Making Sense of Another Greek Threat To Leave the Euro

There has been a great deal written on Greece in the recent weeks. Normally, I refrain from writing about any subject when it gathers all the attention. For one, there isn’t much that I can say that is already said. But above all, it takes me a while to get a grip on events and take a stance. Yes, I do take a stance every once in a while.February was a month when Greece was the word in global markets and crisis vocabulary found a new addition – Greek Crisis 2.0. The stalemate ended with Greece managing to wrangle a deal or something like that with its creditors in the last week of February. My friends in the European bond markets kept reassuring me that a deal would happen. Quite bizarre indeed when there were so many political twists and turns. And so there was an agreement signed between Greece and the EU after three weeks of high drama and lively negotiations. The deal extended the surviving loan agreement and gave Greece four months of guaranteed finance in return for a declaration that all obligations to creditors would be met ‘in full’ and ‘on time’. It was agreed that they would aim for an ‘appropriate’ primary surplus – the difference between what is collected as taxes and what is spent on things beside interest payments. And while the Syriza party came to power on the strength of promises to lower taxes, raise the minimum wage, reverse privatizations and offer humanitarian relief, they had to return with a cease and desist order on most. What surely did tire an already weak hand in negotiations was an imminent bank run and capital flight in Greece. Here’s what the Financial Times had to say:

‘Greek companies and households pulled €7.6bn out of their bank accounts during the government’s standoff with its international bailout creditors in February, driving deposits down to €140.5bn — the lowest level in 10 years. Although the withdrawals were lower than in January, the €20.4bn pulled out over the two months shows how close Greece came to a full-scale bank run before Athens reached agreement with eurozone authorities to extend its €172bn bailout into June.

Originally, Greece’s EU rescue programme was due to expire at the end of February. Repeated failures by the new Greek government to reach agreement with eurozone creditors led to a rapid speeding up of capital flight. Officials said that in the days before an extension deal was reached, almost €800m was being withdrawn from Greek banks every day.’

I believe that the Syriza government had to pay a high price for staying alive. Some like Paul Krugman in this post opine that Greece came out of the negotiations pretty well but the big fights are yet to come. But everyone is unanimous in their view that

  1. The economy is clearly in a deflationary spiral with little or no fuel left to reverse the flow.
  2. The only positive sign that the Bank of Greece reported was a primary surplus of +2% of GDP. Clearly this will contract – many analysts believe that Greeks are delaying payment of taxes in anticipation of relief after the new Syriza government took office.

In this background, the EU insistence on austerity and primary balances is madness. But the charade has been going on for so long now that it’s almost like an old gramophone record stuck in a worn out groove. I wish to expend more energy on this topic in a series of future posts (yes, one will not suffice. The tale has too many twists) but I’d like to focus here on a more recent development.

Following the excitement of March, I had once again settled into the belief that a new era of the old extend and pretend games had begun when newsbytes came up with a bolt from the blue. Last week, Ambrose Evans-Pritchard at the Telegraph came out with a piece that was ominously titled – Greece draws up drachma plans, prepares to miss IMF payments. So, Greece owes the IMF around € 462 Million on April 9th. A few days thereon, € 1.4 Billion in T-Bills come due followed by a further € 1 Billion. Come 1st May, the IMF is owed a further € 202 Billion in interest. That’s a little over € 3 Billion that Greece needs to fork out between April and May. However, as per the Telegraph, Greece will not be able to do good on the very first payment to the IMF. That is until it has to skip on paying salaries and pension dues. The piece has some quotes from unnamed sources within the ruling Syriza party. Sample this

“Syriza sources say they are fully aware that a tough line with creditors risks setting off an unstoppable chain reaction. They insist that they are willing to contemplate the worst rather than abandon their electoral pledges to the Greek people. An emergency fallback plan is already in the works.

We will shut down the banks and nationalize them and then issue IOU’s if we have to, and we all know what this means. What we will not do is become a protectorate of the EU”

Now, the idea of Greece leaving the Eurozone is hardly news. Indeed, the Greeks have made veiled threats to the effect on many occasions. The financial press too has been plotting the ramifications of a ‘Grexit’ for quite many years now. But I believe this time, the press leak is a bluff and worse still, looks like a poorly executed extortion gambit. It only suggests the desperation of Greek negotiators to remain within the Eurozone at all costs but at the same time wriggle out concessions from official creditors.

