Germans try to rescue the negotiations with Greek private sector bondholders

China’s forex reserves declined for the 1st time in more than 10 years. Forex reserves as at 31st December fell to US$3.18tr, from US$3.2tr on 30th September. Further declines are likely. The PBoC warned of the likelihood of large capital withdrawals this year. Previous speculative inflows are likely to become outflows, which will slow down (and indeed could well reverse) the Yuan’s appreciation against the US$. SAFE (State Administration of Foreign Exchange) also states that forex inflows will drop sharply this year. There is speculation that the Chinese authorities may widen the Yuan’s trading band – currently 0.5% above or below a daily reference rate (against the US$) set by the PBoC;

London is to become an offshore trading centre for the Yuan, as talks between the UK and Hong Kong (which currently is the largest offshore Yuan trading centre) continue, in particular, to implement clearing and settlement systems, market liquidity and the development of new Yuan products. The Yuan was used to settle just 0.7% of Chinese trade in the 1st half of 2010 – this increased to 9.0% in the 1st half of 2011.. The move will help to increase the Yuan become a large global currency (Source FT), with talk of full convertibility by 2014/15. Personally, I believe talk of Yuan convertibility is way too premature;

Bloomberg reports that Chinese 4th Q 2011 GDP may slow to the lowest level in 10 Q’s. No great surprise if that’s the case. The 1st half of 2012 is going to be tough for China – a lot depends on the US and Europe;

Saudi Arabia stated that it wished to stabilise Oil prices around US$100, adding that it had sufficient capacity (3mn bpd ie up to 12.5mn bpd, from the current 9.5mn bpd) to meet any loss of Iranian exports, following the introduction of additional sanctions

The recent ECB 3 year LTRO facility has expanded the ECB’s balance sheet to E2.73tr, or nearly 30% of the Euro Zone’s GDP – and that’s before the next 3 year LTRO on 29th Feb (take up is expected to be significant – quite likely even higher than the E489bn last time around in my humble opinion, particularly as collateral rules have been relaxed and the haircut on Sovereign bonds is much lower than should be the case), which will increase the ECB’s balance sheet size to well above E3tr – will far exceed the FED’s;

Last month, S&P reported that the French downgrade could reduce the current E440bn lending capacity of the EFSF by roughly 1/3rd to just E293bn. The EFSF’s existing commitments to Greece, Ireland and Portugal amount to approximately E250bn, which leaves just E43bn for other Euro Zone countries, bank recaps, etc, etc….. Oops.

S&P is to deliver its verdict on the EFSF shortly. I can’t see the Euro Zone countries increasing their guarantees to the fund, especially following Fridays credit downgrade of France and Austria. As a result, it is likely that the Euro Zone will be forced to accept a lower credit rating (probably the same as France’s ie AA+), as to maintain the current AAA rating would reduce the EFSF’s lending capacity by E169bn, according to RBS. However, the bottom line remains the same – the EFSF/ESM does not have sufficient resources. In theory, if the other credit agencies retain their AAA rating, the EFSF/ESM could remain AAA rated, I suppose (need to check), but I cant believe that the other ratings agencies (Moody’s, in particular) wont reconsider their ratings in due course, if not at this stage, particularly as they are to review France’s this Q (see below) . The EFSF is scheduled to sell up to E1.5bn of 6 month bills this week, by the way – should be OK, given the LTRO.

Following last Friday’s breakdown of negotiations between private sector bondholders and the Greek authorities (together with other parties, including the IMF), Greece could well be the 1st European country to default in 60 years, though I believe that current negotiations with bondholders will result in an deal being reached. The problem appears to be the interest rate on the new 30 year bond to be issued to the bondholders – the IMF is seeking a lower (2.0%) coupon, though the bondholders want 4.0%+, with an opportunity of a higher rate if Greece’s economy improves in due course.

Greek officials report that talks are expected to resume on Wednesday, with a deal expected to be completed weeks ahead of the maturity of a E14.5bn Greek Sovereign bond on 20th March. However, believing the Greeks has proved to be a particularly dangerous and, indeed, extremely costly pastime. Further Euro Zone/IMF support (the 2nd EU/IMF E130bn bail out package) for Greece is conditional on a deal being agreed with the private sector bondholders on PSI – the intent is to reduce the E205bn of outstanding debt held by private investors by some 50% or E100bn – somewhat more (60%+) on an NPV basis – STILL NOT ENOUGH.

The ECB refuses (officially) to contemplate a haircut on its holdings of Greek bonds – well they can take that position, but is it credible? I think not. Apparently, there were discussions (no decision was reached though) at last Thursday ECB meeting about the possibility of the ECB agreeing to a haircut on its holdings of Greek bonds (estimated to be between E40bn – E50bn) purchased under it’s SMP programme. Furthermore, there are (unconfirmed) reports that the Euro Zone national central banks will accept a haircut of between 25% – 30% on Greek bonds bought before the SMP, though they will be compensated by their governments if they face losses. However, haircuts on bond holdings do not mean that the size of the losses to Euro Zone national Central banks/ECB will be equivalent to the % haircut, as Greek bonds would have been purchased at below par. (Source Credit Suisse). Optically, a better option than Euro Zone Governments having to provide additional funds for Greece (politically impossible in any case), particularly if the haircuts do not result in actual losses. However, it will set a precedent which Portugal (at the very least) will follow.

The bottom line is that a Greek default becomes more and more likely as every day goes by. The current EU/IMF E130bn bail out package is insufficient and I cant see Euro Zone countries wishing to increase their commitments, as suggested by the IMF. Indeed, the IMF are becoming increasingly sceptical as to whether the 2nd bail out package of E130bn (agreed in late October 2011) will be sufficient – which, off course, it is not.

