Article from Fidelity Worldwide Investment
The Greek government in April issued an emergency decree ordering local and regional governments and public agencies to hand cash to the central Bank of Greece so it could pay wage and pension obligations and make an imminent repayment to the IMF.
Such a desperate ploy only highlighted what has been obvious since Greece’s 100 billion euro (A$139 billion) default to private creditors in 2012; that bankrupt Athens, now owning debt worth 177% of a broken economy, must soon miss payments to its official creditors.
Greece and its lenders, which are mostly other EU governments, the European Central Bank and the IMF, are at loggerheads over giving the Balkan country the money it needs to meet upcoming bills. Creditors won’t agree to release some of the 7.2 billion euros still tied to the second, 2012 bailout because the new Syriza-led leftist government wants to renege on the austerity and other stringent conditions agreed to by its centre-right predecessor. The core issue is that Athens – more pointedly, the Greek population – no longer accepts the austerity that has backfired by destroying a quarter of Greece’s economy, boosted the jobless rate towards 30% and strained society, for little of the bail-out money helps Greece; it just rebounds out as debt payments. Thus the first default by a eurozone country could occur within weeks or months, almost certainly by next year. The biggest unknown is almost how controlled any default is.
The consequences of an uncontrolled Greek default to official bodies are unknowable, for Greece, Europe, the euro and the world. It’s more likely than not to lead to a Greek exit from the euro. A Greek departure from the common currency could happen slowly in various piecemeal ways or abruptly over, say, a week-long bank closure. What is more certain is that the failure of Europe’s political elite in 2010 to agree to the Lazard-designed debt write-off to private creditors that would have helped Greece bounce back has led to the ultimate dysfunction. Almost all the players in Greece’s misfortune are being forced into decisions that will ensure outcomes they want to avoid.
To be fair, it would have been hard for European authorities in 2010 to wear a Greek default that could have shaken Europe’s banking system and put taxpayers at risk to revive a country whose former government had lied about its finances. It’s more likely than not that German-led creditors will agree to give Greece enough money linked to the second bailout to stave off an immediate default. A dénouement of the Greek crisis may herald the political, economic and fiscal integration that is needed to revive Europe and ensure the euro’s future. While a comprehensive deal can almost certainly be ruled out, surely creditor nations can agree to an amicable default by Greece that their voters will back. The reality, though, is that five years of fudges (stretching maturities on Greek debt), half-steps (slashing interest rates on Greek debt) and mistakes (imposing austerity) have run their course of usefulness. The crisis has led to political shifts within Greece and across the eurozone that will make it difficult to negotiate a third bailout, when the extended second bailout expires in June, that includes a Greek default that somehow would get a country with few competitive advantages flourishing again. Investors must prepare for the probability that the Greek crisis will detonate soon enough.
Blasé investors
The Greek default in 2012 was to private creditors who agreed to write-downs so as not to trigger credit-default swaps that could have caused mayhem. Any upcoming default on the 320 billion-plus euros that Greece owes would be to public authorities that financed the first, 2010 bailout and thus assumed the risk. Greece faces about 15 separate payments before August and if any are missed taxpayers in neighbouring countries will be walloped. For years, Europe’s political elite have told eurozone taxpayers that their prosperity is not at risk from a Greek default, even though it was.
The jump in yields on Greek government debt, higher premiums on Greek credit-default swaps and the plunge in Greek stocks show that investors are pricing in a Greek default. Yields on Greek two-year bonds, for instance, were at 20.9% on April 30 compared with 7.1% six months earlier, before the snap election in January was a possibility. (Greeks went to the polls after parliament in December failed to agree on a president.)
The yields on other debt-laden eurozone sovereigns, however, are close to zero, implying no risk of “contagion” from a Greek default, even if much of that is slow acting. (Bond yields should still reflect these risks.) Investors seem assured that so-called firewalls such as the ECB’s untested and qualified lender-of-last-resort power, Europe’s rescue fund and steps towards a banking union will shield debt-heavy countries such as Italy (public debt at 132% of GDP), Portugal (130% debt to output) and Spain (98% debt to GDP). On April 30, Italian, Portuguese and Spanish two-year sovereign bonds were trading at 0.17%, 0.18% and 0.01% respectively.
This smacks of complacency even if Greece’s economy is small and few private creditors hold Greek debt. Lehman Brothers was tiny in comparison to the US economy but the company was pivotal enough to rock the global financial system, which was only steadied by radical steps by authorities. Any Greek default that is followed not long after by a euro exit could rend similar global shocks, at a time when central banks (having already cut rates to close to zero) and debt-laden governments have less ability to steady the world’s banking system.
Bad or worse
So why are the players in the Greek calamity sticking with positions that threaten their self-interest on many levels? Mainly because politics gives them little choice.
Take the EU. The aim of ensuring peace and prosperity in Europe drove the enlargement of a united Europe, the (largely) free trade between members and the creation of the euro, often against the wishes of voters. Greece’s entry into the EU and the eurozone was a political decision by Europe’s elite whereby the conditions of entry were waived to cement the EU’s reach into the Balkans. The EU’s western spread is now under threat because Russia has reacted to Nato’s encroachment on its traditional buffer states. The EU can’t afford to lose its Balkan base and no EU official or politician would want to wear history’s blame for forcing out Greece. Yet the EU must risk a rupture with Greece to stem the rise of nationalistic political parties in Europe spawned by the debt crisis, even though it knows a Greek default will fan these anti-EU forces.
