Q110. Perspectives. Western Asset Management Greece Sovereign Debt Analysis

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1 Perspectives Western Asset Management Greece Sovereign Debt Analysis FOR PROFESSIONAL USE ONLY. Q110 Batterymarch Brandywine Global ClearBridge Advisors Congruix Esemplia Global Currents Legg Mason Capital Management Legg Mason Hong Kong Permal Private Capital Management Royce & Associates Western Asset Management

2 Executive Summary Greek spreads at 3.75% over Germany offer value. They are back to where they were before Greece joined the eurozone and trade close to levels of similar European countries that are outside EMU. Current valuations meaningfully overstate the probability of Greece leaving the EU and/or defaulting. Greece is in a privileged position with base rates at 1% and not having to face a currency or banking crisis. Greece is not facing an imminent funding crisis. While the ECB cannot actively buy Greek bonds, it can help finance their purchase by accepting them as collateral for repo operations currently until the end of As highlighted by last week s five-year auction, Greece is still able to access the capital markets. While improbable, if Greece were to decide to leave the EU it could only happen after a lengthy negotiation process with the European Commission. There is no clause in European law that deals with the expulsion of countries from the EU or from European Monetary Union. The European authorities have a strong incentive to punish Greece and send a clear message that countries which abuse the system will suffer. The solution to this problem is not a Greek default or exit from the EU but rather a reworking of the Maastricht Treaty to avoid a recurrence of this situation. The Current Situation In late January 2010, Greece successfully brought an 8 billion five-year deal which was initially well received. The book size was increased and pricing tightened from initial estimates. Over the days immediately following the new issue, the spread versus German government bonds widened to about 425 basis points (bps). This left investors concerned about Greece s ability to pay a much elevated level of interest on debt. Greece is currently rated BBB+ by S&P (negative watch), A2 by Moody s (negative watch) and BBB+ by Fitch. After the October 2009 parliamentary elections, the Greek government revised its fiscal deficit estimate for 2009 from 3.7% of GDP to 12.5% of GDP. At the same time the country revised its deficit figure for 2008 from 5.0% to 7.7%. Summary of Credibility Crisis The Greek National Bank warned Greek banks about relying too much on the European Central Bank (ECB) s low rates for financing as 2009 headed to a close. This increased market concerns that Greek debt would not be accepted as collateral for much longer at the ECB. Downgrades in December by Fitch and then by S&P quickly followed, prompting speculation about a possible default on Greek sovereign debt and/or the possibility of the exit of Greece from using the euro and from the European Union (EU). Greece has just faced its first recession since adopting the euro as its currency. Prior to this, the country benefited from above average growth rates. That said, a large proportion of this growth was driven by increased levels of public spending rather than by corporate growth. Greek fiscal problems are not new to the market and it is commonly said that Greece dressed up its deficit numbers to meet the criteria to join the EU. By mid 2009 the International Monetary Fund (IMF) had already warned about the size of the Greek fiscal deficit. The surprising factor was the lack of coordination between the Greek government and the European authorities who insisted that Greece is on its own in terms of solving its debt problems. Austerity Plan At the end of December, Greece Finance Minister Papaconstantinou announced an austerity plan for the country that was not well received by the European Commission (EC). Since then a more aggressive plan has been announced. The EC have subsequently endorsed this version although they have made some suggestions with regards to strengthening the plan. The next key date is 16 February when EcoFin are expected to announce their endorsement of the EC analysis and proposal. The plan calls for Greece to take the following actions: 1) Target a fiscal deficit of 2.8% of GDP by 2012 and 8.7% of GDP by the end of 2010 (Exhibit 1). 2) See its debt-to-gdp ratio peak at 120.6% of GDP in 2011 (Exhibit 2). 3) Decrease government expenditure to 47.7% of GDP in 2013 from the current 52% of GDP. 4) Increase government revenues from the current 39.3% of GDP to 45.7% of GDP in Western Asset Management Company This publication is the property of Western Asset Management Company and is intended for the sole use of its clients, consultants, and other intended recipients. It should not be forwarded to any other person. Contents herein should be treated as confidential and proprietary information. This material may not be reproduced or used in any form or medium without express written permission.

