Greece, The IMF, And What Comes Next

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By Peter Boone and Simon Johnson

The latest developments from Europe – including Greece appealing for an IMF program today – may well be a watershed, but if so, it is not a good one.  The key event yesterday was that the yield on all the debt of weak eurozone governments widened while German yields fell.  The spreads show all you need to know: a very clear and large contagion risk. 

The five year Portuguese yields rose from 3.84% to 4.26%.  The five year Spanish bonds rose from 2.89% to 3.03%, and the five year Irish bonds rose from 3.74% to 3.97%.  These are not minor moves for investment grade sovereign bond funds.  This kind of change means, for example (and roughly), you lose 0.5% on the value of a bond in one day.  These are bonds that just pay 3% per year – and one such day may be enough to cause “investment grade investors” to decide not to stay involved and not to come back for a long while. 

If these bonds transition towards being held by “emerging market investors” (usually quite different people), and stronger European commercial banks decide to limit their exposure to the weaker government’s bonds, we could be in for quite a major increase in yields across the spectrum. 

Emerging market investors look at these weaker eurozone bonds – compared to say Argentina with 10% yields – and think they represent unappealing reward for the risk.  Greek 5 year bonds rose to 9.4% yesterday from 8.1% the previous day.  This is still low for a country on the verge of default.

These higher government bond yields are also hitting banks.  No doubt there is a bank run on in Greece to some extent at the wholesale level.  This will spread to other banks in the region.  Since their marginal funding costs are tied to the creditworthiness of the sovereign, and since the collateral for these banks’ portfolios is tied to local property values and assets, these changes in sovereign yields will have a negative impact on banks’ balance sheets. 

Greece, The IMF, And What Comes Next

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