter and 4.6% on a year-over-year basis.

Source: Eurostat

The Greek government wants to use this opportunity to obtain yet another bailout loan from the EU/IMF. In spite of this slowdown in GDP contraction and a somewhat better fiscal deficit, the Greek government is expected to run out of money by the end of next year.

Barclays Research: - ... the programme could very likely run out of funds before the end of 2014 as lower-than-expected growth last year, extra costs for buybacks and the delays in implementing reforms have opened up a funding gap. In addition, at this stage, we don’t see how Greece could be in a position to return to market funding by the end of 2014, meaning that it will also need its bailout programme extending. Finally, long-term sustainability is still far from obvious and reaching the magical 120% debt-to-GDP ratio by 2020 will require substantial debt-relief measures.

A rift is developing within the IMF over the fund's ongoing disbursements to Greece from funds that have already been committed (see story). The IMF has been pressuring the EU for some time to provide Greece with some "debt relief/extension" - possibly including outright "haircuts" to public sector loans. That means the Eurozone nations will need to accept worse terms and possibly a write-down of some sort in order to make the bailout plan more "sustainable".

The European Commission however is not ready to kick off the discussions on the topic - at least not until after the upcoming German elections in late September. And the idea of relaxing conditions for current funding as well as additional funding for Greece is generating some skepticism in Germany.

The Local: - Germany's central bank expects Greece to receive another bail-out loan later this year or by early 2014, the German weekly Der Spiegel reported Sunday, citing an internal Bundesbank document.

[Bundesbank's] experts however rated the risks of the international loan programme as "exceptionally high" and the Greek government's performance as "barely satisfactory", the magazine said.

The paper's authors also voiced "considerable doubt" about the Greek government's ability to implement essential reforms, said Der Spiegel.

The paper, reportedly written for Germany's finance ministry and the International Monetary Fund (IMF), also criticised the latest credit tranche, saying it had been approved due to "political constraints".

What makes the potential modification of Greek debt particularly troubling is that it can not be viewed in isolation. If Greece receives some form of relaxation of terms, Portugal is right behind them. Portugal will need its loans extended at some point as well, since the nation is unlikely to enter the private markets any time soon. And treating Greece differently from Portugal is not going to be possible. Now the Eurozone may have a double bailout on their hands - something many of the partner nations are unlikely to accept.

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From our sponsor:

Could business optimism in Greece translate into stabilization?

Last week the International Monetary Fund said it will provide Greece with another installment in the amount of €1.7 billion under the second bailout plan. As the nation complies with troika's bailout provisions, including dismissing thousands of public-sector employees, economic indicators out of Greece continue to worsen. The latest unemployment rate clocked at 27%, resulting in a spectacular drop in consumer spending.

Source: Tradingeconomics (€ million)

The banking system is nearly frozen, as credit to private sector continues to decline (as old loans mature).

Source: Tradingeconomics (€ million)

Manufacturers struggle to bring product to market because they can't finance purchases of raw materials. In many cases neither the banks nor the suppliers are willing to provide credit (except for Iran who lends oil to Greek refiners).

On its own, Greece would do what Japan is currently doing - flood the banking system with excess reserves, force the central bank to buy government debt, and devalue the currency. But as long as the nation is part of the Eurozone, it has no control over the monetary system.

Amazingly, in spite of this full fledged economic depression, surveys are showing improvements in business sentiment and future outlook. When in comes to business conditions, Greeks seem to be at least as optimistic as the rest of the Eurozone, if not more.

Source: JPMorgan

Source: JPMorgan

And the latest overall economic sentiment index has spiked to the highest level since 2009.

The Telegraph: - The debt-gripped nation registered a 93.8 reading on the European Commission's economic sentiment index, putting it above northern European peers Austria, Finland and Denmark, and well above the eurozone average of 89.4.

Greece was among the steepest risers in the survey, which gauges consumer and business confidence, suggesting that pessimism is waning fast as the population pegs hopes on recovery.

Source: Tradingeconomics

Greeks seem to believe that improvements to their nation's conditions are under way. Maybe the hope is that the recapitalization of banks will result in more credit or maybe the tourist season will bring some much needed cash. Whatever the case, any sign of potential stabilization is welcome news.

In the end it's going to be all about how much tax the Greek authorities can collect in order to take the government to 4.5% budget surplus by 2016, as per troika's plan (amazingly, the original plan called for this surplus to to be reached in 2014 - see this article for full discussion). The goal is to one day return to market-based funding. But if the growth trajectory remains anything like it has been and tax receipts stay weak, the earlier tensions with the Eurozone and the IMF will return.

JPMorgan: - If growth remains sluggish, and after the painful fiscal consolidation to date, the question of whether Greece should continue to adjust on the timescale demanded by its European creditors will remain a pointed one.

Let's hope that the recent business optimism in Greece will spur some stabilization - otherwise we are back to square one.

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