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'Stabilize the Sovereigns, Stabilize the Banks': Pimco

With political uncertainty rising in Greece, following the call for a referendum, and then rumors of Prime Minister Papandreou's resignation, the expected effects of the European Financial Stability Fund (EFSF), which had gone up last week, crashed down again on Wednesday.

The European Union and Greek national flags fly near the Parthenon temple on Acropolis hill in Athens, Greece.
Bloomberg | Getty Images
The European Union and Greek national flags fly near the Parthenon temple on Acropolis hill in Athens, Greece.

"I think Greece is going to default," Andrew Balls, managing director of PIMCO europe, told CNBC.com. "They can call it voluntary or not, the big issue is whether it will be more orderly or less orderly, whether it will be something that is well managed or poorly managed."

The problem is, with PASOK—the ruling party in Greece—splitting on the question of the referendum, and rumors over the possible resignation of Papandreou, chances of an "orderly" management of the situation weaken.

"At the moment, the current events have raised the risk of the disorderly outcome," Balls said. The only way Greece could avoid default would be "if you get a complete turnabout in terms of the European policy response," he added.

Such a default would have strong consequences over other countries' sovereigns.

"It makes it even more important that you have a credible firewall for Italy and Spain. And so far, the indications there have not been particularly encouraging either," Balls explained . But for the moment, Pimco is "very cautious on European sovereign risk, European peripheral risk," he added.

Not all European sovereigns are at stake, but uncertainty is the key word here.

"We think it makes sense to wait for a much greater clarity here," Balls said. " We would want to look to the global opportunity set. And find the best global opportunities."

"With Bunds, or Treasurys or Gilts, there are questions about whether the valuation is particularly attractive," he said, before adding that "these are safer havens, at a difficult time. And in terms of looking for good global opportunities, we would look for strong balance sheets... that can include, certainly, emerging markets, where you can invest in stronger balance sheets."

However, as the bankruptcy of MF Globalrevealed, sovereigns are not the only values suffering from the situation. Private banks are also at risk.

"The extent of the crisis in Europe; and the extent of the repricing in sovereign risk, is going to have a very broad—has had, and will continue to have—ramifications."

"Earlier in the crisis, the issue was the banks providing the instability to the system, and sovereigns stabilizing," Balls explained. " On the European side of this question at the moment, the issue is less the banks but more the sovereigns, the sovereign instability, the sovereign uncertainty, it is something that has clearly impacted the European banking sector."

Stabilizing the sovereign is then now the priority in order to stabilize the banks, but recapitalization should not be crossed off the list of options.

"I think there are definitively banks that need to be recapitalized," Balls said, talking about the impact of risky sovereigns and difficult macro economic outlook. I think the question of what the right level of capital is for European banks is intertwined with the question of the quality of the sovereign exposures," he said. "If Italy and Spain are going to be stabilized, that has a set of implications, if Italy and Spain credit just continues to deteriorate, that has another set of implications…" he added.

The question then is where would the money come from, with governments already highly in debt, private investors quite distrusting banking stocks and the threat of a credit crunch in case of high provisioning.

"The first instance will be the private market, the second instance, national governments, the third instance, the EFSF," Balls said . He added that: " I n terms of the ability of banks to raise money from private markets, this will be a function of their own balance sheet characteristics. It's also going to be a function of firstly, Europe's success or not in stabilizing the crisis. "

Contact Europe: Economy

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