|Chart 1: change in yield curve
Rescue package’s conditions confirmed
Negotiations between Greece, EU leaders and IMF have finally come to a conclusion as of 1 May 2010. The negotiations were completed earlier than initially planned as the deteriorating market sentiments pushed for a swift resolution. The final package will provide Greece with financing of up to 110 billions euros over the next 3 years, almost 2.5 times more than the initial amount of 45 billion euros. The 15 nations from Eurozone will provide 80 billion euros while IMF will fork out 30 billion euros. The rescue package should be sufficient in meeting Greece’s short term obligations before it has to return to the open market for future refinancing options.
However, there is a heavy price to pay in order for Greece to tap on the package for financing. On top of previously announced austerity measures, this rescue package will require further measures to be undertaken by the Greek government which amount to a 30 billion euro reduction in expenditures over the next three years.
Greece agreed to new measures
On 1 May 2010, Greece Prime Minister George Papandreou announced that they will agree to implement the additional measures demanded by EU and the IMF. Greece was faced with no other alternative as the market was demanding yields that will make refinancing unsustainable and impossible (short term bond yields at more than 15% while long term bond yields at more than 7%). The new measures will cover some of the following:
- VAT to increase from 23% to 25%
- 10% tax hike on fuel, alcohol and tobacco
- Removal of 13th and 14th month bonus for civil servants (bonus to cap at 1000 euros for workers earning less than 3000 euros a month)
- Wage freeze for 3 years until 2012
- Public sector allowance to be cut by a further 8%
- Retirement age to be linked to average life expectancy
- Minimum contribution period for full pension to be increased to 40 years by 2015
Alongside the new measures, the Greek government will attempt to strengthen its tax administration, control government entitlements, reform pension system, improve structural policies and reduce military spending. The rescue package will also include setting up a “Financial Stabilization” fund to support bad debt write offs from Greek banks.
These new measures will amount to about a 30 billion euro reduction over the next three years. However, Greece’s budget deficit is only expected to fall below the 3% convergence criteria based on ECB’s Stability & Growth Pact, earliest by 2014, one year later than initially planned. Meanwhile, total government debt is expected to peak in 2013 before coming down in 2014.
ECB softened rules on refinancing
Meanwhile, ECB softened refinancing rules once again as they announced on 3 May 2010 to suspend the required minimum credit rating threshold for Greek debts used for the purpose of Eurosystems’s credit operations. The ECB will continue to allow financial institutions to use Greek bonds as collateral for loans. This suspension will be maintained until further notice.
The minimum rating for all government debt (used for Eurosystems’s credit operations) was first cut by the ECB in October 2008. As the global economy plunged into recession, the ECB pledged to accept government debts with at least BBB- rating, down from an initial minimum rating requirement of A-. This new policy change will ensure that financial institutions will not be starved of liquidity from the Central bank should Moodys or Fitch follow the footstep of S&P in downgrading Greece’s credit rating to non-investment grade.
Bond prices reverse
Speculative forces saw the formation of an inverted yield curve for Greece. While the negotiations were on going, investors were less forgiving as Greece races against time to raise money to meet May’s redemption. Investors were speculating that the resolution of the rescue package may not be in time for Greece to tap on before May’s redemption, forcing Greece to turn to the open market once again for the 8.5 billion euros it needs.
With fears over a probable debt default, investors demanded astronomical yields to hold Greek debts as shown by the yield curves in Chart 1. The highest was reached on 28 April 2010 with two year bond yield shooting past 15%. While initial plans were projecting EU leaders and IMF to take up to three weeks before they can finalise the terms and conditions, the adverse market conditions prompted EU leaders and IMF to hasten their negotiations.
After the announcement was made over the weekend, bond prices reversed the following day. 2 year bond yield corrected the most, falling by almost 600 bps since 28 April 2010 high to a yield of about 10%.
Implementation still key
The Greece debt saga is not yet complete even though Greece has agreed to the terms and conditions of the rescue package. The agreement to the terms and conditions of the rescue package marks the beginning of a brand new chapter, “the implementation phase”. Although money is now on the table, it will only be disbursed on Greece meeting the stipulated conditions laid out ahead of them. In order for that to happen, the Greek government has to first convince their citizens to accept the terms which by far was termed “savage” by the leaders of work unions. Protests are on-going and this social unrest left unchecked will definitely hamper Greece’s ability to fulfill their end of the bargain.
We remain cautious over Greece’s implementation of the austerity measures and will be watching its development closely moving forward. Short term volatility will likely persist and may affect investment returns temporarily. However, once the uncertainties ease, the focus will soon revert back to the strong global recovery which continues to take place.
As we had mentioned in our previous article, “Will Greece affect my investments in Europe?”, the impact of Greece on European equity funds should be limited and it appears that the global economy plays a more important role in the underlying companies’ earnings. Europe’s valuations remains attractively priced among developed markets and we have a “Very Attractive” 4.0 stars rating on Europe.