Continued European growth and the Greek outlier
Europe is growing again and I see this growth phase lasting a while unless something in the Greek negotiation derails it. And while the Greek negotiations are tense I still believe Greece is an outlier that has indeed been isolated, making the threat of contagion limited.
When I last broached these topics in March, I wrote the following, which I still believe to be true:
“Most of these numbers show a recovery that is gathering steam. This is certainly true in both Germany as an individual country and the Eurozone as a whole. France’s recovery is still somewhat uneven, however. As I wrote 11 days ago about upgrading German and European growth prospects, we are seeing a basing effect in the eurozone, combined with a lift from lower oil prices and a tail risk under-girding from quantitative easing. Think of QE as a bridge to a longer-term growth strategy and the implementation of a more resilient institutional architecture.
“The truth, though, is that we have heard very little of late about changing the Eurozone’s institutional architecture. And that’s worrying because it signals that there is no political appetite for this. And without changes, we are going to be in crisis when the next cyclical downturn hits. The anemic growth in France and Italy as well as the political radicalization assures this.
“Right now, the crisis focus is on Greece. And I think it is fair to say that Greece has been successfully isolated as a special case. If one looks at market-based measures of distress like CDS levels, bond yield and bond spreads, Greece is completely decoupled from the rest of the periphery. So what is happening there is having no market impact. It is the political impact that we need to assess.
“If Greece doesn’t make it through the 4-month bailout extension into a new agreement as I believe is highly likely given the Greek government’s political mandate, we will see a default within the eurozone and capital controls. It is hard to gauge what this means for markets, for the economy or the politics. However, I believe Greece has been well isolated and that a default in and of itself is not something that will lead to catastrophe. If the default does not lead to Greece’s departure from the eurozone, it could end up being the best outcome in that it reduces the NPV of Greece’s loan payments but minimizes redenomination risk elsewhere in Europe.”
I think these points are a good place to start now that Q1 GDP growth numbers for the EU have come in. Growth for Q1 was 0.4% quarter-on-quarter. And those are the best numbers since Q2 2013. This follows a 0.3% growth figure in Q4 2014. The recession in Europe is over now. The big issue for me is France and Italy because these are the two nations that had been growth laggards and both countries are important in terms of European cohesion. France grew faster than the Eurozone as a whole at 0.6% quarter-on-quarter, and better than the 0.4% expected. Italy, which had nine months of recession in 2014 and zero growth in Q4 2014, grew 0.3% in Q1, also better than expected.
At this point, I think we can see this as more than just a basing effect that has been helped along by low oil prices. Instead, we are in the midst of a broad-based recovery in Europe that has legs and should continue, absent large exogenous shocks.
What kind of shocks could throw the eurozone off kilter? The first thing that comes to mind is Greece. We saw Greece’s economy contract 0.2% in Q1. This follows a decline of 0.4% in Q4, meaning that Greece is certainly back into recession again. Economically, Greece has been a disaster for the last seven years.
So the question now is what happens next for Greece. Clearly the economic policies being enacted by the institutions formerly known as the Troika haven’t worked. And just as clearly, the recent political upheaval has caused Greece to slip backwards. There is no way this country can move forward economically without a haircut to its debt. And it is also now clear that there will be no haircut unless Greece unilaterally defaults.
My view here is much as it was in March: the only politically viable outcome is default within the eurozone. If this default does not lead to a Grexit, contagion will be limited. After all, Portugal’s economy is up 1.4% y-oy, 0.4% q-o-q. And Spain’s economy is up 0.9% q-o-q and 2.6% y-oy. Ireland’s figures are not out for Q1, but it grew 4.8% in 2014 and is expected to grow 3.5% in 2015. Greece is a complete outlier, a special case that now has no impact on the real economy of the rest of the eurozone. It can only affect banking systems and bond markets.
Greek banks were active in non-Eurozone eastern Europe. But the IMF is working with subsidiaries of National Bank of Greece, Alpha Bank SA, Piraeus Bank SA in Bulgaria. Greek banks are also active in Romania, Albania, Macedonia and Serbia. But any impact of a Greek government default is going to be limited by what happens to Greek banks and what measures authorities take in these countries. In the eurozone, there is Cyprus, but beyond that, there can be no financial sector contagion.
Also, most of the major credit ratings agencies have said they would not cut Greece’s rating to default if it misses a payment to the International Monetary Fund or to the European Central Bank. This means that the Greek banks could receive ELA from the Greek Central Bank even after a Greek government default, as long as they have adequate capital. The ECB does not necessarily have to cut the Greek banks off.
In my view, the best outcome is a unilateral default within the eurozone because it gives political cover to all concerned. The Greeks can say they tried to get an honourable agreement from their European partners but that the divide was too large to bridge and so they were forced to default. The Eurogroup can claim that Greece was a special case, a recalcitrant debtor that was unwilling to do what was necessary and that the Eurogroup was forced to allow the default for this reason, but that it would work toward a longer-term solution. The ECB can deem the Greek banks still solvent but can claim to be monitoring them even closer to determine if they should still receive ELA. Greece would be in a state of limbo and a haircut by the institutions, so-called official sector involvement (OSI) would finally happen.
If this outcome occurs, Europe can move forward and Greece would remain in the eurozone, having quite well shown the disaster that befalls a country that does not toe the line, which was the goal of the Institutions all along.
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