Tuesday, November 17, 2009

Greek fire

Greek fire: An incendiary weapon used by the Byzantine Empire. The key to its effectiveness was its ability to continue burning under any circumstances, even on the surface of water, making it a "wet, dark, sticky fire,".

Yesterday, the Bank of Greece published the following announcement: "The Bank of Greece has recommended to a number of Greek banks that they show restraint with regard to their participation in the twelve month Eurosystem liquidity providing operation in December, in order to facilitate their exit from the extraordinary and temporary measures of the Eurosystem when these measures are withdrawn." Besides confirming my cautious view with respect to the Eurozone periphery, it serves as a timely reminder that you can not extinguish every fire (in this case an undercapitalised banking system in a structurally challenged economy) purely with the help of water (or as the Greek banks have tried with the help of ECB-provided liquidity). Given the extent to which banks are relying on the central bank liquidity provision measures and because the inevitable adjustments in the economy and in the banking sector via recapitalisation as well as via changes to the business models have not taken place yet, it is no wonder that central banks worry about the feasibility of their exit strategies.

The announcement caused a stir in the Greek equity and bond markets where the ASE lost 3% yesterday (vs. a gain of 1.5% for the ESTOXX) and where 10y Greek government bonds underperformed a bit more than 20bp since last Thursday vs. German Bunds. Yields on 10y Greek bonds have now moved back again above the level offered by 10y Irish government bonds. Furthermore, the uptick in Greek-Bund spreads has also been mirrored by a small uptick in spreads over Bunds for Eurozone issuers (see chart below).
Greek bonds reclaim the top spot for Eurozone government bond spreads over Bunds
Source: Bloomberg, Research Ahead

I have frequently written about the challenges facing the Eurozone peripherals and my view of a multi-year underperformance in economic terms vs. countries such as Germany and France (see for example No easy way out for Eurozone peripherals dated Oct 30) where I also reiterated my underweight stance for Greece, Ireland, Portugal and Spain vs. an overweight in Italy, Austria and Belgium to generate yield pick-up and a neutral allocation for Germany and France.
The announcement by the Bank of Greece confirms my fundamental assessment as well as my market view. The strucutral challenges facing the Eurozone peripherals will dent their economic performance for years to come.
However, it also highlights a deeper problematic with respect to the rising dependency on easy money and the resulting threats posed by the potential ECB exit. The liquidity provided by the ECB has helped banks to survive the freezing up in the credit markets following the Lehman bust. However, it has also delayed a necessary recapitalisation and inevitable adjustments to their business models. This is not purely a Greek problem but applies in general to a lot of Eurozone banks. Clearly, the ECB wants to prepare the grounds for a tightening in liquidity conditions. However, a too early/too quick removal of the added liquidity will put especially the weaker institutions into the danger of a renewed liquidity shortage. It can be assumed that especially those institutions with a weak balance sheet rely most on the ECB's liquidity provision. However, it will be exactly those institutions that will face the most challenging environment if they have to rely again on a market that differentiates/discriminates between counterparties and other banks/investors will either not be willing to lend or only at rather punitive rates.
In turn, one should not expect that the ECB will be able to exit their unconventional measures at a fast pace. This can only take place in a gradual process. On the downside though, if they cant take away the liquidity as quickly as inflation pressures would demand, they will also revert to rate hikes again before they have progressed significantly on the liquidity absorbing front. Still, given my view on the outlook for growth and inflation, I do not expect that this will take place anytime soon.

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