Greece – the next country getting roughed up by the Bond Vigilantes

The original ‘Bond Vigilantes’ were the bond investors who reacted to authorities’ loose monetary or fiscal policies by forcing sovereign bond yields higher, thus punishing central banks or governments by increasing the cost of issuing further debt.  Right now, the Bond Vigilantes are hunting around the world like a pack of wolves. Japan was the prey a few weeks ago (see recent blog comment here), but the winds have changed slightly and the wolves have caught a new scent.  As the chart shows, the credit derivative market is implying that the risk of a Greek default in the next five years is about the same as the risk of a Russian default, and Greece is now deemed a higher risk credit than the Philippines (BB-), Colombia (BB+) or Panama (BB+).  In fact this data is as at yesterday’s close, and Greek 5y CDS has today widened further to 182-87.   At the beginning of November, 10 year Greek government bonds had an excess yield of 1.4% over German government bonds, and they now have an excess yield of over 1.7%.

It’s been known for a while that Greece has structural fiscal problems and unreliable statistics (in Trichet’s own words, there is a “problem with credibility”).  The main issue facing Greece, however, is that neither the Greek authorities nor the Greek population seem prepared to do much about it.  A new Greek government was voted in after the previous government lost the election that it itself called in an effort to win a mandate for its proposed package.  In January this year, the Greek deficit was projected to be – 3.7%, but it’s been steadily revised upwards, to the point that the new government projects a 12.7% budget deficit for this year and 9.4% next year.  The EC projects a more realistic deficit of 12.4% for 2010.  (You may recall that a 3% budget deficit was originally an entry condition to join the Eurozone – it seems Greece has been fudging its budgets for a while).

Things have all properly kicked off in the last week couple of weeks.  The European Commission highlighted that there has been a “lack of effective action” in Greece in sorting out its public finances, a statement that was probably a reaction to the less than credible budget put forward by the new government (increases in health, education and welfare spending, with little in the way of tax rises and spending cuts).  Then last week it was rumoured that the Bank of Greece had advised Greek banks to sell part of their government bond holdings (officially denied), though it seems that they have asked Greek banks to be prudent and try to find alternative ways to fund themselves, as some of the extraordinary stimulus measures are being wound down. Investors are also concerned that Greek banks may find that Greek government bonds could become more expensive as collateral if further rating downgrades occur (the ECB has said that a haircut add-on will be applied to all assets rated below A-, which is where Greece is rated by Fitch and S&P, and Fitch has Greece on negative outlook).  You can add into the mix the fact that the Greek economy is struggling versus its peers – unlike the Eurozone, which is out of recession, Greece is still in recession – and it becomes clear that the country is potentially facing a crisis.

If Greece doesn’t come up with effective measures in the next month, it will be given notice to take measures to remedy the situation under the Excessive Deficit Procedure (Maastricht Treaty).  If it continues to misbehave, then it may face sanctions and the EC may require a non-interest bearing deposit (I’m not sure how effective these measures would be – will it help Greece’s problems if it starts getting fined as well?).   Ultimately, though, it will be the bond vigilantes who move in for the kill, rather than the European authorities.  This was echoed by the ECB’s Gonazales-Paramo last week, when he said that the debt markets will punish countries which don’t control fiscal deficits.  And ‘punish’ is what the bond vigilantes are currently doing.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Mike Riddell

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