- With Greece and the Troika locked in a game of brinkmanship, the risks of a Greek default and an exit from the euro are rising.
- The Greek government believes it is in the Troika’s best interests for Greece to remain in the euro while the Troika wants to hold Greece to its previous commitments, setting an example for other periphery countries.
- We see three likely scenarios: agreement/no default, no agreement/no technical default and no agreement/default.
- Our view is that an agreement will be reached in which the remaining bailout funds are released and default is avoided because both sides have too much to lose if an agreement is not reached.
The Current Situation
The current crisis revolves around the expiration of the Second Economic Adjustment Programme for Greece that was agreed upon between the country and the Troika (the EU/European Central Bank (ECB)/IMF) in March 2012. The programme was to disburse €164.5 billion until the end of 2014 in a series of tranches subject to quantitative performance criteria and a positive evaluation of progress made in periodic reviews with respect to policy criteria. Basically, Greece was to receive funding from the Troika in return for enacting a programme of pension, social security and tax reform, such that the Greek economy and fiscal position would be put on a sustainable path.
The monies from the Troika were hoped to allow the Greek state to continue to pay its commitments as it moved from a primary deficit to a surplus as the economy recovered. Without the cash, public sector and creditor commitments could not be made.
Before the final disbursement of €7.2 billion was made at the end of 2014, it was clear further fiscal consolidation would be necessary to meet the requirements of the fifth review of the adjustment programme. To enable this, Greek Prime Minister Antonis Samaras asked for and was granted a two-month extension to the programme set to expire at the end of February 2015. In order to strengthen his hand domestically, Samaras called a presidential election two months early, but his plan backfired. After three failed attempts to get his nominee elected in Parliament, the Constitution ensured a general election was called. The election resulted in the formation of a government by the anti-austerity, rejectionist Syriza party under Prime Minister Alexis Tsipras, effectively ending the Troika-friendly New Democracy-PASOK coalition led by Samaras in late January.
Elected on a platform that promised to stay in the euro, yet reverse the pension and public sector reforms that the previous government had enacted, the Syriza-led government was set on an immediate collision course with the Troika. Although a last-minute extension to the bailout programme was agreed upon at the end of February (now set to expire on June 30) the sharp deterioration of the Greek economy over 2015 ensured the cashflow crisis faced by the government would only intensify. With growth slowing, tax revenues falling and the primary surplus quickly eroding, the reliance on Troika funding has been magnified.
The government has been working under the premise that it is in the Troika’s best interests for Greece to remain in the euro. Meanwhile, the Troika has been adamant that Greece adheres to previous commitments because the country’s failure to do so could embolden anti-austerity parties in other periphery countries. Despite much speculation and false optimism over a compromise, this standoff has endured for the last four months. Greece has been able to meet commitments so far by raiding public sector accounts and by deferring payments to the IMF. The end of the road has now been reached. No money is left, and commitments are due. In addition to the €1.6 billion needed every month to pay for pension and public sector salaries, the Greek government has to meet creditor payments in the two coming months (Exhibit 1):
Without agreement with the Troika and the disbursement of the final €7.2 billion of bailout funds, Greece will default (de-facto, as the actual default will be subject to grace periods). Even if agreement is reached, this in itself will only buy time as it is clear that a further bailout programme will be necessary to tide Greece over for the next few years.
Theoretically, Greece could stay in the euro even if it defaults. However, this scenario is extremely unlikely because a sovereign debt default would quickly transmute into a Greek banking crisis. Since February, Greek banks have been unable to fund themselves via the ECB’s normal financing procedures. Because Greece has a sovereign rating lower than the ECB’s minimum collateral requirement and the ECB deemed the country unable to successfully conclude a bailout review (giving Greece a credit rating waiver), Greek banks have been unable to use the weekly main refinancing operation (MRO). As a consequence, the Greek banking system has been reliant on Emergency Liquidity Assistance (ELA) to cover its funding gap. The rate payable on this is 150 basis points over the normal refinancing rate (1.55%).
Greek bank funding has been increasingly dependent on ELA funding because of the flight of domestic deposits. With uncertainty over the outcome of the standoff between Syriza and the Troika intensifying, and the risk of a Greek exit from the euro growing, bank depositors have done the rational thing and moved money out of the banking system, either abroad or into physical euros (Exhibit 2).
