In The Days

• Source: WSJ
• News Date: 4/9/10
• Author: CHARLES FORELLE and MARCUS WALKER

Markets Fall on New Bank Fears, Ratcheting Up Pressure on EU; ‘End of the Line’

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Perplexity

“…upon the earth distress•Strongs 4928: sunoche, soon-okh-ay´; from 4912; restraint, i.e. (figuratively) anxiety: — anguish, distress. of nations, with perplexity•Strongs 640: aporia, ap-or-ee´-a; from the same as 639; a (state of) quandary:—perplexity.
•Strongs 639: aporeo, ap-or-eh´-o; from a compound of 1 (as a negative particle) and the base of 4198; to have no way out, i.e. be at a loss (mentally):— (stand in) doubt, be perplexed….”
—Luke 21:25

Concern over a potential liquidity shortage at Greece’s private-sector banks fueled a sharp selloff in Greek debt and equity markets Thursday, suggesting that the European Union’s efforts to defuse the crisis with a vague promise for an International Monetary Fund-backed rescue have all but failed.

Markets signaled fresh worries that Greek banks are having trouble meeting immediate funding needs, after the country’s top four banks on Wednesday asked Athens for access to an emergency government liquidity facility. Greece’s banks have been widely viewed as one of the few bright spots in the country’s financial infrastructure.

“This is clearly a sign that the Greek authorities have reached the end of the line and need to make a phone call to the IMF,” BNP Paribas analysts wrote in a note Thursday morning.

Greek bonds fell for the seventh straight session on Thursday and the Greece’s benchmark stock index tumbled. The yield on Greece’s 10-year bond, a reflection of both the country’s borrowing costs and the risk investors associate with its debt, hit its highest level since the introduction of the euro.

More alarmingly, in a sign Greece may have difficulty finding money in the nearer term, investors drove the interest rate of the Greek two-year bond to 7.45% Thursday, 6.64 percentage points more than what Germany pays. That gap was 5.68 percentage points just a day earlier.

The euro slumped early in the day, though it rose after Jean-Claude Trichet, the European Central Bank president, said Greece wouldn’t default. Any signal from the EU that it was preparing a rescue would likely stabilize the markets further, at least in the immediate term.

The latest turmoil comes despite the EU’s much-touted promise late last month to team with the IMF to intervene to save Greece from default if “market financing is insufficient.”

Germany and France, the euro zone’s dominant members, believed that the assurance would be enough to persuade jittery markets that the EU wouldn’t allow Greece to default.

Yet many investors expressed disappointment that the EU didn’t offer a more detail on terms of the potential loans. Greece’s equity and bond markets have been in a steady decline ever since.

In a sign of crisis’s vicious-cycle nature, Thursday’s bank worries helped sink the price of Greek government debt, which means the interest rate Greece must pay to attract borrowers was knocked higher. The yield on Greece’s 10-year bond hit 7.38%. Bank stocks slumped 6% in Athens, dragging down the broader market 3%.

“EU leaders can try to convince markets that just having a mechanism in place will be enough,” says Fabian Zuleeg, chief economist of the European Policy Centre, a think tank in Brussels. “I’m finding it increasingly unlikely that the markets will believe it.”

The stress on Greece’s banks could force Germany and fellow euro-zone countries to finally step in with a rescue, analysts say. Germany, which would have to pay the lion’s share of a bailout, has until now argued that as long as Greece’s banking system remained stable and Athens was able to raise funds in the capital markets, Greece’s problems weren’t serious enough to merit a rescue. Yet the potential failure of one or more Greek banks, which the government might be powerless to prevent due to its own troubled fiscal state, would likely pose a more fundamental threat to Greece’s economy.

“The problem is metastasizing from a purely fiscal issue,” said Stephen Jen of the London hedge fund BlueGold Capital Management.

That reality may lead the EU to either offer Athens a bailout or force Greece to restructure its debt. The latter step would mean debt investors would have to accept painful losses on their investments, an outcome many in Europe have hoped to avoid for fear that it would undermine confidence in the euro.

