James Bevan: Options for Greece

Hardly a surprise that we need to write about Greece with the Greek central bank urging the country’s leaders to agree to a deal offered two weeks ago, or risk an “uncontrollable crisis” that could force the nation out of the EU. According to the Financial Times, the bank wrote: “The Bank of Greece firmly believes that striking an agreement with our partners is a historical imperative that we cannot afford to ignore”.

Meanwhile, If the latest press reports are to be believed, the IMF, Berlin, Brussels and the other representatives of Greece’s creditors have become increasingly perplexed, or quite simply angry, about Greece’s negotiating stance ahead of what is being billed (yet again) as an eleventh hour attempt at forging a new “deal”.

The fact remains that Greece, in all probability, will never be able to generate the type of sufficiently large current account surpluses that would, in theory, enable it to repay all of the debts that it incurred during the ‘boom years. These are debts that the European Central Bank’s own interest rate policies had encouraged the country to take on in the first place during the late 1990s and 2000s.

Indeed, this is something that is no longer a “theoretical discussion”. Greece’s economy is already almost a third smaller than it was in the mid-2000s but, despite the implied collapse in domestic demand, the country has still not been able to produce anything like the levels of current account surplus that it needs to make a significant dent in its current debt burden.

Most measures of Greece’s economic suffering will concentrate on the 27% fall that has occurred in both real and nominal GDP in Greece since 2008, or even the 47% fall in dollar denominated GDP since the beginning of the global financial crisis. Others may prefer to look at the 32% decline in industrial production as a yardstick. But for the Greek population as a whole we can suspect that it is the 24% decline in employment, the 10% decline in real expenditure on healthcare, the rise in the death rate to its highest level since WWII (this can only partially be explained by the ageing population) and even the drop in defence spending of a third in nominal terms that matter rather more. Against such a background, with a restive domestic political climate, it is not surprising that that Mr Tsipras has appeared so combative to some.

To put Greece’s problems in context, its position is, perhaps, four or five times as bad as that of Thailand in 1997, and even Thailand needed not only a decade of adjustment, though also a massive devaluation, before it was able to emerge from the chaos that had in part been caused by its previous adherence to a fixed exchange rate regime.

Greece, we would argue, has no chance of outperforming flexible, perhaps less democratic, Thailand in the austerity stakes. We would argue that it should not even attempt such a monstrous feat. Quite simply, Greece is facing “mission impossible” with regard to repaying its debt in any of the negotiators’ likely life times.

We can assume that the Greek and other negotiating authorities know and understand these realities. But politicians in Europe cannot admit this for fear of annoying both their financial institutions and even their voters that simply do not want governments to appear to throw good money after bad. Europe’s wider population has, of course, been sold the notion that it is Greece rather than the whole Euro system that is at fault in this crisis. So the authorities in the core countries probably feel that have to continue to blame Greece and to continue to push for the impossible outcome of Greece repaying its debts “in full”.

But the stark truth is that not only did Greece borrow too much money, but the world lent Greece too much money and so reasonably there should be some burden sharing between creditor and debtor. Society has no problem in accusing the overly indulgent parent of an obese child that doesn’t know any better when it tucks into a third burger of neglect, and markets were equally negligent when they lent more money than Greece could ever hope to repay.

The country’s banks, institutions, government and even its population were not entirely innocent, but they were not the only ones at fault. To date, the sacrifices have been almost all on Greece’s side and against such a background it’s no surprise that Greece elected their current combative government.

Yes, Greece should attempt to repay some of its debts; it clearly does need substantial reform of its working practices, tax policies and pension system. It should face some further austerity over the medium term and a weaning from its considerable debt addiction. But these policies should be framed in a wider social context. Greece may not be being crucified on Keynes’ “cross of gold” but its continued membership of the Euro, and the demands of its creditors, are exacting a huge toll on not just its economy but its social fabric. The sustainability or otherwise of this quite frankly ridiculous situation may well be decided today or at least within the next few days.

The Choices Facing Greece & Europe
The first part of the “prediction game” is relatively easy: Greece and its counterparties need to manage some form of default on 30–50% of its external debt either by an explicit write-down or via a redenomination of the debt. Losses of this scale aren’t attractive to lenders but if current policies are maintained, Greece will probably end up defaulting on two thirds of its debt (as its economy continues to shrink) and so it would be better to finally stop kicking the can down the road and reach a conclusion with a bipartisan agreement. Failure to do this will likely result in unilateral default in a few months’ time.

Dealing with Greek competitiveness is much harder. From Greece’s point of view, it could be relatively easy to close its banks for two to three days and then re-open them with a freely floating drachma having, in the meantime, passed the sufficient legislation to convert all contracts that had been enacted under Greek law from euros into drachma at some convenient but, in a sense, largely arbitrary exchange rate (perhaps 10 – to – one).