Without ELA funding, the Greek banking system would collapse. This is the pressure point. The ECB controls the amount of ELA the Bank of Greece can provide and whether or not to provide it. With a two-thirds majority on the governing council, the ECB can end ELA funding. As much of the collateral used to access ELA funding is Greek sovereign debt (Treasury bills), following its own rules, the ECB must declare Greek banks insolvent in the event of a sovereign default, and thus, cut off funding.
While such an event would be catastrophic for Greece, it would also impact the rest of the eurozone. Despite the rhetoric that there has been no debt mutualisation and that ELA is a liability of the national central bank (Bank of Greece), the way the European System of Central Banks (ESCB) works is such that the liability does come back to the ECB via its TARGET2 system. As can be seen from Exhibit 3, the Bank of Greece has a liability of €100 billion to the ESCB as of the end of April.
This figure is no doubt larger now as deposit flight from Greek banks has intensified over recent weeks. This is not the only liability that the EU/ECB faces in the event of default. A breakdown of the holders of outstanding Greek central government debt highlights where the potential losses will fall (Exhibit 4).
As a percent of GDP in the context of the eurozone, the potential losses are not huge but would need to be covered from government budgets.
With both sides locked in a game of brinkmanship, and the risks of a Greek default and exit from the euro rising, what scenario do we envisage unfolding over the coming days and weeks?
We believe there are three likely possibilities:
1) Agreement/No Default
Western Asset’s view is that ultimately, an agreement will be reached according to which the remaining bailout funds are released and default is avoided. Simply put, the reason for such an agreement would be that both sides have much to lose if an agreement is not reached. Greece would ultimately have to accept much of the substance of the Troika’s stance, although some weakening of the terms would allow the Greek government to save some face. Already, we’ve seen some progress that appears to be headed in this direction. News emerging over the weekend suggested that a new proposal from the Greek government that included some structural reforms—including on pensions—was being given a cautious welcome by its creditors. Such an agreement may form the basis for a compromise.
The reason for agreement from the Greek perspective is clear. The alternative—a Greek default and ultimate exit from the euro—is not the panacea that some have painted it to be. Unless a structural adjustment programme is undertaken at the same time that a new currency is established, the gains from the ensuing depreciation will prove to be short lived, as we have seen from other experiences. With domestic support remaining high for Greece staying in the euro, the alternative route of a default with the introduction of capital controls would actually be a worse outcome than a “Grexit”. The Greek government would have no way to recapitalise its banking system, and the rest of the EU would be unlikely to do so. The economy, lacking access to the credit creation mechanism, would essentially grind to a halt. Growth would decline and unemployment would rise, making living standards even worse. A new drachma would allow recapitalisation and the hope of recovery, but the short effects would be similar.
For the rest of the eurozone, the impetus for agreement is less financial and more political. If Greece were to default and exit, the long-term viability of the euro would have to be called into question. As ECB President Mario Draghi said, the euro would no longer be inviolable and eternal. By exiting, Greece would open the door for risk premiums to rise for all non-core assets as some compensation would have to be priced in for the possibility of other countries exiting—no matter how low the probability. The euro would no longer be viewed as a stable monetary union, but, more a superannuated fixed-exchange rate regime—a third iteration of the Exchange Rate Mechanism. Politically, this would be a major setback for EU integration and a reversal of its designated aims over the last 60 years. Furthermore, while the direct financial costs are relatively small for the rest of the eurozone, the fact that there has been a soft form of debt mutualisation via the ECB would be politically problematic, especially in those core countries that have convinced their electorates that this is not the case.
Each side is thus incentivised to reach an agreement, the catalyst for which will be when the Greeks run out of money and a decision has to be made. We are very near that time. Could the process still fail? In our view, obviously, yes. National parliaments in Greece and Germany (among others) have to ratify any agreement. This is potentially a risk, but not one that should be overestimated in our opinion.
From the Greek perspective, the risk comes from the left wing of the Syriza party. Any agreement that involves a reduction in pension payments is likely to be resisted by a substantial minority of Syriza MPs, putting Prime Minister Tsipras in a difficult position. Ultimately, he could rely on the pro-euro New Democracy party to provide the necessary majority, which in turn, would ultimately lead to fissure in the governing coalition and the creation of a government of national unity. From an EU perspective, this would make for an easier negotiating partner and would probably result in the speedy implementation of a third bailout.
