Over the past few weeks, market speculation about the public finances of some countries at the southern periphery of Europe has reached a fever pitch.
Not since the currency crises of the early 1990s has there been this much concern in financial markets about the ability of a European government (Greece) to roll over its existing debt and finance its budget deficit. Although there has so far not been any hard evidence to substantiate these concerns, we note that (il)liquidity is, by its very nature, based on confidence and can therefore be self-fulfilling.
We still believe that financing conditions could change positively if Greece achieves the flawless implementation of the fiscal adjustment that it has promised EU authorities. Under an extreme – and currently hypothetical – scenario, in which access to market funding was closed to a government at any price, we believe that the balance of costs, risks and benefits would lean unequivocally in favour of liquidity support being provided in some form by the EU.
However, we doubt that such support would be unconditional or extended indefinitely, and instead believe that support would be conditional on fiscal adjustment taking place without slippage.
In the event that Greece’s implementation of the promised fiscal adjustment fails to meet the conditions for its partners to provide a backstop liquidity protection – i.e. if public finances remain on an unsustainable path – then we might consider revising our assessment of Greece’s liquidity risk, which could lead to a risk of a multi-notch downward rating migration. But this is not an immediate concern.
We see liquidity risk to be negligible in the case of Portugal and even more so in the case of Spain, both of whose situations are in our view not directly comparable to that of Greece.
Overstated Liquidity Risk
It is worth remembering that there is, as yet, no hard evidence that any euro area government faces an imminent risk of losing market access.
The five-year bond issued by Greece in late January was substantially oversubscribed, and the country’s debt agency ended up issuing €8 billion instead of the planned €3-€5 billion, albeit at the cost of a large widening of yield spreads relative to other European sovereign issuers.
Therefore, speculation that Greece, or any other government, might not be able to roll over existing debt falling due in the spring has so far been based on perception rather than fact.
Even so, in the event that a critical mass of investors starts believing that a government's liquidity is impaired, this could become a self-fulfilling prophecy. Moreover, if enough investors believed that a government's debt is on an unsustainable path, it is unlikely that they would be willing to purchase bonds except at a very high price (which could by itself put the debt on an unsustainable path). In such a situation, a credible alternative source of liquidity would allow a country to fend off financing and ultimately potential payment difficulties, until it regains the trust of commercial markets.
Against this background, much attention has been focused on the possibility that emergency liquidity assistance could be extended by the EU or some of its more robust members to one or more of its weaker members if they encountered temporary liquidity or pricing hurdles.
On balance, we believe there is a very high likelihood that such support would materialize if required, although it would be neither unconditional nor permanent. Statements by EU officials have reflected ambiguous attitudes towards the notion of support towards a member state: acknowledging European solidarity on one hand, whole pointing to the dangers of moral hazard for the stability of the Union on the other.