Greece has once again been making the wrong kind of headlines and is very much front of mind for investors. The breakdown of talks between the Greek delegation and the institutions and inflammatory rhetoric by Greek Prime Minister Tsipras has raised worries about a Greek default and euro exit. Thursday’s Eurogroup made little further progress towards a deal, though an emergency Euro Summit has been planned for Monday. In this note we try and answer ten big questions that arise.
A long-term deal to revive Greece in the eurozone should contain three elements
Nick Kounis Head of Macro Research
1. What is the current state of play?
Some progress has been made but there is still a significant gap between the two sides. The Greek government finally accepts a primary surplus target of 1% GDP for this year, and 2% GDP for next year. This is in line with what was proposed by the creditor institutions. The major remaining sticking point now is that the institutions doubt the effectiveness of some of the fiscal measures proposed by the Greek government to meet those targets. Greece will likely need to propose more realistic policies to cut spending or raise revenue. The IMF is of the view that Greece needs to cut pension expenditure, though it has no problem with Greece protecting the poorest pensioners.
2. What are the key dates coming up?
An emergency EU Summit has been called on Monday (22 June), while a Eurogroup meeting will be scheduled some time before that in order to try and lay the ground work for a deal. There is also regular EU Summit scheduled on 25-26 June, which could effectively be the last opportunity for a deal to be wrapped up ahead of Greece’s bundled IMF payment of around EUR 1.6 bn on 30 June. The day after – on 1 July – the ECB has its regular non-monetary policy meeting, in which it decides whether or not to veto the Greek central bank’s provision of Emergency Liquidity Assistance to the Greek banks. Beyond that, on 20 July, Greek government bonds held by the ECB mature. The principal amounts to EUR 3.5bn, while the coupons total EUR 700m.
3. Will Greece and its creditors reach a deal?
We think they will eventually. Granted, recent rhetoric by Greek Prime Minister Tsipras makes gloomy reading. He said that the IMF “bears criminal responsibility” for the situation in the country. This is a rather ‘unconventional’ way to address one of the institutions that you hope will lend you money. He also said that he was prepared to accept responsibility to say a ‘big no’ to a continuation of the ‘catastrophic policies for Greece’. Meanwhile, Europe and the IMF have responded by saying that the ball was in Greece’s court and they should make a new more acceptable proposal to make a deal.
Despite the stand-off we think that both sides have too much to lose and will eventually reach an agreement. As discussed below, a Greek euro exit would have negative consequences for both sides. Meanwhile, the vast majority of Greeks want to remain in the euro so the government does not have a mandate to act in a way which precipitates such an outcome. The good news is that there is still some time left before the IMF payments are due. We think the differences can be bridged.
4. What if they do not?
If there is no deal, it is likely that the government will run out of cash by the end of the month. It will very likely be unable to pay the IMF. The IMF has said that there would be no grace period, and that Greece would then be seen to be in default to the IMF on 1 July. At that stage Greek euro exit fears would escalate. There would likely be more stress in financial markets. In addition, there would be more uncertainty in Greece, and deposit outflows would likely start to accelerate at a dangerous pace. At this stage, the best case scenario would be that the two sides get back to the table having had a shock and negotiate a deal, which would see them take a step back from the brink.
5. What happens to the Greek banks?
If Greece misses its IMF payment, the banking system would be increasingly vulnerable to a liquidity crunch. Indeed, reports out of Greece suggest that in the first four days of this week, deposit outflows accelerated to EUR 3bn. Defaulting on the IMF would likely see this trend intensify, with a very real risk of a bank run. Given this, the authorities could in those circumstances decide to pre-empt a bank run by implementing deposit and capital controls before the end of the month. This could occur over the weekend (27-28 June) or following a bank holiday at the start of the following week.
The case for such a move could be strengthened because of uncertainty about the continuation of central bank liquidity. There is a question mark about whether the ECB would continue to allow the Greek central bank to provide Emergency Liquidity Assistance. The ECB has said that the Greek banks are solvent. In addition, non-payment of IMF loans is not classified as a ‘default’ by the rating agencies. Furthermore, it takes a two-thirds majority of the Governing Council to block ELA and the ECB may be reluctant to take a decision with such adverse consequences, which it judges should be made by politicians. On the other hand, it would be uncomfortable for the ECB to allow continued ELA in the face of what would be in effect a sovereign default.
6. Would default mean exit?
Not necessarily, but the chances of Greek euro exit would rise considerably. Greece could still reach a deal with its creditors after a default and come back from the brink. It could also theoretically reach no deal and default but stay in the euro. Legally, a member state cannot be thrown out of the single currency. Only it can initiate an exit. However, the situation could over time become unbearable for Greece without any external financing for the government and banks. The economy is already back in recession, but it would likely start to contract very rapidly following the liquidity crunch in the banking sector and the implementation of capital and deposit controls. Cyprus is a recent example of this. Sharp falls in GDP would likely push the primary balance into a large deficit. In the absence of external financing, the government would then need to tighten fiscal policy to balance the books in the face of a deep recession. Greece may decide that the economic and social hardship was too much to take.
7. What would Grexit mean for Greece?
In the first year at least it would mean an even more severe economic crash. The weakness in the economy, banking stress and fiscal tightening would be ‘complemented’ by a collapse in the value of the new currency. Inflation would soar. The central bank would need to be careful in easing monetary policy given the high rate of inflation and the risk to inflation expectations. The experience from countries that have exited currency boards is that eventually, the economy would adjust and rebound. However, in the meantime, social hardship would become severe and there would be a risk of serious political instability.
8. What would Grexit mean for the eurozone?
There would most likely be sharp financial stress, with peripheral government bonds and other Southern European assets leading the decline. However, it may not last long. The Greek exposures of the rest of the eurozone are much less than in the past. In addition, policymakers have the tools to intervene. Calm would eventually be restored, though significant economic damage would be done in the meantime. We have already seen signs that the crisis in Greece is undermining confidence indicators, and we would likely see a more significant deterioration. However, if calm returns relatively quickly the economy should eventually regain its footing.
Still, there are significant risks. A Greek exit could undermine investor confidence in the longevity of the eurozone. They could then permanently price in higher risk premiums, especially for the weaker member states. Furthermore, member states would not welcome the risk of political instability in a geopolitically important area.
9. Will Super Mario save the day?
Yes most likely. In the case that Greek exit risks rise sharply, the ECB would activate the OMT, and buy large quantities of stressed government bonds. This should push down sovereign bond spreads again and generally support financial markets. However, countries in trouble would officially need to be in an adjustment programme. So it is unclear how quickly the OMT could be activated.
10. What would a long-term solution look like?
A long-term deal to revive Greece in the eurozone should contain three elements. First, serious structural reforms to reduce the huge gap with the most competitive and dynamic countries in the single currency area. Under the previous government, significant progress was made, but there is much more to do. Second, a reasonable pace of consolidation to maintain significant primary budget surpluses. Here too Greece, has taken large steps in the past. Finally, debt relief. Greece will unlikely be able to return its debt to sustainable levels over a reasonable period. Further moves by eurozone member states to reduce the debt will likely be needed. These moves could be incremental and made conditional on the delivery of reforms.