Markets not convinced by Greece

Publication date: 20 June 2012
Author: Nordine Naam, Natixis

The rebound of risky assets was over in a flash after the announcement of the victory of New Democracy (29.7% of the votes) in the Greek polls, paving the way for the formation of a pro-austerity coalition government with Pasok (which came in third with 12.3% of the votes). New Democracy now has two days to reach an agreement with other parties and form a coalition. If it fails, it will be Syriza’s turn to attempt to form a coalition government, and so on and so forth.

As matters stand, Syriza has made it clear it will not sign on to a pro-austerity coalition, while Pasok would like Syriza onboard, supposedly to form a government of national unity (but the impression is that there is a lot of domestic political posturing involved too). The widely-held view is that Pasok will relent, and join a coalition government led by new Democracy.

The next challenge will be to form a sufficiently stable coalition. This will depend on what comes out of eventual negotiations with the Troika to mollify public opinion, notably securing an additional delay for cutting public deficits, obtaining lower rates on the bailout money, etc. It is clear, however, that Germany is reluctant to agree to any changes to the programme of economic and fiscal adjustment put in place as part of the second bailout plan. While Germany’s Foreign Affairs Minister hinted a few days ago that Greece could be given more time, Angela Merkel dashed the market’s hopes on Monday by announcing there was little leeway and that a third bailout was not on the agenda.

In the unlikely event that New Democracy and Pasok cannot agree on the formation of a coalition government, then there will be fresh elections, which would be bound to intensify speculation of a disorderly Eurozone exit by Greece. Be that as it may, lingering uncertainties can but lead to more capital leaving Greece. Over the medium to long term, the market remains pessimistic in that Greece will probably fail to restore its solvency, hence comply with its commitments, given the recession and difficulties implementing austerity measures.

In fact, by Monday morning the markets had shifted their attention to Spain. The announcement of another increase in non-performing loans to 8.72% in April came as a timely reminder that the economic situation in Spain remains problematic. The Spanish bank bailout has not convinced, while the market is waiting for the findings of the audits of the banks’ requirements (due out on Thursday) and for details of the bailout (notably the treatment of private creditors, depending on whether the funds are advanced by the EFSF or ESM). With the Spanish budget deficit spiralling out of control, this is heightening speculation Spain will need a full-blown bailout.

In this respect, the International Monetary Fund, which is supervising the bank bailout, has said it will impose economic adjustment measures (which initially should be confined to the banking sector). Under these conditions, Spanish long rates recovered back above 7% to a new record high that is unsustainable over the long term.

In the next few days, the focus will be on progress in Greece towards the formation of a coalition government (which could enable risky asset to rebound slightly) and, especially, on the findings of the Spanish bank audits. As regards indicators, the European PMI will be of some importance in that it should support the scenario of a recession in Europe, notably with difficulties in peripheral countries as well as in Germany. In this environment, it is likely the EUR/USD will be capped at 1.27.