Fisher Investments Editorial Staff

The Benefits of Union

By, 04/28/2010

Story Highlights:

  • S&P downgraded Portuguese and Greek debt Tuesday. Of the two, the Greek downgrade was more substantial (from investment grade to junk).
  • Amid skyrocketing Greek yields, Greece officially activated a promised EMF/EU aid package last Friday.
  • May is Greece's last significant funding hurdle in 2010. Covering May fiscal needs could buy the government time to pacify critics, domestically and abroad.
  • We'll have more answers soon. But until then, markets may fluctuate on all that remains undecided.


Global markets fell Tuesday as S&P downgraded Greek and Portuguese sovereign debt. Though one of the infamous PIIGS, Portugal has mostly escaped recent scrutiny (at least compared to Greece). But in a statement accompanying today's move, S&P remarked the downgrade better reflects the country's ability to meet deficit reduction targets in coming years. Neither the rhetoric nor the downgrade were particularly notable, but reawakened worries Greek troubles could spread to other nations on Europe's periphery.

The Greek downgrade was more substantial—reducing Greek debt to junk status (below investment grade). According to S&P, the downgrade was mostly due to the size and scope of the government's austerity measures and doubts about the country's political will to institute them.


Tuesday's news came on the heels of (and perhaps in direct response to) a number of notable recent developments. Last week, the European statistics agency, Eurostat, raised its estimate of Greece's 2009 deficit from 12.9% to 13.6% of GDP, warning further upward revision may be necessary. Irish deficits were similarly revised higher. Greek strikes protesting austerity measures continued, and Moody's downgraded Greek bonds (though still deeming them investment grade).


Meanwhile, Greek 10-year yields and spreads over German bunds hit record highs (since adopting the euro). Notably, 10-year yields, spiking above 10%, are still below 2-year yields at over 15%—the inversion likely demonstrates investors more acutely fear near-term funding issues. Amid tightening credit conditions, the Greek government successfully floated a few small short-term issues in recent weeks—but neither attempted to sell nor announced plans to auction long-term debt.


It was little surprising then that Greek Prime Minister Papandreou called in a promised EU/IMF aid package last Friday. Greece is the first European country to seek outside fiscal help in the euro's decade-long history.


One might think Greece finally asking for help might calm markets. May is the last significant funding hurdle in 2010. Covering the roughly €8.5 billion in 10-year debt due May 19th could buy Greece time to pacify critics, domestically and abroad. But this process hasn't been pretty so far, and likely won't be as the details are hashed out. Though the EU has offered €30 billion and the IMF €15 billion, much still depends on the results of current negotiations and country-by-country politics.


In the meantime, unconfirmed speculation (and therefore uncertainty) is rife. Will the EU/IMF ask Greece to restructure its current debt load, forcing bondholders to take a loss (a "haircut" in financial jargon)? Will the austerity plan be too harsh, reducing economic growth and therefore worsening deficits down the road? Might €45 billion be too little, particularly if economic output is slowed? What happens if Moody's and Fitch follow S&P's lead and similarly downgrade Greek debt to junk? What about Germany? The German parliament firmly opposes fast-tracking aid without more stringent commitments to debt reduction. (Early-May German regional elections are looming, likely driving hard-line rhetoric.) What about the other PIIGS and the threat of a contagion?


Even as rhetoric questions the viability of the union, the initial terms of EU assistance are a step in the opposite direction. EU decision-making has historically required unanimity. But in this case, German hesitation (or objections by any single country) can't stop other member nations from disbursing aid when they're ready. German politicians agreed to this stipulation—perhaps because they recognized they could little afford to easily support the bailout before the elections, but likewise recognized its urgent necessity.


In any case, the French government is readying a portion of its contribution. Other countries may follow suit in the coming days. We'll have more answers soon. But until then, markets may fluctuate on all that remains undecided.


This is the toughest test of monetary union Europe has yet faced. Precisely the challenge Milton Friedman famously thought might sink the euro. Uncertainty may remain high—a stuttering, patchwork approach will do that. But despite political jawboning, actions so far indicate member countries value the benefits of union over the costs of dissolution.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.


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