3 Exhibit 1 General Government Deficit Percent of GDP Exhibit 2 General Government Debt To achieve these objectives the Greek government has proposed a set of measures that are currently being evaluated by the EC, the ECB and the IMF. 1) Reduce government spending and social security expenditure by 10% each in This will be achieved by cutting public sector salaries over 2,000 per month by 10%, cutting short-term contracts by one third and establishing a hiring freeze in After 2010, one new employee will only be hired for every five employees who retire. Greece will also close a number of global tourism offices. 2) Increase the tax base by abolishing tax exemptions, simplifying tax regulation, making citizens declare not only income but assets and increasing the marginal tax rate as well as levies on tobacco and alcohol ) After explaining that cutting the budget without investing in the future would be wrong, Mr. Papakonstantinou confirmed that the public investment program (which is mainly financed with euro system funds) would not be cut in any way. He also mentioned efforts to improve 105 productivity such as reducing the time it takes to set up a business in Greece ) Several strategies were mentioned to tackle the current credibility problem These included having the stability and growth program be verified by the EC, creating an independent statistics office 80 and delivering politically. As they hold the E 2010F 2011F 2012F 2013F biggest majority in parliament in recent Source: Eurostat, Greek Ministry of Finance history, the current centre-left government believes that they can easily pass aggressive legislation. Also, as a leftist party, they are in a better position to negotiate with the unions. Percent of GDP E 2010F 2011F 2012F 2013F Source: Eurostat, Greek Ministry of Finance Time will tell whether Greece can meet these objectives. The lack of competitiveness in the Greek economy is definitely a medium-term concern, as a nominal adjustment via currency depreciation is not an option. The Commission commented that the improved fiscal position also relies largely on increasing tax revenues, which is more difficult to realise than cutting back spending (Exhibit 3). This is particularly the case in an environment likely to be characterised by low growth. Western Asset 2

4 Exhibit 3 Ongoing Adjustment Scenarios According to Official Forecasts (% GDP) Revenue Increase Expenditure Reduction Total Fiscal Adjustment Adjustment in Debt-to-GDP Ratio Debt Ratio at End of Adjustment Period Greece ( ) Latvia ( ) Estonia ( ) Hungary ( ) Source: Greek Ministry of Finance: Hellenic Stability and Growth Programme ( IMF Reports, Barclays Capital Exhibit 4 Change in the structural primary balance, in % of GDP Change in the Structural Primary Balance, in % of GDP Turkey 1987 to 1990 Czech Rep 1995 to 1999 Hungary 2006 to 2011 Greece 2009 to 2013 Slovakia 1992 to 1995 Hungary 1993 to 1996 Bulgaria 1993 to 1996 Turkey 1997 to 2001 Romania 1979 to 1984 Romania 1996 to 1999 Source: Barclays Capital Exhibit 5 Bond Maturity Profile (billions) Percent of GDP Bills Bond Maturity Profile Bonds Source: Greek Public Debt Management Agency As you can see in Exhibit 4, the current Greek fiscal austerity program ranks high in terms of it s s i z e. Nonetheless, it is still smaller than successful plans such as that executed by the Czech Republic in the 1990s or Hungary s current plan. The problem is not that Greece cannot issue its own currency and therefore pay for its government debt via the central bank s printing press. This is hardly the case for other small economies with big fiscal and current account deficits that need to keep their interest rates high to keep the currency from collapsing (Hungary and Turkey again come to mind). Greece is in a privileged position to have base rates at 1% and not face a currency or banking crisis. The more imminent concerns are whether the country is facing a funding crisis and a potential exit from the EU and from using the euro. Challenge 1: Funding We do not believe that Greece is facing an imminent funding crisis. Although the country has debt maturities amounting to 50% of GDP over the next five years ( 133 billion per Exhibit 5), of which 20 billion are due in April and May (out of about 55 billion of issuance expected for 2010), Greece is still able to access the capital markets. While the ECB cannot actively buy Greek bonds, it will help finance their purchase by accepting them as collateral for repo operations at least until the end of At this point it will revert to only accepting paper rated A or higher (see Exhibits 6 and 7 for further information on Western Asset 3