In terms of a German Bundestag rejection of any agreement, much of this has been based on a perceived split between Chancellor Angela Merkel and her finance minister and fellow Christian Democratic Union (CDU) member, Wolfgang Schäuble, with the latter being more hawkish and less willing to compromise with the Greeks. In terms of the CDU, Schäuble has been an MP since 1972 and was seen as former Chancellor Helmut Kohl’s protégé. Thus, he has widespread respect and support in the party and its sister party, the Christian Social Union (CSU). If Schäuble was clearly against any extension, he would have a substantial bloc of votes that would follow him. Would he force a split in the party? We doubt it. In over 40 years as a party man, although he has been outspoken at times, he has always been ultimately loyal. Why would he risk the CDU’s political hegemony now—even for a Greece deal that, however unpalatable to him, is a minor issue in the context of the wider European economic and geopolitical situation? Aside from this dynamic, could a deal be voted down by other members of the Bundestag? This, in our view, would be unlikely, as Chancellor Merkel could tie it to a confidence vote thus ensuring her MPs rally to her support or, in extremis, rely on the votes of more agreement-friendly MPs from other parties such as the Social Democratic Party (SPD) and/or the German Green Party (the Greens).
2) No Agreement/No Technical Default
Depending on the willingness of the creditor authorities to be flexible in their interpretation of events, Greece could miss paying back its IMF obligation on June 30 and not trigger a default event. This would only buy the negotiating parties a little more time, but may be sufficient to focus minds and ensure an agreement is reached, having stared the abyss in the face.
How would this occur? Despite comments from IMF Managing Director Christine Lagarde that Greece would have no grace period if the 30th June loan repayment were missed, flexibility would surely occur if it was thought time would proffer a solution. Providing the ECB continues to finance the Greek banking system through the provision of ELA funding (decreeing the missed payment as not a default), Greece would be able to stagger on for a while longer. The payment of pensions and public sector salaries would be an issue, but could be overcome in extremis by the issue of IOUs.
On July 20, the Greek government has to repay €3.5 billion to the ECB. If no agreement is reached by then, this would become a catalyst for a decision, for it is difficult to see how the ECB could allow the Greek banks to use ELA if they have been defaulted on.
If this breaks the deadlock, we revert to Scenario 1, if not, we move to Scenario 3.
3) No Agreement/Default
In the event that the EU and the Greek government are unable to reach agreement, and the deadlock is such that the IMF payment is missed or there is a failure to redeem the ECB’s bond holding and a default event is triggered, we would quickly move into an environment of Greek capital controls and eventually the introduction of a new currency. As previously stated, capital controls would have to be introduced to prevent further domestic bank deposit flight, although the banks would still be insolvent as the ECB would withdraw ELA support. With no resources to recapitalize the banks, the Greek government would quickly have to move in issuing a new currency, at least in parallel form. With cash heavily restricted and the black market economy increasing, the near-term economic outlook for Greece, in our view, would be one of recession, higher inflation and a sharp decline in living standards. Over the medium term, assuming structural reforms are pushed through, increased international competitiveness should allow the economy to recover somewhat, although domestic demand would remain depressed.
For the eurozone, the risks are primarily via contagion to the periphery. With the euro taking on the appearance of a fixed exchange rate regime, in our view, risk premiums on periphery bonds would rise. Similarly, damaged confidence and the prospect of a slowing eurozone economy would see pressure put on equity and credit market valuations. Unambiguously, we believe this would be limited in its extent and, as such, present a clear buying opportunity. The ECB has already witnessed a tightening of monetary conditions via the rise in European bond yields and the appreciation of the euro. Therefore, any prospect of that being exacerbated by a Greek euro exit would prompt swift and decisive action. If Greece were to leave, the ECB would quickly flood the eurozone banking system with liquidity, and to prevent contagion to other periphery countries, enhance or bring forward its quantitative easing measures. President Draghi would not want the good work of the last 18 months, which has put the economy back on a growth track, to be derailed through inaction.