Apparently, the IMF has warned Euro Zone politicians that Greece’s fiscal and economic position is worse than was expected – what a surprise – I think not. They propose either a larger haircut on private sector bondholders, or the Euro Zone Central banks/ECB accepting haircuts on their holdings of bonds (see above) and/or additional aid from Euro Zone countries – their (Christine Lagarde) suggestion is that Greece needs several 10’s of billions of Euro’s of additional funds, on top of the E130bn bail out package proposed !!!! Some hope of Euro Zone countries providing more funds. Increasingly, senior politicians within Euro Zone cry out “enough is enough” and talk openly about a Greek default. It is inevitable, in my humble view – the only issue is when and certainly not if, even if the current negotiations with private sector bondholders are “successful” – which, at the end of the day, remains the most likely scenario.

A Greek newspaper reports that, following a review by Blackrock, Greek banks need a further E15bn to adequately provide for non performing loans !!!!. The Greek Finance Minister stated that Greek banks would need E40bn to enable them to be recapitalised. Well, may I suggest that the Greeks sell some of their gold reserves and use the funds to recapitalise their own banks.

Greece’s debt, even based on the assumption that a deal is completed with private sector bondholders, will remain unsustainable (the current optimistic projections, which the IMF is backing off, predict Greek debt to GDP will remain around 120% in 2020) and, as we all know, the Greeks will NEVER meet their commitments. Far better for the Euro Zone to allow Greece to default, move on and, in particular, adopt measures to avoid contagion spreading to other Euro Zone countries. However, senior German politicians are flying to Athens to rescue the negotiations, in an attempt to kick the can down the road, yet again. The real concern (for the EU/Germany/France, etc) is that the Euro Zone has no credible measures in place to stem contagion (following a Greek default) from spreading to other countries – Portugal being the next obvious target – its 10 year bond yield rose by over 100 bps today, following its downgrade to junk by S&P last Friday – a 40%+ haircut is inevitable. The resources available to the EFSF/ESM are totally inadequate for its intended task – and that was before the impact of last Friday’s downgrade by S&P. That’s when the ECB will have to step in, in my humble view;

The ECB is reported to be buying Italian and Spanish bonds today;

As you know, I believe that the ECB will introduce QE. However, there is an interesting (alternative?) option for the ECB. The ECB’s recent 3 year LTRO has reduced short term Euro Zone Sovereign debt yields significantly and in a very short period of time – indeed by more than most, including myself, would have expected. Having seen the result, the ECB could introduce a longer term (say 5 year, possibly even longer) LTRO, which should reduce medium term (possibly even longer term) Euro Zone Sovereign debt yields. Essentially, the ECB could, as a result, claim (as they are at present) that they are just assisting Euro Zone banks (which is their responsibility) and not acting as lender of last resort to Euro Zone Sovereigns and/or introducing QE – which clearly they are with the introduction of the recent 3 year LTRO and would be even further if they were to introduce a longer term LTRO – its just that the ECB would get the banks to act on their behalf.

However, I believe that the major banks will find it difficult to admit to an increase in their holdings of Euro Zone Sovereign debt – the smaller ones and especially those in trouble will have no qualms playing the carry trade, irrespective of the associated risks. Analysts are likely to view an increase in Euro Zone Sovereign debt exposure (particularly of certain countries) by banks as negative (with adverse consequences for their share price), in spite of the obvious carry trade benefits, once again, ex the associated risks. In addition, I don’t believe that regulators will accept Sovereign debt as zero weighted for the purposes of calculating RWA (risk weighted assets), which will negatively impact capital ratios, if banks buy Sovereign debt.

The Euro Zone/ECB have proved to be less than transparent and, as a result, the above must remain a credible option. It is tantamount to further QE, though the ECB will say otherwise. In any event, if introduced, it just will reconfirm my bullish views on European financials (especially UK financials), particularly those that do not need to raise capital – don’t forget the life insurance companies as well;

Spain’s autonomous regions have continued spending – the main reason for the 2011 budget deficit increasing to a forecast 8.0% – indeed, it will be higher. However, the new Spanish administration wants to force the regions to submit spending plans to Central authorities in advance – clearly being resisted by the regions. In addition, the Central administration proposes to introduce legislation which will include a spending limit for each region, which each region can decide how to spend. Sanctions for those who breach their deficit targets is proposed. Not going to be easy. I repeat, Spain is in serious trouble;

Moody’s announced today that it will review its “stable outlook” on France’s AAA rating in the 1st Q – not great for Mr Sarkozy’s chances of reelection as President. They add that a deterioration in France’s debt metrics, combined with the potential for an increase in contingent liabilities, are adding pressure to their existing outlook. Furthermore, France has less room to manoeuvre on public finances than it had in 2008. Ominously, Moody’s states that France’s AAA rating could come under pressure if debt to GDP rises and/or if the Euro Zone crisis worsens – both of which are inevitable, in my humble view;

The main Asian markets (ex India which was modestly higher on the day as wholesale inflation came in at +7.3% YoY, from +9.1% in November – a 2 year low) closed over 1.0% lower today. However, European markets are flat to slightly higher (and improving), having opened lower in response to S&P downgrade after market hours last Friday. The S&P news was widely leaked/anticipated and, indeed, turned out to be not as bad as feared.

The Euro is slightly lower (US$1.2667) than Friday’s close – a lower Euro will be of significant help to the Euro Zone.

All in all, not too bad at all.

Brent is trading around US$110 – without fears of, inter alia, military intervention re Iran, it would be much lower.

The main US markets are closed today.

Wow, European markets are now higher, with even the Euro picking up slightly (US$1.2681) – I feel a further Euro short coming on.

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