Jon Levy, an analyst at New York-based consultancy Eurasia Group, says banking-sector concerns “could prompt the Greek government to seek an IMF arrangement more rapidly” than it intended to.

Greece’s four biggest banks asked the government for permission on Wednesday to tap €17 billion ($23 billion) in unused liquidity measures from Greece’s banking-sector support scheme, mostly consisting of state guarantees for banks’ bonds.

The Greek state guarantees would allow banks to use up to €14 billion of their own bonds as collateral with the ECB. The government could issue bonds to cover the remaining €3 billion. The banks haven’t carried out such a transaction so far, but rather have prepared the option as a “safety net,” according to Greek banking officials.

Extra ECB funds could help Greek banks to compensate for their steady loss of access to international repo markets, in which banks raise short-term funds from other banks. The repo market has “almost gummed up” for Greek lenders, one Athens banking official said.

ECB president Mr. Trichet offered a mix of verbal and concrete support Thursday for Greece and its banks. A Greek default “is not an issue,” he said at his monthly news conference. He also confirmed the ECB would maintain its relaxed collateral rules into next year, removing a source of uncertainty for Greek Greek banks that rely heavily on Greek government bonds as backing for cheap ECB loans.

Doubts over when the EU could come in to help, and at what terms, have hammered Greek bonds for days. April is a crucial month, with a sequence of Greek treasury bills maturing beginning next week, and then an €8 billion bond coming due the week after. Greek officials insist they have enough cash to pay those bills.

May is another matter. The biggest redemption that month comes on May 19, for €8.5 billion. Greece is all but certain to have to borrow or seek aid before then.

In pledging their support last month, EU leaders hoped to reassure investors that something would be done to prevent them from losing money in a Greek default. That, in turn, would bring down the amount of interest Greece has to pay to attract investors.

Dispensing aid to Greece would require approval of all euro-zone leaders, which means German Chancellor Angela Merkel, reluctant to bail out a free-spending peer, has an effective veto. EU officials remain wide apart on what should trigger a bailout.

Despite the danger signs in the financial markets, many investors find it hard to believe that the EU will let Greece fail.

“Greece is part of the EU, and the Europeans have a huge imperative to sort this out,” said Jon Taylor at Principal Global Investors in London. “It took 30-some years to get where they are now, and they’re not going to let a country that represents 2.5% of the EU’s economic output derail the project.”

Mr. Taylor said he was buying short-term Greek debt on Wednesday when prices plunged.

Even if Greece gets a loan package from the IMF and euro-zone governments, its debt crisis doesn’t end there. A potential package of €20 billion to €30 billion would get Greece through only the next few months. Its overall debt pile, at 113% of GDP and rising, would remain difficult to tame—especially since Greece’s austerity measures are pushing its economy deeper into recession, which makes balancing the budget harder still.

“An aid package would only give Greece a bit of breathing space,” says David Mackie, economist at J.P. Morgan. Greece’s debt problem will be solved only if the country either implements austerity measures for long enough to cut its overall debts, or else sits down with its creditors and agrees on a debt restructuring plan.

Such a restructuring would involve bondholders agreeing to cut the amount Greece owes them, as a way of avoiding a unilateral debt default that could inflict still-greater losses on bondholders. A restructuring “wouldn’t be a panacea,” says Mr. Mackie: Greece would still need to borrow fresh funds every year to cover its deficits and could soon find itself in a similar crisis.

“A debt restructuring would be a disaster,” says Yannis Stournaras, director of the Foundation for Economic and Industrial Research, an Athens think tank. Borrowing costs for Greece’s government and companies would be significantly higher for years to come after such a step, as investors demanded an even-higher risk premium for lending to Greece.

“A restructuring would bring a short-term benefit but a heavy long-term cost,” Mr. Stournaras says.

—Michael Wilson, Nina Koeppen, Brian Blackstone, Alkman Granitsas and Adam Cohen contributed to this article.