Some thoughts on the coming defaults of Greece
After the meeting in Riga, it is more clear than ever that the gap between Greece and the Eurogroup finance ministers is wide. Default looks likely and so we have to start thinking about what this means for Greece and for Europe. My base case has always been default within the eurozone but eventual Grexit over the longer-term horizon. However, there are other scenarios in which Grexit happens sooner, and those will be instructive for other peripheral countries when the next eurozone recession hits, particularly Italy.
The assessment by Charles Wyplosz that Greece will probably default is very much in line with my thinking. As I wrote last month, “I anticipate either default in the hashing out of the reform list during the extension or default when the new bailout agreement is under discussion. In short, my base case is Greek default.” But default scenarios vary and my interpretation of what the options are differs from Wyplosz.
There are two principal options here. And because the ECB is the only entity in the eurozone that simulates a federal government, the scenarios depend crucially upon what it decides. In essence, the ECB will decide whether monetary union is invioable.
In the first option, which I consider a base case, Greece defaults and remains within the eurozone. In this scenario, the ECB continues to act as lender of last resort because the large majority of Greek bank assets are not Greek government bonds. And the degree to which Greek government bonds impair Greek bank capital, the Greek government is able to help recapitalize their banks in some fashion. But there will be some key points here.
The ECB would ostensibly refuse to accept defaulted bonds as collateral and this is why ECB officials have repeatedly said that the Greek banks are solvent for now, suggesting that their solvency will come into question were the Greek government to default. The first question is which bonds the Greek government will default on and whether this default makes other bonds held by the Greek banks lose enough value to cause insolvency. Since 85% of Greek debt is owed to the official sector, I believe that the Greek government could default on bonds to the institutions formerly known as the Troika and continue to service other bonds. The test would come via ECB rules on Greek issuance of short-term funding, ECB rules regarding acceptance of any Greek government collateral for ELA and the ECB’s decision regarding Greek bank solvency.
The Greek government might be able to function without issuing 3-month bonds into the market if it uses a parallel currency or currency scrip IOU’s in lieu of currency to make payments. These IOUs would be payable for taxes like the Tax Anticipation Notes suggested by Rob Parenteau in February. However, if the ECB wants Greece to continue in the eurozone, it would have to accept Greek banks as solvent and allow them to continue to receive ELA from the Greek central bank. Deeming the banks insolvent, and, thus, cutting them off from ELA would collapse the Greek banking system and force Greece into a situation that would make Grexit much more attractive.
But even if the Greek banking system collapsed, given that there is no formal mechanism for Grexit, it is still not clear to me this necessarily means Grexit, something that involves a unanimous vote of eurozone members including Greece and the printing a new currency plus thousands of other preparatory moves. This second option, Grexit, would have to, thus, be scripted, not just the currency controls and the scrip but the preparation for the Drachma and the formal voting process to remove Greece from the eurozone, deal with the Target2 issues and with the legal issues surrounding whether contracts made in euros under Greek or European law could be forcibly converted into Drachma contracts at a 1 for 1 ratio. Thus, in my view, it is precipitous to say that Grexit can follow based on an uncontrolled crisis situation, rather than based on a more methodical plodding approach.
When I penned a piece on Greece’s eventual exit from the eurozone in 2013, I wrote the following: “I don’t think it’s a big secret that I believe Greece will eventually leave the eurozone. I have said this repeatedly. But I have also written that I do not believe that Greece would attempt to do so while Europe’s economic crisis is ongoing. Instead I believe that Greece will exit once things have stabilized but it becomes clear that it faces an interminable jobless recovery.
“My view here is very much related to the post I wrote yesterday on Germany’s response to Euroland’s problems. I do not believe that Germany is the driving force of austerity and depression within the eurozone. Instead, I believe the institutional structure of the eurozone is such a straitjacket that it’s hard to find a solution to the euro zone’s economic problems within the existing framework without years of pain. Europe would need to make huge constitutional and operating changes and create even more significant dodges to existing law to prevent another decade of malaise.
“This is a particular problem for Greece given the magnitude of the downturn in Greece and the level of joblessness there.
“The only chance Greece has of remaining within the eurozone is if it can pull of a huge economic resurgence that beats back the populist political wave which will almost surely spell exit as long as joblessness remains so high. I don’t see this happening without significant reform to eurozone institutions.”
In sum, Greece is in a depression. And right now, polls show that the Greek people still want the euro. That changes the longer the depression continues or if it worsens as a result of Greek default and ELA being pulled. AT the same time, the EU wants us to believe the eurozone is inviolable, meaning they will do “whatever it takes” to keep it intact including Greece. This in and of itself means that more support should be forthcoming in some way. Yet, continued depression in Greece will eventually lead to anti-euro sentiment and voluntary exit. In my view, the question is when, not if, as long as the institutional framework and policy directives remain unchanged. If Greece were to leave, it would not be an immediate catastrophe for the eurozone because of mechanisms in place to prevent contagion. But a challenge will come later at the next cyclical downturn.
Now, the path to exit from the eurozone is arduous because there are no mechanisms for getting there. It is a legal and operational quagmire that involves considerable preparation. As a result, Grexit can only occur through mutual consent in a formalized process that takes months if not years. This outcome is instructive for other peripheral nations because it would set a clear path through which to leave the eurozone. Italy comes to mind here.
With zero real GDP growth, weak nominal GDP growth, a lack of reforms and 140% government debt/GDP, Italy will be challenged at the next recession. Recession in Italy, post-Grexit means deficits and debt increases, but to what level? 150%, 160% of GDP? That’s very close to Greek levels today. Would Italian banks be well capitalized? How many bad loans would mount due to recession? Would bail-ins feed a loss of tax revenue? All of this matters regarding contingent liabilities and private sector debt deflation if those contingent liabilities are not met. In the next recession in Italy, someone will have to increase the debt burden to replace the lost income due to souring debt. And if not, the lost income will result in a decline in GDP and tax revenue. Either way, government debt will go up substantially. Redenomination risk will mount because government debt will rise. Bottom line: the next Italian recession post-Grexit would put Italian debt/GDP levels within reach of Greek levels. Redenomination risk will be palpable. And the same is likely true in Portugal as well, but Italy matters more.
If Italy sees the Grexit path having already been paved, the Italexit path will be smoothed. And without Italy, frankly, I think the eurozone comes apart because the euro would appreciate. This would asphyxiate the economies in France and Spain at a minimum, and probably Finland and Austria as well because these are two economies I see as weak links in the core. Finland is problematic due to a low-grade depression and Austria due to government debt, contingent liabilities and a weak banking system.
Thus, even though Grexit may have a limited first order impact in the near term, it would have unintended consequences that would make a disintegration of the euro easier down the line. I believe the ECB understands these risks and is set against allowing the Greek situation to act as a blueprint for eurozone breakup. However, the risk of policy error, as always in crisis situation, remains high.
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