Yves here. Das published this post in February and I thought it would be useful to reprise it for three reasons. First, it has held up well to the passage of time. Second, for latecomers to the Greek saga, it summarizes the background, the stances of the parties, and key economic and financial considerations. Third, the section starting “Controlled Warfare” (about 2/3 of the way through the post) summarizes the consequences to the lenders of a Grexit. Those risks are why almost no one thought we’d wind up where we are now, with two sides issuing ultimatums a mere two days before a possible Greek default, and why most of the financial media still believes a deal will get done.
By Satyajit Das, a former banker and author of Extreme Money and Traders Guns & Money
Not since the era of Aeschylus, Sophocles and Euripides has Greek drama enjoyed such popularity.
Audiences are riveted by provocative dialogue (“immoral beggar”; “fiscal water boarding”), tested themes (a Greek David versus a German and European Union (“EU”) Goliath), modish pop science (game theory) and sex (a Greek Finance Minister who attracts attention in equal measure for his economics as his appearance and sartorial choice). Financial markets watch passively, firmly convinced that the theatrical action on stage is entirely fiction.
The Syriza led government claims the moral high ground. The human cost of Greek austerity is unarguable: an economy which has shrunk by a quarter, 25% unemployment, over 50% youth unemployment, large cuts to income and social benefits, reductions in essential services like healthcare etc. But this ignores earlier actions at the heart of current problems. Greece has been on a long borrowing binge that fuelled consumption and government spending.
Greece resents the humiliating loss of sovereignty to the interfering Troika. But a financially distressed borrower cannot expect its creditors to leave it unsupervised and with full freedom of action.
The EU, led by the Germans, is also convinced of its moral position. Agreements must be honoured, particularly since two assistance packages have been provided. Germany refuses to acknowledge that its large savings and trade surpluses contributed to the excess borrowing and spending in Greece. Lenders were recklessly indifferent to risk in making loans. Bailouts benefitted banks, particularly from Germany and France, with less that 10% of the €240 billion bailout going to Greece. Europe refuses to accept that it allowed Greece to fudge its way into the Euro. It cannot countenance that a single currency without full political and financial integration was a bad idea.
Confusingly, the Greek want to write off debt but also want to continue as members of the EU and the Euro. No one here has clean hands.
The initial action has focused on a temporary extension to the existing bailout which expires on 28 February 2015 to allow time for fuller negotiations. Greece sought a bridging loan but not an extension of the existing arrangements with its deeply resented conditions.
Syriza did not want to be associated with the measures of previous governments which are blamed for Greece’s economic slump. It sought to stop asset sales, increase the minimum wage and some pensions, rehire dismissed public servants and reverse some labour reforms. But such changes to existing arrangements unlike an extension would require parliamentary approval in Germany, the Netherlands, Finland and Slovakia, with uncertain outcomes.
After several iterations, on Friday 20 February 2015, Greece and its creditors agreed to possibly agree to a tentative four-month extension of Greece’s existing bailout program but only if certain conditions were met. The extension commits Greece to completion of a review by the Troika as well as continuation of austerity programs and existing reform measures. There is no debt relief.
In return for conditional funding from existing programs, the Greek government has been forced into an embarrassing somersault in its position. Greece’s finance minister sought to portray the deal as mutually beneficial and allowing Greece greater freedom of action. The German Finance Minister was closer to the mark when he gloated that the Greek would have a difficult time explaining the deal to their voters. The problem has been resolved for somewhere between a few days and 4 months.
Greece’s debt is not the immediate issue. Interest expense excluding deferred interest is around 2.6% of gross domestic product. This compares to 5% for Italy and Portugal and 3.3% for Spain. The interest rate on loans from the European Financial Stability Fund which make up 45% of its debt is around 1.50%.
Greek debt is generally long term with an average maturity of over 16 years. Some bailout loans mature in 2053. Greece has around €22.5 billion of debt repayments this year, primarily €4 billion owed to the International Monetary Fund (“IMF”) in March 2015 and €11.4bn owed mainly to the European Central Bank (“ECB”) in June, July and August 2015.
However, Greece is unlikely to be ever able to pay back its current borrowings. No amount of semantics and pettifoggery can disguise that fact which has not changed since the start of the crisis. What cannot be paid back will not be paid back.
The real short term concerns are capital flight, the banking system and Greece’s current cash needs.