5 peripheral economy comparisons and a history of Greek government bond ratings). While the ECB has insisted that the rules would not be changed to help any of the member states, it is hard to see why it would make an exception and help banks during the crisis but not make an exception to help a member state. It is also hard to see why European governments would cut transfers to Greece if the intent of those funds is to bridge the gap in productivity between the core and the poorer peripheral economies. Why would the EU support an IMF rescue package for non-emu Hungary and not one of its members? As the French Economy Minister noted in October 2008, Allowing Lehman Brothers to fail last month was a major mistake for the equilibrium of the global financial system. Exhibit 6 Key Statistics for Euro Periphery Ratings (Outlook) Average S&P Fitch Moodys Structural Balance (%GDP) Interest Payments (%GDP) Debt %GDP ( bln) C/A Balance (%GDP) Greece BBB+ (watch -ve) BBB+ (-ve) ( 129) A2 (-ve) Italy A AA- ( 1380) Aa2 Ireland AA (-ve) AA- ( 42) Aa1 (-ve) Spain AA+ (-ve) AAA ( 330) Aaa Portugal A+ (-ve) AA (-ve) ( 83) Aa2 (-ve) Euro n/a ( 4949) Source: Barclays Capital Exhibit 7 Rating History and ECB Eligibility of Greece Moodys Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Moodys Fitch S&P R&I Source: Barclays Capital, Fitch, Moodys, R&! Rating Agencies, S&P AA AA A+ A A BBB+ BBB BBB Fitch / S&P / R&I This is a typical agency/theory-type problem: the European authorities are refusing to work on a help package for Greece, just as the US government categorically refused any government participation in a Lehman Brothers rescue package in No bail-outs was the expression being used at the time. The contract, in this case the Maastricht Treaty, failed to align the interests of the European authorities with Greece s interests. It could be that the incentives or the penalties for the countries that did not comply with the treaty were not high enough or that the rules were too rigid to deal with crisis type of situations or that Greece shouldn t have been part of the euro in the first place. The bail-out option is more beneficial for both parties than the default option, as we saw from the Lehman collapse. Yet the principle that the European authorities have a strong incentive to punish the agent (Greece) in order to send a clear message that countries that abuse the system will suffer. The solution game theory provides is for the contract, (the Maastricht Treaty) to be rewritten in order to better align Greece s interests with the EU s interests, just as the contract is being rewritten in the US regarding bank regulation. Challenge 2: EU Exit? The question now is how far may spreads go before the European authorities believe that Greece has learned its lesson? The threshold should be close to the level where Greece is indifferent to staying in the eurozone. There is no clause in European law that deals with the expul- Western Asset 4

6 sion of countries from the EU or from using the euro. There is, however, an exit clause in the Lisbon Treaty that would allow a member state to exit the EU. In a rather well-timed paper published in December 2009 titled Withdrawal and Expulsion from the EU and EMU, Some Reflections, the ECB concludes that it would be legally difficult for a country to leave the EU, let alone be expelled. The paper suggests revising the treaty and introducing an exit clause and a right of collective expulsion from the EU. In short, there is no quick solution at hand. Even if Greece decides to leave the EU, it would only happen after a lengthy negotiation process with the EC. Valuation Framework Before Greece announced its intention to join the eurozone, its spreads were between 4-5% (over German government bonds) in the five-year part of the yield curve. Its spread was an average of 0.12% from December 2001 to June 2007 and the current average spread for BBB rated corporate bonds relative to Eurozone government bonds is 2.35%. Given these metrics, Greece appears to be paying a higher spread partially because of its downgrades but also because the market is pricing in a good probability of Greece exiting the EU or being downgraded to below investment-grade (which would make its government debt ineligible for collateral for repo operations with the ECB). Exhibit 8 Greece and Hungary Spreads over Germany 5-Year Greece and Hungary spreads over Germany 5yr Percent Hungary Greece -2 Jul 98 Jul 99 Jul 00 Jul 01 Jul 02 Jul 03 Jul 04 Jul 05 Jul 06 Jul 07 Jul 08 Jul 09 Source: Bloomberg, Western Asset Exhibit 9 Where We Stand 5-yr CDS Change Since 08 Dec (bps) Current Level (bps) Govt. Debt / GDP 2010F Fiscal Deficit 2010F Greece % -10% Hungary % -4% Croatia % -3% Bulgaria % -2% SOAF % -6% Turkey % -5% Russia % -3% Lithuania % -11% Source: Barclays Capital, Bloomberg It is relevant to compare Greece to Hungary, which had to undergo a very similar fiscal austerity plan, has a very similar macro profile (with big current account and budget deficits), is BBB rated by all the agencies and is a relatively small economy. As shown in Exhibit 8 Hungary s five-year government bonds trade approximately 5% over German government bonds and its base rate is 6%. Greece s five-year bonds trade at 3.75% over German government bonds and its base rate is 1% (set by the ECB). More importantly, five-year/five-year forward spreads in Greece and Hungary are trading approximately 2.5% over Germany. Considering the still poor situation in Hungary, we believe there is little eurozone convergence priced into Hungarian forwards. This metric therefore indicates a high probability of an extreme event such as an EMU exit or further downgrades already priced into the market levels for Greek government bonds. Exhibit 9 provides some further comparisons between countries CDS levels and fiscal positions. Turning to the possibility of default, Exhibit 11 shows the recovery rates on defaulted sovereign bond issuers range from a low of 30% in the case of Argentina in 2001 to 95% in the Western Asset 5

