Forget France – Greece is the big worry for Europe today
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MoneyWeek Editor
John Stepek Jan 16, 2012
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So France isn't a AAA-rated economy any more. Ah well.
But other than being yet another thing for Nicolas Sarkozy to get huffy about, how much does it matter?
In financial terms, not a lot. As usual, the ratings agencies are just catching up with the market. They're acting a bit faster than they did during the sub-prime mortgage crisis. But France hasn't been able to borrow at a AAA rate for a long time now.
There's a certain psychological significance to the downgrades, which we'll get to in a minute. But in terms of timing, S&P may have in fact done Europe a favour with Friday's swathe of downgrades.
It helped to distract everyone from the fact that Greece moved one step closer to the 'disorderly default' that everyone fears so much…
The Greek debt talks stall
While markets were waiting with bated breath on Friday for S&P to change its credit ratings to better reflect reality, talks between Greece and its creditors were going badly.
Here's what's going on. These are the PSI talks – private sector involvement. This is all about how big a loss ('haircut') private holders of Greek debt take on their loans. The idea is that holders will swap their existing Greek government bonds for new, 30-year bonds of lower value. About €100bn in Greek debt will be written off in the process.
The authorities want the deal to be voluntary. That way, Greece won't be considered to have defaulted. This avoids triggering credit default swap (CDS) insurance (which could be bad news for banks that have written this insurance). But it also means that non-private sector holders of Gree debt – such as the European Central Bank (ECB) – won't have to write down their own holdings.
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Much of the deal is agreed, according to reports. The sticking point is over what coupon (interest rate) the new bonds should pay. The private sector bondholders thought they had agreed to 5%. The IMF and other eurozone governments are pushing for a lower coupon. Depending on the exact figure, that could increase the haircut to more than 80%.
A deal really needs to be reached within the next week or so. Why the urgency? Because Greece needs a second bail-out package (part-funded by the IMF). The first instalment of this is due in March. Greece has to repay around €14.4bn in government debt on 20 March, so it's badly needed. However, the IMF isn't happy to sign off on the deal unless the haircut has been agreed by then.
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So what happens next?
Chances are, a deal will be reached. But the longer this drags on for, the bigger the risk that it won't. There's only so much of a haircut the private sector will take before the prospect of pinning their hopes on a CDS pay-out starts to look attractive.
And from a German perspective, a Greek default might actually be politically popular. This is where we come to the psychological impact of S&P's decisions. Germany is now the only stable AAA-rated sovereign in the eurozone. Correctly or not, that gives the country every incentive to feel that its 'austerity-first' stance is the right one.
In German news magazine Der Spiegel, Hans-Werner Sinn of the influential Ifo Institute says: "When it comes to Greece, it's clear that it's hopeless. It would be better for the country to finally leave the euro and transform its foreign debts to drachma, than to constantly beg for new aid and set itself up for lasting charity."
Perhaps the most complicated issue of all is what would happen to the ECB if Greece went bust. The ECB has been acting as an incredibly forgiving pawnbroker to the most troubled banks in the eurozone. Basically, it will accept troubled debt like Greek bonds and lend out hard cash in return.
If it turns out that those loans can't be repaid and the collateral backing them is dud, then the ECB could end up having to be recapitalised. In other words, it'd be bust itself, and Europe's taxpayers would have to cough up to raise funds for it. As Der Speigel points out, Germany is on the hook for 27% of "such capital injections." But they might consider that a worthwhile price to pay, given that it might draw a line under their commitments.
It doesn't help matters that even if the deal is done, Greece still looks unsalvageable. This haircut will leave Greece with a 120% debt-to-GDP ratio… by 2020. Given that a ratio above 90% is generally seen as bad news for growth, the idea that this is any kind of solution just looks like wishful thinking.
European stocks are starting to look cheap
It all adds up to another fraught week for the eurozone. What's interesting though is that the more intelligent fund management groups are starting to nibble at Europe. Ben Inker at US group GMO (home to the well-respected Jeremy Grantham) notes that "it's hard to buy Europe today, when there's so much uncertainty and despondency." However, "Europe ex-UK stocks are a particularly attractive asset class, because they're cheap."
We'll be looking at cheap stocks on offer in Europe in an upcoming issue of MoneyWeek magazine (If you're not already a subscriber, get your first three copies free here). However, as I noted last week, I suspect Europe can still get cheaper if there are any more nasty surprises.
Inker notes that GMO likes another cheap developed market, which I can definitely get behind: Japan. My colleague Merryn Somerset Webb interviewed Japan fund manager John Paul Temperley recently about the best ways to invest in the country.
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