For one, it is no surprise to anyone that a large majority of Greeks love the Euro. Their biggest fear is that quitting the Eurozone might precipitate a vicious downward spiral. After all, they’ve had plenty of bad experience with the Drachma. It’s no secret that they fear the return of the Drachma as much as the Germans yearn for their Deutsche Marks. A new Drachma would very quickly devalue against the Euro as the central bank is forced to print money to pay salaries and keep the insolvent banks going.  Devaluation will cause the price of essential imports to skyrocket and standard of living to fall further. Greeks who have foreign debts to repay in Euro’s would be instantly worse off. None of this sounds pretty. There’s no doubt that in the longer term devaluation will help the economy regain some lost competitiveness and help in putting idle real resources back to work. However, this argument is convincing to the economists. It will not cut ice with the Greek people and no political coalition will want to take a unilateral stance against majority public opinion. Then of course you have government officials and politicians for whom pension payouts in a currency other than the Euro is cause for serious heartache.

But there’s another reason for me to believe that the bluff is going nowhere. Back in 2011-12, the markets would react disastrously at the mere mention of the word Grexit and EU officials naturally gave a lot of credence to markets. After all, the very design of the Eurozone meant that each member state was at the mercy of the bond markets to fund their fiscal deficits. At the time, the German minister of Finance – Mr. Wolfgang Schauble had overtly pushed for a Greek exit. But as markets across the Eurozone boiled, Angela Merkel capitulated and overruled Schauble’s campaign. The feeling then was that Germany and other Eurozone nations would not be insulated from pandemonium that would follow. In stark contrast, both bond and equity markets are rather sanguine. According to a recent Bank of America – Merrill Lynch fund manager survey a record net 60% of fund managers were overweight on European equities in March, up from 20% in January. The confidence has shown up in the Eurostoxx 50 index going up by around 19% since the beginning of the year. As for the bond markets, we have nearly € 2 Trillion of debt issued by European governments currently trading at negative yields. Some might call it a derangement and I would like to believe that this is the result of the European Central Bank destroying every semblance of honest price discovery by embarking on its own version of Quantitative Easing (QE). It is also no surprise that markets are calm because relative to 2011-12, the country’s largest creditors are the ECB, IMF and the Euro Group. Of the € 317 Billion debt load, just around € 68 Billion currently trades in the market. What all this means is that if markets do shrug off Greece leaving the Eurozone, the negotiators have little or no leverage. By the same token, it would please them to see a rise in yields of Spanish, Portuguese and Italian bonds relative to German Bunds.

Now, with this knowledge at hand should one be concerned of a contagion in markets? Surely the Greek equity markets will have to settle in for a tumble but I can only think of one angle to explain the chances of a of a broader Euro debt market crisis. In finance, the theory of reflexivity states that investors’ and traders’ biases can change the fundamentals that assist in determining market prices. The theory was propounded famously by George Soros. Let’s take a generic example: When investors consider the world to be a low risk bet, they rush to buy assets that are initially priced attractive. At some point it would be normal to borrow and supplement their capital. Cheap leverage and low risk build up expectations of high profits. However, their buying would drive up the cost of assets, transforming their low risk strategies into high risk ones. The belief that an asset/strategy was safe led to investor behaviour that made it unsafe. This is reflexivity.

Returning to our context, markets could be calm because

  1. They expect the Northern European nations and the ECB to resolve the crisis and prevent any disorderly/accidental withdrawal of Greece from the Euro.
  2. Alternately, markets could be ebullient because traders are accumulating, not selling in anticipation of the ECB’s monthly bid of $ 70 Billion hitting the market in the weeks ahead.

Back in 2012, EU officials took to the hills when markets got volatile. But what if EU officials have misread quiet markets this time as a sign that defenses are strong enough to withstand a Greek exit and so act in manner that cause the event to happen? If markets are calm because of the QE bonus or because of their misplaced trust on the EU powers, there will be contagion. For now though, the answer is a mystery.

I believe that the design of the Eurozone has caused imbalances to proliferate and none of these can be justified to sustain a common currency in the name of a political project. It’s not just Greece but the entire European periphery that is suffering the consequences of these imbalances. It is also my belief that creditors to Greece have to take a hit (and will in all likelihood do so) on repayment to allow Greece a shot at orderly recovery. In fact, I am convinced that EU officials are well aware of this. They’re just playing for time before tax payers can be saddled with the news. The truth lies here – The net present value of Greek debt that attracts virtually zero interest rates is considerably lower than the current value of outstanding debt. But for now, it does seem that the drama, press leaks and conspiracy theories will endure.

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