While the Greek debt crisis has caused global markets to plunge and economies to decelerate, there’s nothing particularly new about this brand of financial collapse.In fourth century BC, the Delian League, an association of 13 city-states that made up Greece, had borrowed money from the Temple of Apollo and hit financial troubles. Dionysius, ruler of the city-state of Syracuse, came up with an innovative solution to the debt problem. He recalled all the money and simply doubled the denomination of each coin, thinking Syracuse would be rich again. Except that it wasn’t. A virulent inflation ensued, wiping out all savings, and the 10 city-state, nevertheless, reneged on their loans with the temple taking an 80% haircut on the debt – the first recorded incidence of sovereign default.
Twenty-four centuries and multiple defaults since, Greece is once again on the brink biggest sovereign default and policy makers are worried about global shock waves of insolvency by a government with a debt of €353 billion ($483 billion) – five times the size of Argentina’s $95 billion default in 2001.
Why is Greece in Debt? The Genesis....
Greece was living beyond its means even before it joined the euro. The membership, therefore, allowed the government to refinance its debt at even more favorable terms – the ratio of net interest costs to GDP fell by 6.5% in the decade after 1995. But the government’s failure to consolidate the fiscal position together with a low interest rate regime fuelled a strong consumption and property related credit boom. Public spending rose 50% during 1999-2007 and the country also accumulated staggering debts by paying for the 2004 Athens Olympics. This spending splurge coincided with the securitization boom in international financial markets which meant money was on call by issuing securities, because markets treated debt of all Euro members identical and indirectly guaranteed by stronger member states. Low retirement age, generous pensions and rampant tax evasion further compounded the problem.
However, a strong GDP growth of about 4% until 2008 masked the fault lines within the public finances. The public debt ratio declined, not because debt was curtailed, but because GDP in cash terms grew faster than debt, and because government managed the books to meet the fiscal deficit target of 3% of GDP, required of members of the Eurozone. But this did little to cool the economy. Inflation stayed above the euro-area average, hurting Greece’s competitiveness, and thus creating a persistent current account deficit (CAD) that widened to 14.6% of GDP in 2008, meaning the economy increasingly relied on dollar borrowings to finance imports.
The Crisis…
The reliance on short term external borrowing proved costly for Greece when cross-border flows dried up with the onset of global financial crisis in 2007. But shielded by euro membership, it could still borrow easily, if not as cheaply. And there was the European Central Bank (ECB) support in terms of lower interest rate and access to euro and dollar liquidity to withstand the recession. However, by 2009 Greece’s concealed debts were out in the open – actual budget deficit was around 13.6% instead of 3.6% as reported earlier. With falling credibility and rating downgrade, Greek yields began to spike, markets refused to roll over Greek bonds, and the country faced a debt crisis.
The Troika Therapy: Austerity….
The troika of European Commission, International Monetary Fund (IMF) and ECB provided two bail-out packages totaling €240 billion during 2010-12 to help Greece pay its creditors till June 2015. Apart from these soft loans (i.e. low interest rates and extended maturities), Greece’s private sector and European banks took haircuts on their debts, amounting to approximately €40 billion. But the bail-out was contingent on Greece undertaking structural reforms (privatization, rationalization of minimal wages, generous pension system, tax receipts etc.) to boost growth, and imposing austerity measures, that involved sharp tax hikes and deep spending cuts, in order to repay the reduced debt by running a primary budget surplus (i.e. budget balance excluding interest payments) equivalent to 3% of GDP.
The bailout protected the Eurozone investors (particularly banks) from the brunt of default by transferring Greek debts from private to public hands. And even though, officials privately acknowledged that the burden would have to be halved if Greece is to emerge from the economic mire, a haircut of that magnitude could potentially wreck the finances of other members of the bloc.
So while the bailout kept the cash flowing, large scale spending cuts had a devastating effect on the purchasing power and deepened the slump. Yet fearing the consequences of default and eventual exit from the Eurozone the political establishment continued with the austerity program year after year. And when creditors demanded yet more austerity – on a scale that might have driven unemployment to 30% – the nation, in January this year, voted for left-wing coalition Syriza that vowed to renegotiate the bail-out conditions and end the austerity nightmare.
The Gridlock in Eurozone….
