The crisis in Greece has crystallised concerns about growing public deficits in a number of European countries raising fears of a domino effect throughout the financial system. The economic turmoil reached a new high following rating agency S&P’s downgrade of Greek debt to the level of junk, even as the European Union (EU) and the International Monetary Fund (IMF) agreed on a joint €110bn aid package for the next three years with €45bn allocated this year. Greece's refinancing of a 10-year bond set to mature May 19 is now secured. “We don't expect Greece to default on its debt. Theoretically, Europe's solidarity should be enough to prevent a restructuring of Greece's debt,” notes Rene Defossez, economist at Natixis. “Moreover, there is a strong commitment from the European Central Bank (ECB) to prevent a major sovereign accident.”

On May 2, the European Union and the IMF announced more details about the financial support mechanism extended to Greece. First, the 16 EU members will lend a total of €80bn in the next three years with contributions from each country depending on their equity stake in the ECB. The IMF will contribute a further €30bn. Greece agreed to sharp budget cuts to secure the loan. It will have to reduce its fiscal deficit from 14 % in 2009 to 3 % in 2014. JP Morgan Chase points out that there is no seniority between the IMF and euro financing. “The IMF always intends to get its money back,” notes David Mackie, economist at JP Morgan Chase. “The seniority of the euro area lending is unclear, and it is not apparent what would happen to these loans if Greece fails to reduce its deficit as planned.” As the clock ticks, the EU will have to coordinate the legal process needed in each country to authorise the disbursement of bilateral loans. “Our impression is that that there will not be any major hurdles in the legislatures, although, Germany looks likely to face a challenge in the Constitutional Court,” notes Mackie.

The challenge of Greece achieving debt sustainability has spread to other sovereigns in the region. Spain has joined Greece and Portugal in seeing its credit rating downgraded by S&P, reinforcing fears of budgetary difficulties in southern Europe with a knock-on effect on the value of the euro. It sank to its lowest level against the dollar in a year, trading at 1.31 on May 4. The 10 economists who are part of our monthly interest rate and foreign exchange panel have lowered their euro/dollar projections for July. The average three months out now stands at 1.33 compared to 1.37 a month earlier. At the low end is ING at 1.29.

Before the rescue plan, talk of a Greek support mechanism failed to calm market sentiment in the way policymakers had hoped. The yield on the benchmark Greek 10-year government bond reached 11.2%, about three times that of the benchmark German bond and just below those issued by Pakistan. “Spreads will remain elevated in the short-term, at least until the first part of the EU/IMF financial rescue package is made available”, notes Guillaume Menuet, senior Europe economist at BofA Merrill Lynch. “Depending on the conditionality attached to the 2011-12 segment of the financing and the amounts involved, we think that Greek solvency issues will fade progressively. Under such a baseline scenario, we would envisage the 10-year Greece/Germany spread to compress towards the 300bp level around year-end.”

Contagion

The costs of insuring Greek, Spanish, Portuguese and Italian debt against a default were also at record levels, a sign that Greece’s fiscal woes are escalating into a Europe-wide crisis of confidence. Italy, which has one of the world’s highest debt-to-GDP ratios, saw its credit default spreads widen 10bps to 160bps at the end of April. Credit default swaps on Portuguese debt widened by as much as 395bps. This re-assessment of sovereign risk suggests that the ECB will almost certainly leave the refinance rate at 1% at its next policy meeting May 6. Indeed, neither the refi rate nor the federal funds rate is expected to change this year. Our panellists forecast more of the same in the US, where the federal funds rate is 25bps. Based on their forecasts, 10-year UK government bonds will yield 4.30% at the end of October, while comparable US bonds will yield 3.99% and similar Eurobonds 3.34%. How does this compare to their projections from a month ago? Generally, 10-year bond rates are lower in Europe and higher in the US and UK, which reflects slower growth prospects in Europe outside of the UK.Greece remains the weakest link among the EU countries cited above, though Portugal and Spain must also undergo painful adjustment in their government finances if their public debt position is to become sustainable again. “Given the intense pressure from financial markets, it is likely that in some cases that a tough fiscal adjustment program (or rather the promise that one will be forthcoming) might not be enough to a void a ‘sudden stop’ of necessary external funding of the public sector,” notes Thomas Mayer, head of Deutsche Bank Research.

Consensus tables May 2010

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