Eurozone shmurozone. Tired of the constant stream of bad news coming out of Europe? You’re not the only one. Even the investing gurus are starting to yawn at the apocalyptic headlines about debt-riddled Portugal and Greece. If the global economy were going to blow because of the debt problems boiling over in Greece, shouldn’t it have happened by now?
The crisis fatigue has been building for a while. But the effects are finally starting to show. The downgrade of Portugal’s debt by rating agency Moody’s to junk status this week opened the door to yet another European bailout. Moody’s said there was an “increasing probability” that Portugal would be unable to borrow at affordable rates, which would require a bailout on top of the $100 billion it already snagged from the IMF and EU in April. And yet, compared to the market reaction to downgrades and bailouts of the past, this time investors barely flinched. The euro dropped a mere .9% on the day against the dollar, a fraction of the nearly 3.5% drop the euro took in the two days after Portugal agreed to take its first bailout in May. Yields on Portuguese bonds rose on the Moody’s downgrade, but that’s not surprising either. A flurry of analysts have been riffing on Portugal’s troublesome high bond yields for months. Take Rabobank strategist Richard McGuire, who said back in March that: “With yields at these levels this outcome will do nothing to challenge expectations Portugal is heading for a bailout and in somewhat short order.”
Indeed, just about the only people who don’t think Portugal and Greece aren’t headed for default are the ones still caught holding their debt. Credit rating agency Standard and Poor’s already warned European officials it wouldn’t be fooled by their plans to evade a Greek default by simply rolling over the debt. Such plans for Greece, the rater said, would still constitute default. And yet, Germany, whose banks have the most skin in the game, is refusing to admit defeat. In response to the Moody’s downgrade and prediction of default, Merkel responded: “I think it’s important that we in the Troika – the International Monetary Fund, the European Central Bank and the European Commission – don’t allow ourselves to relinquish our freedom to judge…That’s why I trust in the evaluations of these three institutions when it comes to specific procedures” rather than those of rating agencies.
And that’s where everyone gets lost. With all the back and forth about whose word the markets should actually trust, it’s hard to suss out what the latest Portuguese downgrade or a pending Greek default actually means. Credit Suisse’s Andrew Garthwaite sums up his thoughts on that in one word: nothing. Normally, a downgrade of Portuguese debt by four notches to junk would mean a lot, Garthwaite explains in an analyst’s note (care of FT‘s Alphaville), since the ECB does not normally allow European banks to use bonds rated that poorly as collateral. But ECB President Jean-Claude Trichet has thrown that standard out the window by continuing to accept Greek bonds from banks as collateral “as long as it doesn’t default.” S&P also muddied the waters by saying it might turn around and upgrade Greek bonds after a short period of a rollover-type default. S&P:
It is our view that each of the two financing options described in the Federation Bancaire Francaise proposal would likely amount to a default…
But, once either option is implemented, we would assign a new issuer credit rating to Greece after a short time reflecting our forward-looking view of Greece’s sovereign credit risk.
So, even if Portugal’s downgrade does lead to default (which is more than likely, given that Portugal’s hidden private sector leverage raises its debt to a whopping 230% of GDP), that probably won’t be what it’s called. Instead, the ECB will continue accepting underwater Portuguese bonds as collateral and stockpiling eurozone debt until the eurozone’s troubles slowly, and quietly, evaporate. But if that’s the case, it prompts the question: Are there any repercussions for racking up high debts if countries can just engineer sneaky, backdoor escapes from cold, hard defaults? Garthwaite weighs in:
One day the market will wake up and realize that repoing [when the ECB accepts collateral from banks] €300bn of bonds with peripheral Europe (rising to a lot more, owing to deposit flight) lowers the quality of the ECB balance sheet (surely the domestic collateral is inadequate).
My personal view is strongly that the ECB will be forced to repo more and more peripheral European debt as deposit flight accelerates and at some point the ECB is so much on the hook that they have to continue to repo come what may because if they do not the Euro threatens to break up and if the Euro breaks up, there is a 50% default (because peripheral Europe has net foreign debt of 80% of GDP or so) and if the Euro breaks up who would recapitalize the ECB (apart from the ECB by printing!)?
Nobody cares about Portugal now because the realities of its pending default are being craftily swept under the rug. A day of reckoning will come, but thanks to a fine show of smoke and mirrors by Greece and Portugal’s bondholders, that day could now be years, and bailouts, away.