Foreign Emerging

Greek Drama

June 22nd, 2015 | By Nick Sargen

Highlights

  • Time is running out for Greece to reach an agreement with its creditors. Without a deal, Greece will not be able to pay the €1.7 billion to the IMF that is due this month. Press reports indicate Greek officials submitted a proposal to European leaders over the weekend that include tax increases and spending cuts to hit budget targets, and markets have rallied on the news.
  • Assuming a deal is reached, it would not constitute a permanent solution to Greece's problems: The country's debt ratio of 175% of GDP is unsustainable. A deal would merely postpone the day of reckoning when Greece receives additional debt relief.
  • Should talks break down, Greece would likely resort to capital controls to stem the flow of money out of Greek banks. Ultimately, its fate in the eurozone would rest with the European Central Bank, which provides liquidity to the Greek central bank.
  • Thus far, the markets' response to the drama has been muted outside of Greece and the euro has strengthened, as investors believe the eurozone is better equipped to cope with a "Grexit" today. However, such an outcome would also raise questions about the long-term viability of the eurozone.

Negotiations Reach a Critical Phase

Market participants once again are focused on Greece, as time is running out for the country to reach an agreement that would unlock funds so it can pay creditors. The IMF and European Commission (EC) are now preparing for the possibility that no agreement will be forthcoming for Greece to meet its obligations that are due at the end of this month. At the same time, Greece's central bank urged the Greek government to accept a deal offered two weeks ago, or risk an "uncontrollable crisis" that might force the country out of the European Union.

The angst about Greece heightened last week when the IMF and EC broke off negotiations with the Greek government after Prime Minister Tsipras' rejection of what he described as the "absurd" bailout offer by Greece's creditors. Should Greece fail to repay €1.5 billion owed to the IMF at the end of the month, it would not be in default technically, because it would be considered to be "in arrears."

The Greek government is hoping it can make a better deal with European leaders at an emergency summit meeting today that would unlock €7.2 billion in rescue funds. Press reports indicate that new proposals by Greece include a package of tax increases and spending cuts in return for debt relief from its creditors, and financial markets have rallied on the news. In the event a deal is reached, it would buy time for Greece to undertake structural reforms to make its economy more competitive. However, its ratio of debt to GDP is 175%, which is unsustainable. A deal, therefore, would merely postpone the day of reckoning when it would need additional debt relief.

Without agreement on economic reforms, officials have indicated there is no hope of extending the assistance program for a third time, meaning Greece would be without an EU safety net for the first time in five years. The most likely outcome in that event is Greece would experience a further run on the banks that would force the government to impose capital controls. Meanwhile, the Greek central bank has sought the assistance of the ECB. Should the outflows continue, the ECB would be in the predicament of having to declare whether the Greek banks are insolvent. According to the Financial Times, the drop-dead deadline for Greece is July 20, when two bonds totaling €3.5 billion fall due to the ECB, as failure to pay these bonds would be considered a full default and make it almost impossible for Greece to survive in the eurozone.


Limited Market Response

Prior to today's developments, markets had taken the news in stride, and the euro even strengthened a bit against the dollar. This suggests market participants anticipated that a deal would be reached. If that is not the case, we would expect to see increased market volatility, with the euro weakening against the dollar while risk assets sell off.

Even in that event, the eurozone is less vulnerable to contagion than it was in the 2010-2012 time frame for several reasons: (i) the ECB now functions as a true lender-of-last resort for the eurozone, as it is free to buy bonds of member country governments; (ii) the program of quantitative easing that it implemented at the start of the year provides protection not only against deflation, but also against a "Grexit"; and (iii) private sector institutions have reduced their exposure to Greece significantly, while banks in the eurozone are better capitalized today.

Weighing these considerations, some market participants believe a sell-off of risk assets in Europe would present a buying opportunity. While that may be the case in the near term, I believe a "Grexit" would be a blow to the credibility of the eurozone, because investors would be left wondering what might happen if another member country became troubled.


What a Waste!

I regard what has happened to be a terrible waste. It is tragic considering the pain and suffering the Greek people have endured the last five years, with real GDP falling by 27%, while the unemployment rate reached a peak of 28% in 2013. As Martin Wolf of the Financial Times observes (June 17, 2015):

"Such a brutal adjustment would have shredded the politics of any country. Europeans are now dealing with Syriza because of this calamity. But they are also dealing with Syriza because of the refusal to write down more of the debt in 2010."

At the same time, the incorrigible and defiant stance the Greek government has taken with its creditors has alienated it even among those who are critical of austerity programs. In an article titled "A Greek Suicide?" (project-syndicate.org, June 11, 2015), Anatole Kaletsky contends that while the economic analysis underlying Syriza's demand for an easing of austerity was broadly right, the Greek government wasted six months on symbolic battles over irrelevant issues and political grandstanding, while failing to realize it no longer held the trump card to threaten the viability of the eurozone, because of the actions to bolster the power of the ECB:

"Greek politicians who still see the threat of financial contagion as their trump card should note the coincidence of the Greek election and the ECB's bond-buying program and draw the obvious conclusion. The ECB's new policy was designed to protect the euro from the consequences of a Greek exit or default."

For these reasons, I view the outcome at best a morbid comedy if an agreement is reached, and a tragedy if one is not reached.