Total capital flight is estimated as €25 billion since December 2014 (about 8% of GDP). Withdrawal of deposits from banks is running at around €2 billion a week but accelerating. Greek banks are dependent on funding from the ECB to meet these outflows. The banks also rely on ECB funds to purchase Treasury Bills needed to finance day to day government operations. The Greek government’s insistence in public statements that the country has a solvency not a short term cash flow problem is awkward, even if it is true. Theoretically, the ECB cannot finance Greek banks if they are insolvent, which would deepen the crisis.
On 4 February 2015, the ECB stopped accepting Greek government debt as collateral in its monetary policy operations, eliminating Greek bank access to cheap loans. At the same time, the ECB agreed to provide increased funding access to Greek banks through its Emergency Liquidity Assistance (“ELA”) program at higher interest rates. Withdrawal of the ELA assistance (currently near its cap of €65 billion) would precipitate a collapse of the banking system.
Greece also needs €30 to 50 billion this year for normal operations and to repay maturing debt. In effect, it needs new funding without which any bridging arrangement would lead nowhere.
This short term cash requirement and the ECB’s tactical manoeuvring, effectively acting as the EU’s enforcers, may explain the embarrassing and politically risky back down on the temporary extension.
Under The Skin…
The effects of austerity and the shrinkage of the economy are one problem. Greece fundamentally suffers from a lack of revenue.
Tax collections fell in anticipation of a Syriza victory expected to reduce tax liabilities. The present government has resolved to tackle tax avoidance and improve revenue collection. While desirable, in a world of mobile capital, it is difficult to see this having any short term impact. The Greek government expects to raise more than €5.5 billion from tax reforms and better enforcement. But it also plans to write off over €70 billion in unpaid penalties against taxpayers.
Greece is internationally uncompetitive. Even in tourism in which it enjoys advantages, it struggles to compete with Turkey and other Mediterranean resort destinations. In part, this is the result of the Euro cost base which compares unfavourably to the weak Turkish Lira.
Since the commencement of the Greek crisis, internal devaluation, mainly through lower wages, has reduced costs by around 15%. But this has not resulted in a significant increase in exports. The correction of Greece’s current account deficit reflects the collapse of imports due to a shrinking domestic economy rather than higher exports.
Outside of tourism and some agricultural produce, Greece simply does not have much to export. Higher energy costs (driven by excise taxes and electricity rates) and (in recent times) lack of bank credit reduce competitiveness. Weak global demand is unhelpful to Greek export prospects. As a result, Greek goods exports are 17% of GDP, much lower than Germany (38%), Portugal (29%) and Malta (37%). Only Cyprus at 13% within the Euro-zone is lower.
Extensions and debt negotiations do not deal with the problem that Greece has insufficient revenue to meet its spending commitments. They merely defer the problems.
No Good Options…
Greece’s choices are fairly clear.
In the first option, the EU makes allowances. Maturities of borrowings, especially near term commitments, are extended. There are concessions on interest rates. Existing debt may be replaced with securities without maturity and a coupon linked to growth, so called Keynes-style Bisque bonds. The required primary budget surplus is reduced, perhaps with some new investment from the EU to boost activity. The ECB continues to support the liquidity needs of the Greek banks. The hated Troika becomes the ‘institutions’ to remove the odious association with the past.
Despite the reduction in the economic value of the debt outstanding, the EU and lenders avoid a politically difficult explicit debt write down. Syriza can claim to have fulfilled its mandate to stand up to the EU and Germany and reclaim Hellenic sovereignty and pride.
In reality, little changes. Professor Stephen Lubben has pointed out that the Bisque bonds are similar to securities used by the original J.P. Morgan to restructure insolvent American railroads in the Gilded Age. Many of these restructurings failed as the borrowers were left with unsustainable debt levels and were unable to obtain new financing.
Under this scenario, Greece and the EU are back at the negotiating table, within 6 to 12 months, confronting the same issues.
In the second option, Greece defaults on its debt but stays in the Euro, an option originally favoured by the current Greek Finance Minister when he was a mortal academic. It is not clear how a defaulted nation can remain within the Euro other than the fortuitous absence of an ejection mechanism.
Greek banks collapse if the ECB decides to withdraw funding. Capital flight accelerates, forcing implementation of capital controls. The Greek government is left with no obvious source of funding of its operations, other than a parallel currency or IOUs used during some government shutdowns in the US. Greece’s competitive position is unchanged as it purports to use the Euro. The EU and lenders incur immediate substantial losses on their loans.
