Why an eventual Grexit is still unavoidable

Daily Commentary

Summary: Europe is in the sweet spot right now, with recovery looking like it has taken hold. Greece remains an outlier. The question is what will happen to Greece over the medium- to-  long-term. I believe the answer is an exit from the euro zone. Below are some brief thoughts on why.

I have been relatively bullish on the eurozone for months now, the periphery included.Things looked fairly bleak early in the year as the Cyprus episode exploded onto the scene. But ever since the Cyprus depositor bail-in, most of the news out of Euroland has been positive, in no small part because of the move to backloading austerity, something German Chancellor Angela Merkel has tacitly supported.

When I first sensed in April that Europe was moving to the backloaded austerity paradigm, I first wrote why austerity in Europe will continue due to economic dogma in core Europe, the desire to maintain policy consistency and the fear of government’s without a sovereign currency losing market favour. All of these factors mandated that austerity in some form continue. Nevertheless, it was clear that the facts on the ground had deteriorated so markedly that Europe would be forced to seed ground. Hence the move to backloading, something I explained in a follow-up post in April.

At that time, I ended my post writing that I continue to believe this favours Greece more than anyone else because their bonds have the most room to rally if targets are relaxed. And yes, Greece’s bond and equity markets have rallied a lot, both before I wrote this and since that time. But the market is not the economy. And in Greece the economy is poor. Here are a few macro facts:

• The most recent figures for retail sales in Greece show a 7.8% drop year-on-year through August 2013. For the first eight months of 2013, retail sales averaged 10% below the year ago figures. The retail sector had already shrunk by 34% in the period from 2009 to 2012.
• Greek household disposable income dropped another 9.2% year-on-year through Q2 2013, the latest quarter for which figures are available. Salaries have dropped even faster at a 13.9% rate.
• The most recent unemployment figures show 27.6% unemployment through July 2013, with youth unemployment at 55.1%
• In the latest round of manufacturing PMIs, only Greece and France showed contraction, with Greece registering a declining and still abysmal 47.3. The Greek PMI reached a 44-month high of 48.7 in August but has since gone down. Manufacturing is only 10% of Greece’s economy but the PMI figures demonstrate at once that domestic deman is weak and that an export-led, internal-devaluation created recovery remains elusive.
• According to Price Waterhouse Coopers, Greek non-performing loans are still increasing. The latest PwC figures show 65 billion euros of NPLs. Greek lenders have a capital base of only 30 billion euros, meaning tha Greek banks are deeply insolvent and still dependent on liquidity from the ELA to remain operational. If you recall, the ECB’s threat to shut down the ELA window is what finally triggered the Cypriot crisis. Note that the 65 billion euro figure represents more than 30% of all loans outstanding, a percentage higher than the 25% at the end of 2012 and the 18% at the end of 2011, according to PwC.

This picture is – in a word – bleak. And the reality is that more demand-sucking government spending cuts are in the pipeline in order for Greece to remain in the Troika’s favour and receive funding. Likely we will see a sovereign debt restructuring in 2014, but the policy mix will still be austerity, structural reform, and privatization in exchange for funding. The Greek government believes the Greek economy can eke out growth in 2014 nonetheless. We will have to wait and see if this prediction proves true. But even if it does, the growth will be unspectacular. And this is why Grexit must occur.

If you recall, during the Great Depression, the U.S. economy was cut by a third and unemployment was 25% by the time Franklin Roosevelt got into office in March 1933. The situation was bleak in the U.S., just as it is in Greece today. Roosevelt then commenced with the New Deal, confiscated private gold and cut the U.S. dollar’s tether to gold by one third, reducing the dollar from $20 per ounce to $35 per ounce. We can debate the legality or effectiveness of individual items in this policy mix but what is clear is that the U.S. economy and the U.S. stock market went into a hockey-stick style expansion phase that lasted four years.

In Greece, we cannot expect anything like this. Yes, the EU Commissioner for Regional Policy Johannes Hahn is calling for structural funds to help Greece’s recovery. But that’s the only help I see coming down the pike. Debt restructuring does not add to economic growth, the banks remain deeply insolvent and will not increase credit, and the government spending cuts retard growth. The most Greece can hope for is a tepid upswing predicated on tourism, some renewed export competitiveness.

Thus, in the period after restructuring Greeks will see that there is no way out, that the euro is an albatross around the neck of the Greek economy, strangling the life out of it. And they will look for an exit, either brokered or unilateral. In 2011, Nouriel Roubini predicted that the eurozone could break up over a five-year time horizon and he cautioned that debt restructurings were inevitable, the key question being how disorderly they would be. I believe his piece will come to be prophetic. Restructuring is not going to save the euro unless we see growth in the periphery. And so we remain on a course that leads to a Greek exit from the euro.