7 Exhibit 10 Recovery Holding Period (yrs) 1 Spread Recovery Rate 1.5% 2% 2.5% 3% 3.5% 4% 4.5% 5% 5.5% 6% 30% 2.1% 2.9% 3.6% 4.3% 5.0% 5.7% 6.4% 7.1% 7.9% 8.6% 50% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0% 11.0% 12.0% 70% 5.0% 6.7% 8.3% 10.0% 11.7% 13.3% 15.0% 16.7% 18.3% 20.0% 90% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0% 45.0% 50.0% 55.0% 60.0% Holding Period (Years) 2 Spread Recovery Rate 1.5% 2% 2.5% 3% 3.5% 4% 4.5% 5% 5.5% 6% 30% 4.3% 5.8% 7.2% 8.7% 10.2% 11.7% 13.1% 14.6% 16.1% 17.7% 50% 6.0% 8.1% 10.1% 12.2% 14.2% 16.3% 18.4% 20.5% 22.6% 24.7% 70% 10.1% 13.5% 16.9% 20.3% 23.7% 27.2% 30.7% 34.2% 37.7% 41.2% 90% 30.2% 40.4% 50.6% 60.9% 71.2% 81.6% 92.0% 102.5% 113.0% 123.6% Holding Period (Years) 3 Spread Recovery Rate 1.5% 2% 2.5% 3% 3.5% 4% 4.5% 5% 5.5% 6% 30% 6.5% 8.7% 11.0% 13.2% 15.5% 17.8% 20.2% 22.5% 24.9% 27.3% 50% 9.1% 12.2% 15.4% 18.5% 21.7% 25.0% 28.2% 31.5% 34.8% 38.2% 70% 15.2% 20.4% 25.6% 30.9% 36.2% 41.6% 47.1% 52.5% 58.1% 63.7% 90% 45.7% 61.2% 76.9% 92.7% 108.7% 124.9% 141.2% 157.6% 174.2% 191.0% Source: Moodys, Western Asset Exhibit 11 Recovery Rates on Defaulted Sovereign Bond Issuers Year of Default Defaulting Country Avg Trading Price** (% of par) PV*** Ratio of Cash Flows (ratio in %) 1998 Russia Pakistan Ecuador Ukraine Ivory Coast* 18 n/a 2001 Argentina Moldova Uruguay Grenada* 65 n/a 2005 Dominican Republic Belize 76 n/a 2008 Seychelles* 29 n/a 2008 Ecuador 26 n/a Issuer-Weighted Recovery Rates Value-Weighted Recovery Rates Source: Moodys * Not rated by Moodys at the time of default ** 30-day post-default price or pre-distressed exchange trading price *** Ratio of the PV of cash flows received as a result of the distressed exchange versus those initially promised, discounted using YTM immediately prior to default (source: Bank of England 2005) Dominican Republic in (These numbers were calculated using Moody s methodology of taking the present value of the cash flows received.) Russia s recovery rate was around 50% when it defaulted in Exhibit 10 summarises the spread-implied default probability given different recovery rate assumptions (assuming that Germany has a virtually 0% probability of defaulting). In the extreme case of a Greek default, we believe recovery rates would be on the high side (50-70%) if Greece remains in the eurozone. This is because unlike other sovereign defaults, the banking sector would still be able to finance itself via the ECB. As time passes and Greece pays its coupons and maturities, these implied probabilities become less realistic, yet the likelihood of default decreases as Greece would have been able to finance its near-term issuance. It is therefore important that Greece be able to finance this year s 55 billion of issuance. Even in a one year holding period case, we believe that implied probabilities at current spreads seem to be in overshoot territory. If a default were to take place, we believe the ongoing credibility of the EU would require them to be involved at the least in the restructuring phase. Western Asset 6