The ECB quandary is that, as one of Greece’s biggest creditors, it must for political reasons take a brutal line against Greece that boosts the risk of a default and a euro exit. Once any country leaves the euro, the irreversibility of this political project is busted forever. The monetary union just becomes a fixed-exchange-rate system and such systems rarely endure for long. The ECB, at one level, is thus threatening its own existence for it only lasts as long as the euro does. The other dilemma is that an institution that needs to set itself above politics to survive could end up being blamed for political decisions that will reverberate in Europe for decades.
The IMF is another Greek creditor that must play tough with Athens and yet that only heightens the risk of the mayhem that it is designed to control. While Greece is a humanitarian disaster in European terms, it’s a rich country on a global comparison. The IMF can’t allow Greece to default while demanding payments from the world’s poorest countries that are its wards. (The IMF won’t mind, though, if EU taxpayers wear a default.)
The creditor nations, embodied in Germany, must press Greece for three reasons. Firstly, their populations are feeling uncharitable for they are battling economic stagnation at home. Secondly, governments are confronting populist parties that would benefit from a Greek default hitting taxpayers and damaging the credibility of the elite. Angela Merkel’s party, for instance, is losing votes on the right to the Alternative for Germany party whose first policy was for Germany to leave the euro. Finland, which is one of Europe’s worst-performing economies, has just elected a coalition that is propped up by the anti-bailout, euro-sceptic and right-wing Finns party. Languishing France confronts the rise of the anti-euro, anti-EU right-wing National Front. It typically only takes one country to torpedo agreements in Europe. The third and biggest political problem for creditor governments is that they have assured their populations that their wealth will not be squandered on Greece.
Creditor nations, however, face the dilemma that if they break Greece they could trigger two booby traps that will cost their taxpayers much more than the amount defaulted. The first stems from the eurozone’s interbank system, known as Target-2.[1] The issues with Target-2 arise because a country’s balance of payments must balance. In the absence of private investment, it has unwittingly fallen on national central banks within the eurozone to balance balances of payments via pseudo euro transfers. These transfers create liabilities for current-account debtors and claims for those running current-account surpluses – namely Germany. In case of default, the ECB would have to write off a defaulting country’s Target-2 liabilities and the cost would be shared among the eurozone’s central banks in proportion to their ownership of capital in the ECB. That’s a big hit for German and other taxpayers. While a Greek default would be bad enough (for its Target-2 liabilities are at an estimated 80 billion euros), a collapse of the euro would wipe out Germany’s wealth claims because there are no laws determining how they would be paid should the eurozone splinter.
The second trap is the threat to free trade from a Greek default. A deep concern for Germany, whose exports reach a high 50% of GDP, is that a busted Greece could resort to tariffs to protect its shrunken economy. Berlin worries that other governments under the influence of populists could adopt similar measures that would destroy Europe as a free-trade area.
Other debtor nations are pressing Athens because governments in countries such as Italy, Spain and Portugal have imposed austerity on their populations and face populist forces that would benefit if Greece were to gain debt relief. Perhaps Syriza’s biggest miscalculation since it won power in January is that it assumed the support of austerity-gripped neighbours.
Vote threat
The Greek government is obviously the hub of the debt talks. The chief constraint on Syriza, which is a coalition that includes some radical leftist parties, is the loyalty of the Greek electorate that backed its promise to unwind austerity and implement measures such as higher minimum wages but which still favours keeping the euro. Athens can’t back down on austerity for the coalition would split and Greek voters may turn to more revolutionary parties. If talks fail to ease austerity, Athens is threatening to hold a referendum to see if Greeks would accept such an outcome. This would only add to the uncertainty surrounding Athens’ brinkmanship with the EU that is roiling Greece’s economy, turning a primary fiscal surplus into deficit by slashing government revenue and intensifying a bank run.
The bankrupt government is thus left with pursuing a strategy of risking mayhem via default or referendum to force the EU to ease austerity and abandon asset sales. But it must ensure that any default or vote does not trigger a euro exit. All the while, it is running short of cash, time and possibly public support due to the fact that its confrontational style is failing to win concessions. In theory, Athens can default to the ECB or IMF without the country leaving the euro (just as it defaulted to private creditors three years ago) but in practice it’s hard to see how it could achieve this. A missed payment to the ECB or IMF and Greece would destroy investor confidence, upset the only bodies that can backstop the Greek banking system and call into question loans from Europe’s bailout fund. Such an outcome could test the population’s capacity for hardship, a limit, which crossed, could undermine Greece’s democracy.
The numbers say that something must give in the Greek crisis. Political forces are juggling against each other to see how that comes about and how soon.
Government debt-toGDP ratios are based on gross government debt and come from Eurostat, “Provision of deficit and debt data for 2014 – first notification”, 21 April. 2015, http://ec.europa.eu/eurostat/documents/2995521/6796757/2-21042015-AP-EN.pdf/2a3922ae-2976-4aef-b6ce-af19bde6a236. Other financial information comes from Bloomberg unless stated otherwise.