Viewpoints

January 2010

This article was originally published in the Financial Times on January 29, 2010.

Greece Part of Unfolding Sovereign Debt Story

By Mohamed El-Erian

Global investors worldwide are starting to pay more attention to what is unfolding in
Greece. Yet most still think of Greece as an isolated case, just as they did for Dubai a
few months ago.

With time, they will see Greece as part of a much larger investment theme that is a
direct outcome of the global financial crisis: The 2008–2009 ballooning of sovereign
balance sheets in advanced economies is consequential and is becoming an important
influence on valuations in many markets around the world.

As realization spreads of this key sovereign investment theme, it is important to be

clear about what Greece is, and what it is not.

At the simplest level, think of Greece as Europe’s big game of chicken, with the
operational question for markets being two-fold: Who will blink first, the Greek
authorities, donors or both; and will they blink in time to avoid truly disorderly debt and
market dynamics that also entail significant contagion risk.

Let us start with Greece, where, under any realistic scenario, a meaningful internal
adjustment is needed.

There is no solution to the country’s debt issues without a deep and sustained policy
effort. Yet, given the initial conditions (including the size and maturity profile of its debt)
and the existing policy framework (anchored on adherence to a fixed exchange rate via
the euro), such adjustment is difficult and not sufficient.

If unaccompanied by extraordinary external assistance, it would entail such

contractionary fiscal measures as to raise legitimate socio-political problems.

External assistance is needed to support the meaningful implementation of internal

policies. And it has to be consequential in scale and durability, as well as timely and
well-targeted.

Understandably, such assistance faces headwinds on account of donors’ moral hazard

concerns (vis-à-vis Greece and beyond), of donors’ understanding that a Greek bailout
would not be a one-shot deal, and of donors’ own domestic budgetary considerations.

Because of this, I suspect that at least three of the following four conditions are needed
to force the hand of European donors, and that is assuming that Greece provides them
at least with the fig leaf of commitment to meaningful internal policy actions.

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• First, evidence that Greek markets are being severely impacted by funding
concerns. With the recent surge in borrowing costs and the disruptions in the
normal functioning of government and corporate markets, this condition is
clearly already met.

• Second, evidence that other peripherals in Europe – such as Ireland, Italy,

Portugal and Spain – are also being impacted. This is happening, as signaled
by the gradual widening in market risk spreads.

• Third, evidence that other providers of capital are sharing the burden of
financing Greece. Tuesday’s €8 billion bond issuance to private creditors is
consistent with this.

• Fourth, evidence that the Greek financial disruptions are starting to undermine
core European countries. Evidence here is limited to the weakening of the
euro, which, as yet, cannot be viewed as disruptive (indeed, some view it as
helpful for Europe).

Notwithstanding this last condition, we are much closer today to the point where
donors’ hands will be forced. Yet investors should remain wary, as this would offer, at
best, only a short-term tactical opportunity. Greater clarity as to what Greece can
deliver in internal adjustment should remain the primary driver for long-term investment
opportunities.

Investors should also remember that “market technicals” remain tricky and now
constitute a meaningful marginal price setter. The shift in the investment
characterization of Greece, from being primarily an interest rate exposure to a credit
exposure, has happened in such a way as to allow for little orderly repositioning. Many
investors are trapped and the phenomenon has been accentuated by the recent
evaporation of market liquidity.

Where does all this leave us?

Over the next few days, we are likely to get some combination of Greek and European
donor announcements aimed at calming markets, reducing volatility and reducing
contagion risk. But the impact on markets is unlikely to be sustained as both sides face
multi-round, protracted challenges which contain all the elements of complex game
dynamics.

No matter how you view it, markets in Greece will remain volatile and more global
investors will be paying attention. In the process, this will accelerate the more general
recognition that sovereign balance sheets in many advanced economies are now in
play when it comes to broad portfolio positioning considerations.

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About the author:

Mohamed El-Erian is CEO and co-CIO of PIMCO and is based in the Newport Beach office. He re-joined
PIMCO at the end of 2007 after serving for two years as president and CEO of Harvard Management
Company, the entity that manages Harvard’s endowment and related accounts. Dr. El-Erian also served as a
member of the faculty of Harvard Business School. He first joined PIMCO in 1999 and was a senior member
of PIMCO’s portfolio management and investment strategy group. Before coming to PIMCO, Dr. El-Erian was
a managing director at Salomon Smith Barney/Citigroup in London and before that, he spent 15 years at the
International Monetary Fund in Washington, D.C. Dr. El-Erian has published widely on international economic
and finance topics. His book, When Markets Collide, was a New York Times and Wall Street Journal
bestseller, won the Financial Times/Goldman Sachs 2008 Business Book of the Year and was named a book
of the year by The Economist. Dr. El-Erian has served on several boards and committees, including the U.S.
Treasury Borrowing Advisory Committee, the International Center for Research on Women, and the IMF’s
Committee of Eminent Persons. He is currently a board member of the NBER and the Peterson Institute for
International Economics. He holds a master’s degree and doctorate in economics from Oxford University and
received his undergraduate degree from Cambridge University.

Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond
market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Sovereign
securities are generally backed by the issuing government, obligations of U.S. Government agencies and
authorities are supported by varying degrees but are generally not backed by the full faith of the U.S.
Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are
subject to change without notice. This material has been distributed for informational purposes only and
should not be considered as investment advice or a recommendation of any particular security, strategy or
investment product. Information contained herein has been obtained from sources believed to be reliable, but
not guaranteed. This material was reprinted with permission of Financial Times. Date of original publication
January 29, 2010.