8 As discussed, we see very little probability of Greece being expelled from the EU in the near term for legal and institutional reasons. Conclusion We have believed for some time that peripheral country spreads within the eurozone did not compensate investors for the risk they represented, particularly when compared to other spread products such as credit or even agency or supranational types of paper. This is partly the result of a poor fiscal situation that was hidden by cheap financing but also because fundamental differences between eurozone countries meant that without the flexibility of floating exchange rates, real adjustments rather than nominal adjustments would need to take place in order to settle these differences. Greece is the first of these peripheral countries to undergo such an adjustment but is unlikely to be the last. Greek government spreads relative to Germany have been the first to adapt to the new economic reality, and have most likely overshot the probability of Greece either leaving the EU, which provides the only mechanism whereby they can leave the EMU, or of defaulting. Given this investment framework we believe that five-year Greek spreads at a yield of 3.75% over Germany offer value. We consider a valuation of around % over the medium term more appropriate given Greece s fundamentals, the high probability we give to Greece continuing to be part of the EU and Greece s relative value against similar countries. We favour adding Greece exposure at current levels. It is possible that the Greek experience will incite other peripheral eurozone countries to make the adjustments needed to avoid landing in a similar situation but we do not believe that current spread levels compensate for the risk of these countries not learning from Greece. The EU was born from a political rather than an economic process and it is the political will of its core countries that is likely to keep it together. We continue to believe that a break-up of the eurozone would be led by the sponsors of the EU such as Germany, rather than the main beneficiaries of the EU such as Greece. We believe we are witnessing a structural shift in European spreads that should better reflect the economic reality in the peripheral eurozone countries. From an investors point of view that should be a good thing. Past results are not indicative of future investment results. This publication is for informational purposes only and reflects the current opinions of Western Asset Management. Information contained herein is believed to be accurate, but cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice. Employees and/or clients of Western Asset Management may have a position in the securities mentioned. This publication has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. It is your responsibility to be aware of and observe the applicable laws and regulations of your country of residence. Western Asset Management Company Distribuidora de Títulos e Valores Limitada is authorized and regulated by Comissão de Valores Mobiliários and Banco Central do Brasil. Western Asset Management Company Pty Ltd ABN is the holder of the Australian Financial Services Licence Western Asset Management Company Pte. Ltd. Co. Reg. No R is a holder of a Capital Markets Services Licence for fund management and regulated by the Monetary Authority of Singapore. Western Asset Management Company Ltd is a registered financial instruments dealer whose business is investment advisory or agency business, investment management, and Type II Financial Instruments Dealing business with the registration number KLFB (FID) No. 427, and a member of JSIAA (membership number ). Western Asset Management Company Limited ( WAMCL ) is authorised and regulated by the Financial Services Authority ( FSA ). In the UK this communication is a financial promotion solely intended for professional clients as defined in the FSA Handbook and has been approved by WAMCL. For more information on Western Asset visit our website at Western Asset 7

9 This document does not constitute an invitation to invest. The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested. The value of investments and the income from them can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. These are the views of Western Asset Management. Western Asset Management is affiliated with Legg Mason Investments through common control and ownership by Legg Mason, Inc. This document is for use by Professional Clients and Eligible Counterparties. It is not aimed at, or for use by, Retail Clients. This information has been prepared from sources believed reliable but is not guaranteed by Legg Mason Investments (Europe) Limited and is not a complete summary or statement of all available data. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of individual investors. Issued and approved by Legg Mason Investments (Europe) Limited, registered office 75 King William Street, London, EC4N 7BE. Registered in England and Wales, Company No Authorised and regulated by the Financial Services Authority. Client Services +44 (0) Ref: 5337 FOR PROFESSIONAL USE ONLY.