Fractious six-month long talks to persuade banks and other holders of Greek debt to accept losses were running into the night on Friday.
Even if there is a deal, the fate of one of the eurozone’s smallest countries could upset the best start to a year for markets in decades.
A Greek deal poses far more questions than it answers, says Nick Gartside, international chief investment officer for fixed income at JPMorgan Asset Management.
“It is not necessarily the act of Greek default that is of concern,” he says. “It is the consequences of it: Is it Greece on its own or other weaker countries? Is there a firewall for Italy and Spain in place?”
Markets are taking all the relief they can, happy to tick off at least one thing from their long list of uncertainties for this year. But Mr Gartside describes markets as being stuck in the usual January “phoney war” and notes that the price of almost all assets – government bonds, shares, corporate bonds – has risen so far this year.
For many investors, three issues remain of deep concern before fears over Greek contagion can be laid to rest.
First of all is Greece itself. Even if a private sector involvement (PSI) deal is reached, many uncertainties remain over its execution. Not all investors are willing to take part in what is being sold as a “voluntary” deal so Greece could impose “collective action clauses”, which would allow it to impose the will of a supermajority on holdouts. That, however, would likely trigger payments on credit default swaps, potentially unleashing contagion to a number of banks.
Even if a deal gets through relatively unscathed, deep questions remain about the sustainability of Greek debt. In what is almost a best-case scenario, Greece’s debt to gross domestic product ratio would fall to 120 per cent from about 180 per cent.
“This is a large step but one which in terms of the debt outstanding for Greece is still a pretty small one,” says Gary Jenkins of Swordfish Research. Like many, he expects Greece will need to undergo further restructurings, not least to touch the bonds held by the European Central Bank and the international bail-out loans that are unaffected by the PSI deal.
The second area of concern extends to how other bailed-out countries, especially Portugal, respond. Portuguese bond yields have reached distressed levels as fears of Lisbon either asking for or being forced to follow a similar path to Greece abound. Three-year bond yields have jumped from about 15-20 per cent in one week, not helped by the recent downgrade of Portugal’s credit rating to junk by Standard & Poor’s.
“Greece could be a catalyst that accelerates concerns about other economies,” says Ben May, European economist at Capital Economics.
For Mr Jenkins, the worry is that it only takes one Portuguese politician to suggest the country would also like a 50 per cent write-off of its debt for investors to fret even more about default. “It is not just about the ability to repay, it is about the willingness to repay. There is the contagion element: that Greece is not just a template for others but an example,” he adds.
The final issue is over the much bigger contagion issue and whether Italy and Spain – the eurozone’s third- and fourth-biggest economies – are properly protected. In recent weeks, Spain has once again decoupled from its southern European neighbour with its borrowing costs falling. Analysts estimate that after a couple of better than expected auctions Madrid has already raised at least a fifth of its total funding for the year.
But Rome is in a different position. The tyranny of its funding schedule – it needs to raise about €350bn this year – means it will be in the markets almost every week.
Help has undoubtedly come from the ECB’s offer to banks of three-year loans. Mr Gartside calls it “really very powerful”. But both he and Mr May still fret that growth in Italy and the rest of the eurozone could disappoint, throwing a lot of the financial projections off course. “There are a lot of worries about how much Italy and Spain could contract: that is another banana skin out there,” says Mr May.
For now, there is a chance that a Greek PSI deal can add to the positive momentum and allow the rally in equities and corporate credit to carry on. “Money is cheap, and every day, confidence is building little by little, prompting buying. The resulting asset performance in turn raises confidence further,” says Hans Lorenzen, analyst at Citi.
For worries about Greece to abate completely, the eurozone needs to come up with perfect answers to all three concerns, and few in the markets are willing to credit them with that kind of omnipotence. Mr Jenkins says: “Exactly how it will play out is unknown but you have to feel that for all the positive spin in the short term, in the midterm it doesn’t solve the Greek issue. I think the bond market will be fairly nervy.”
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