BLUF (Bottom Line Up Front)
When Greek politicians and a Hedge Fund which has tendered to buy 10% of all outstanding Greek Debt start to make noises, just as the Fed starts to look as though it is serious about Tapering, we get interested.
Japonica Partners started buying Greek debt in June[i]. It was paying a 25% premium to where the debt was in 2012.
In November Japonica started talking its book; in an open letter demanding that Greece be rated A+[ii]. The rhetoric is quite instructive:
"Call-to-action: It is an irrefutable fact that Greece has accomplished one of history's most extraordinary sovereign fiscal rejuvenations, an A+ performance. Now is the time to progress beyond the current economically irrational and anachronistic accounting that obfuscates that Greece merits an A+ credit rating and government bond interest costs below 5%. Now is the time to recognize that this accounting is the single biggest and most easily removed obstacle to extraordinary growth in Greece. And, now is the time for public policy makers to expeditiously advocate accounting as well as presentation that reflects economic reality, improves decision making,and increases accountability."
If we read it correctly, Japonica is demanding an accounting change to "rejuvenate" Greece's credit rating (and Japonica's P&L). Greece's A+ for effort allegedly translates into an A+ credit rating. It's an elaborate form of accounting casuistry, in an economy which has literally returned back to the Classical Age in order to balance the national accounts. One wonders how a primitive agrarian society will be able to generate the economic activity to pay even 5% on its debt. 5% of no economic activity is still nothing. All that Greece has done is to seize the money injected by the Troika and then move it around the system without allowing it to leak out. Since this money is denominated in Euros, it will leave very swiftly however. Normally investing strategies like this turn the debt into equity in the "rejuvenated" economy. This "rejuvenated" equity is usually in the form of natural resources, such as Oil, which can then be sold for hard currency. Japonica does not appear to be interested in taking a position in Olives or Fetta Cheese however. Japonica has very little faith in the "rejuvenated" Greek economy; nor can it find any hard assets worth owning. Japonica therefore wants to realise "hard currency" in the form of Euros and then get the hell out of Dodge.
Presumably, the Greeks have encouraged Japonica to opine the "call to action". Greece gets a sub 5% interest cost and Japonica makes the trade of the decade.
Let's take a closer look at the Greek position. Currently, Greece has a primary surplus; which is defined as its fiscal revenues being greater than its expenditure, "ex-interest cost". This means that if Greece did not have to pay interest on its debt (quite a big if) that it could finance its projected fiscal expenditures without having to seek another Troika bailout. Ignoring interest payments, Greece has balanced its books. It is clear where this is going. Since Greece does not need another bailout, it is being cute and seeing if it can get away with lowering its interest payments. Japonica is a convenient tool to see how much leverage can be applied in this way.
The dark side of this tale is that since Greece can finance itself without another bailout, it has a pecuniary incentive to default on its interest payments. Most of the debt that is not owned by Japonica is owned by the Greek banks. The banks will implode; but this doesn't matter because they are Greek anyway. At this point Japonica will suddenly cease to be a friend of Greece; and will sue in the hope of triggering a default, which will then force the Troika to bail Greece out rather than risk a domino effect rippling through Portugal, Spain, Italy and Ireland. Said domino effect could then go global and cause America to apply pressure on Europe to go down the bailout rather than bail-in route. The problem for Japonica is that if Greece defaults, only its banks and Japonica go under. The Troika will thus let Greece default and then turn the debt it owns into real Greek "hard assets". If Greece refuses or rebels, it will then face years in the political wilderness. Greece no longer represents the threat it once did on its own. It only becomes a threat if other nations follow.
In our opinion Portugal, Spain , Italy and Ireland are watching the situation carefully; and are hoping that it comes to the brink of default. Currently, they are all following the Greek model. Public expenditure is being cut so that a primary surplus is created. The creation of the primary surplus is the bargaining chip to be used against Northern Europe. Northern Europe is blindly walking in to this trap, by forcing these counties to apply fiscal austerity in order to create the primary surplus. Like Greece, these Peripheral countries have nothing to lose. They have everything to gain, by getting their interest rate costs down and/or getting further fiscal support from Northern Europe. The ECB has been facilitating the process by applying the LTRO to keep Peripheral interest costs down. The LTRO has now however been repaid, so either the ECB must do another one or these countries must do what Greece is doing to get their interest costs down.
It is a totally different story in Northern Europe; and we suggest that they are in no mood to be blackmailed. Germany has in fact hardened its position against a central resolution of the debt crisis and a central banking authority. This has forced the Peripheral countries to rely on blackmail once the ECB stops holding Peripheral interest rates down. Over this weekend the European finance ministers meet to discuss a banking union amongst other things. It should be noted that Jens Weidmann has been getting more militant in his assertions that not all European debt is rated equally; and that capital requirements should be adjusted by the banks to reflect this reality. He has also said that the ECB should not regulate the banks in the long term; and that national regulators should exist under the ECB umbrella. Reading between the lines, we think that he is waiting for a position to attack. Coming out of this weekend we would expect him to turn up the criticism and invective; especially as what he will perceive as charlatans and blackmailers are trying to upgrade Greece.
We have no idea how this will play out; but we have a strong opinion that it will get played out with very volatile consequences in 2014. Factor in the US Taper and the picture looks even more volatile. Our suspicion is that Mario Draghi is resigned to another LTRO; but he cannot do anything until Peripheral interest rates spike upwards. He also has to contend with Angela Merkel; who has now been re-elected and can afford a nasty fight to save German taxpayer funds.
Finally, there is also a strong overweight investor position in Europe, from the likes of Japonica, who are of the view that the ECB -
"will do whatever it takes."
Although not saying actually that he will do whatever it takes to save the Periphery, Draghi intended that he,
"will do whatever it takes to save the Euro."