Real household incomes and wealth would fall considerably in the ensuing depreciation of the currency but at least the economy could function thereafter and would start again with a new more competitive exchange rate. New binding monetary and fiscal rules would need to be introduced to support the currency over the longer term and to prevent the repeating of past mistakes, but whilst the first week of the ‘event’ would be traumatic, other economies have suffered these types of events (Europe 1930s, LATAM 1980s, and Asia 1990s) and survived.Many have prospered and all of them have long since found their way back into global capital markets.

The bigger problem with ‘GREXIT’ is for Europe with a spread of secession risk across not just the long end of the bond markets (which would by itself make it more expensive for other European countries to remain in the system) but also in equity markets and, most importantly of all, at the short end of the yield curve. Thus if one country were to leave the Euro, then presumably every creditor bank in the Euro System would want to know the nationality of its counter parties and charge differential rates accordingly.

This would not imply the end of the single currency per se (banks used to charge differentiated rates when lending to other banks within the Yen interbank markets during the late 1990s and the JPY survived). But it does imy that the ECB would probably have to nationalise/underwrite the interbank markets at a time in which, in all probability, the latter would need to mobilize huge funds as nervous savers in other perceived weak economies attempted to move their savings into the core countries’ banking systems.

Under this scenario, the strain on the TARGET2 and Emergency Liquidity Assistance (ELA) systems might be immense. In theory the ECB could manage these problems but the politics might be messy.

For the UK, USA or even Japan and Asia, we may suspect that any fall-out from such a situation, although unpleasant in the near term, could be managed by the authorities given their central banks’ existing abilities to become both lenders and dealers of last resort when necessary. We may be more nervous about the ECB having either the nous, ability or even mandate to provide sufficient funds and “market liquidity” in times of crisis.

We can therefore fear GREXIT not from Greece’s point of view but from what it might do to an unprepared and inherently fragile European Monetary System. For this reason we still hope or expect that at the wire, Europe will find itself, however reluctantly, obliged to agree to some form of pretend and extend form of debt default, coupled with continued Greek membership of the Euro that is itself made possible by large fiscal transfers from Europe into the still uncompetitive Greek economy.

Given Greece’s lack of competitiveness, the country cannot be expected to prosper inside the Euro unless the EU/EIB or some other entity invests not only in Greece’s infrastructure, education system and other key areas but also provides long term support for its balance of payments despite he still overvalued real exchange rate.

Conclusions: Market Outcomes
With this analysis in mind, can construct a number of potential outcomes to this week’s discussions and below we rank them in order of their “financial market friendliness”.

i) Market Friendly
A thinly disguised Greek default (pretend, extend and then ultimately forget). This would be coupled with continued Greek Membership of the Euro and a pledge for significant “investment funds” (i.e. quasi equity flows) from the EU and IMF that can both improve Greek productivity, and support its balance of payments despite the overvalued real FX rate. In return, Greece promises moderate economic reforms. This would be a hard sell to Europe’s electorate but in reality the best possible outcome for markets.

ii) Less Market Friendly but Acceptable in Short Term
Negotiations begin on debt forgiveness but have a suitably long deadline such that the world eventually loses interest. The IMF/EU provide more emergency funding for the economy in the near term, Greece remains in Euro and commits to moderate reforms. This is can-kicking but the markets might approve even now. Within this scenario, Greece might even be allowed some form of internal parallel currency arrangement for public sector payments.

iii) Market Unfriendly
Greece defaults on its debts to foreign private sector creditors but remains in the Euro – a default does not have to result in GREXIT but the implied failure to address the competitiveness issue ensures that the Greek economy remains weak and therefore a degree of uncertainty remains over the medium term.

iv) More Market Unfriendly
Greece defaults on its private sector creditors but reaches workable agreement with its public sector creditors, GREXIT occurs but there is a successful re-introduction of drachma and Greece repays TARGET2 and ELA funds at par despite the depreciation. Under this scenario, contagion fears spread through European financial markets and there is deposit flight in the other peripheral countries but the system essentially survives intact. The uncertainty factor drives European markets down 10% at their lows.

v) Disaster Scenario
Greece defaults on public & private sector liabilities including TARGET2 & ELA. GREXIT occurs, Greece’s financial system freezes even temporarily, and as a result some systemic failures occur within the European financial system that the ECB cannot easily contain due, in part, to the political constraints that are likely to be imposed following a Greek TARGET2 default. Significant collateral damage to global financial system although the more market-savvy central banks contain worst of the crisis. Future of EMS thrown into doubt by breakdown of TARGET2. Euro falls adding to global deflation worries, Europe enters new recession casting doubt on the entire Euro project.

We can suspect that quite rationally markets have been expecting one of the top two outcomes to occur. But that’s not assured. What we can say is that given Greece’s situation, its government has an incentive to push for the disaster scenario, if only to force its counter parties into being more accommodating.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla