21 March 2012

Jacob Funk Kirkegaard: Greece’s new bonds - is another default coming?

The new concern is Greece’s new long-term bonds that were thrust upon the country’s hapless private creditors in last week’s coercive bond swap. They have begun trading at north of 20 per cent yields. In what is probably an illiquid market, these yields suggest that markets expect a second Greek default against private creditors.

The question, however, is whether this is a foregone conclusion, even if Greece requires additional eurozone funding.

• If Greece ‘defaults’ again, requiring more eurozone taxpayer money, why would the eurozone force another default on private creditors? Coupon payments are merely 2 per cent on the new bonds until 2015, so the cash savings of defaulting on these bonds during the next three years would be relatively small.
• Such a default would also undoubtedly result in further losses in the eurozone banking system, where most participating banks probably book these new bonds at their par value. They would not likely be in the general interest of eurozone governments.
• A second Greek default against private creditors would also further undermine any notion of risk-free status for sovereign eurozone bonds, reigniting potential contagion to other markets. Renewed contagion would make a mockery of attempts to restore the market credibility of eurozone sovereign bond markets.

The only scenario in which another default against remaining private Greek creditors and their newly swapped bonds will be sanctioned by the eurozone is one in which Greece exits the euro. Note that Greece, which is living with a eurozone-sponsored escrow account, no longer has the fiscal sovereignty to declare such a default independently.

A future populist Greek leadership might seek an exit to safeguard national sovereignty, despite what would be an accompanying economic disaster. The prospect of an exit is also not nearly as high as current Greek bond yields suggest, however. Greece’s new bonds will not likely exist until the last ones are redeemed in 2042. More likely they will be converted into eurobonds, perhaps in 20 years, rather than be defaulted against again.

Breaking the risk-free taboo of sovereign bonds has stirred fears of irreparable damage to the eurozone debt markets and caused their cost of capital to rise. But eurozone leaders say they are determined to restore pre–private sector involvement status quo of euro sovereign debt.

Ironically, eurozone leaders’ insistence on private sector involvement for Greece might have created a self-fulfilling prophecy with respect to the loss of risk-free status of their sovereign debt. Markets prefer not to have to think hard about such complex issues. They prefer the analytical shortcuts conferred by market conventions about ‘risk-free status’ or rating agencies that have too easily granted AAA-ratings because the markets then avoid the trouble of making their own proper risk assessment. The status of sovereign debt for years as risk-free gave the markets a misleadingly convenient benchmark by which to price all sorts of other financial assets.

Eliminating the sacrosanct risk-free status of their debt has exposed eurozone leaders to the markets’ myopia and simplistic understanding of eurozone politics. Current eurozone economic research from various investment banks is full of long-term political judgements like this: “[P]rivate sector involvement cannot be ruled out at a later stage. As time goes by, reform fatigue may become a problem and support for more radical political parties may emerge” (see Kennedy 2012).

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