In the third option, Greece defaults and leaves the Euro, replacing the common currency with new Drachmas. It defaults or its equivalent, repaying nominal debt in the new weak currency. Domestic banks have to be supported by the Greek central bank. There is short term chaos. Activity in Greece collapses. The EU and lenders face the same problem as in the second option. In addition, the Euro is destabilised.
The third option allows Greece to regain control of its currency, money supply and interest rates. Sharp devaluation of the new Drachma improves competitiveness, for example in tourism. The ability of the central bank to create and control money supply helps restore liquidity to the banking system and provides a mechanism for financing the government.
A cheap new Drachma, if appropriately managed, may reverse capital flight, as the threat of a loss of purchasing power is reduced. A devalued currency may help attract inflows of funds looking for bargains. In time, Greece regains access to capital markets as Russia did after its 1998 default.
Greece regains economic sovereignty but at the cost of reduced living standards as import prices sky-rocket and international purchasing power is diminished. But after the initial dislocation, and with the implementation of correct policies, a strong recovery may ensue.
The fourth option entails Greece caving in to EU demands, continuing with the mandated bailout terms and adjustment program, that is austerity. Syriza may be able to manage the backlash against its concession on the short term extension. But continuing failure may result in internal and electoral problems, triggering a collapse of the governing coalition. In turn, new elections take place.
Syria may return with a specific mandate to default and leave the Euro. Alternatively, disillusioned with the main parties and now Syriza, Greeks ay turn to the fascist, rabidly anti-Europe and anti-Euro Golden Dawn party. Civil disorder and societal breakdown may occur. A reversion to military rule which only ceased in 1974 cannot be ruled out. The underlying economic problems remain.
Given the effects of existing policies, Greeks are unlikely to be threatened by continued or further hardships. They may be willing to bear pain and make great sacrifices provided there is longer term hope for themselves and the country.
EU and German negotiating stance that a Greek default and exit from the Euro (“Grexit”) is manageable is akin to Dr. Strangelove’s belief in survivable thermo nuclear war.
With around 85% of Greek debt owed to official lenders, Grexit would immediately trigger significant losses on bilateral government loans, ECB holding of bonds, the loans made by bailout funds and under the TARGET settlement system. The total amount at risk is around €256 billion. The exposure of Germany, France, Italy, Spain, the Netherlands and Finland are €73, €55, €48, €33, €15 and €5 billion respectively.
Losses would convert off-balance sheet contingent guarantees into actual cash outflows. If Greece defaults, the EFSF, for example, will require each guarantor to make fiscal appropriations to cover any deficiency. The ECB may need to be recapitalised. The potential losses are significant relative to individual countries resources and budgets, especially for Spain, Portugal, Ireland, France and Italy which face their own financial problems. Covering shortfalls would make it more difficult for all nations to meet their EU mandated budget and debt targets.
The political cost would be greater, as the voters realise that the true implications of the bailouts and their exposure to losses were not fully disclosed by their politicians and technocratic elite.
Grexit would trigger capital flight from other vulnerable nations. Depositors would not place reliance on weak governments, an unfunded deposit insurance scheme and potential ECB support. Access to money markets for nations suspected of being exposed would fall. Borrowing costs for these countries would increase.
The Euro would become volatile, driven by speculation of its future composition and value dynamics. If the assumption is that the Euro becomes the new Deutschemark for a smaller Euro-Zone group, then it might appreciate sharply, reducing German export competitiveness.
The effect on the real economy and trade is difficult to forecast. Volatility and uncertainty would be bad for investment and consumption.
The effect on European domestic politics may be significant. Even though it is not part of the single currency, the current problems impact upon the UK elections and the prospects of Euro-sceptic parties such as UKIP. In France, Germany and Finland, it provides impetus to nationalist anti-Euro parties such as Front National, AfD and the True Finns.
In Spain, Podemos, which has similar positions on some issues as Syriza, are leading the two major parties in polls for an election later in 2015. Developments in Greece are also relevant to anti-austerity advocates in Portugal, Ireland, France and Italy.
Once Greece defaults and/or leaves the Euro, it would be difficult to stop speculation about other peripheral nations, undermining the entire basis for the common currency. Even without a full Grexit, any concessions to Greece would result in other countries such as Ireland, Portugal, Spain, Italy and France seeking relaxation on budgets and reform. Debt and fiscal sustainability within the Euro-zone would become unachievable.
There are now no more good options left for Greece. Whatever the outcome, the unwillingness of Europe to face reality means that problems will fester, dooming the continent to prolonged stagnation or worse.