The deep rift between Athens and its European creditors meant that negotiations are in disarray, thereby triggering a state of uncertainty, even as the country races against the time to reach a new financial deal. Primary reasons for the stalemate are:
Differing Demands: Athens, suffering with austerity fatigue, demands more cash but easier terms (a smaller primary budget surplus target of 1-1.5% against 3% being demanded by its creditors) along with a partial rollback of austerity measures. Doing so effectively means a fiscal stimulus, which they claim, will allow the economy to grow more quickly, boost government coffers and thus create a virtuous circle. Consequently, it proposes to exchange outstanding debt with perpetual bonds and growth bonds (repayment linked to future economic growth). But Euro bloc points to insufficient progress on structural reforms promised by the Greek government and hence (due to their own domestic political constraints) insists on sticking to the bail-out terms agreed earlier. Consequently, it has withheld funds (i.e. last €7.2 billion slice of rescue funds and €1.9 billion profits made by the ECB on purchase of Greek sovereign bonds) required to make debt payments looming in next couple of months.
Confrontational Rhetoric: Another sticking point is the dwindling faith in austerity economics in Greece. After some improvements in the macroeconomic fundamentals 2014, the economy has again weakened as reflected by recent slippages in tax collections (January shortfall was €1 billion, 20% below official projection). Thus, the Syriza government beliefs that the austerity programme is hurting their society and has now decided to push back. The creditors on the other hand, encouraged by buoyed financial markets in Europe and by the creation of the firewall (Emergency Bailout Assistance of $800 billion) to tackle future crises, have chosen to take a maximalist position as they believe that Grexit would be manageable for the remainder of the Eurozone. Thus, a resulting confrontational rhetoric on both sides to deflect blame for the slow progress of negotiations has created mistrust.
Devil or the Deep Blue Sea?....
Comparing the upcoming debt maturities against the fiscal position (i.e. government deposits) suggests that the government may run out of money by June (when the current bailout programme ends). And while negotiations, in all likelihood, will continue until the cash position holds, the former itself may fluctuate depending on various factors like:
- Additions in revenues through tax pre- payment from private sector, clearance of tax arrears or withholding of salaries and pensions.
- The effective level of deposits and liquid assets available in the economy post accounting for broader public sector. For instance, on April 21, a presidential decree ordered state-owned entities to transfer their cash reserves to the State, which will reportedly raise up to €3.5 billion.
- The willingness of the ECB to maintain liquidity support to Greek banks against Greece sovereign bonds along with the pace of deposit withdrawals from banks.
- The willingness of the ECB and the IMF to consider a deferral on debt repayments (unlikely).
- The willingness of the Eurozone members to purchase more of maturing Greeks debts (unlikely).
- Thus, with the economy fast running out of cash, Athens is teetering on the edge of a default. It has three options, but none is easy.
Option 1: Default and Exit
Greece can never service its debts in full, and in all likely will default, if a bail-out package is not negotiated in next couple of months. So in absence of a deal or debt forgiveness, on whom could, or should, it default?
It would be suicidal for the government to default on wages and pensions of its citizens. A default on private investors is out of question as Greece desperately needs them to roll over its treasury bills (given it has remained stable so far) and none of the Eurozone loans are due before 2020. Only IMF and ECB are expecting a series of repayments in near term. But then countries have rarely reneged on the IMF and even those who did later ended up paying in full (e.g. Argentina and Brazil). In addition, a default on the IMF would accelerate payment of the Eurozone loans as per the provisions of the bailout. Finally, a default on ECB would have implications for the access of liquidity by Greek banks, which thus means that all roads lead to the negotiating table!
In any case, Grexit, if occurs, would be characterized by the reintroduction drachma (the old currency from 1832 to 2002) as legal tender with an analogous exchange rate with the euro, and conversion of all Greek euro denominated contracts and financial instruments denominated into drachma. A return to the drachma will allow Greece to avoid austerity conditions and control its monetary policy (i.e. ability to devalue its currency). And a devalued drachma, in turn, will stimulate growth through competitive tourism and export sector. For instance, Russia’s economy grew in double digit and Argentina’s by 8% after their decision to default in 1998 and 2001, respectively. More recently, post the financial crisis of 2008, Iceland defaulted on its $85 billion debt, but after a painful transition GDP is finally back at pre-crisis level.
At the same time, fixing government finances is only the beginning for Greece. It will have to streamline taxation and boost productivity across industries to take advantage of the devalued currency. Not to forget, with little access to credit on bond markets and none from the ECB, a Grexit could cause a bank run (given nervous depositors have withdrawn €25 billion in last three months, a panic caused in case of exit could trigger capital controls like bank holidays, deposit withdrawal restrictions etc., or could even result in outright nationalization!).
Investors’ wealth will get eroded by virtue of being exchanged into a devalued currency, thereby limiting investments. On top of that, an extremely devalued currency will make imports expensive, create inflationary pressures and eventually restrict production. Thus, exiting the euro does little to solve Greek’s debt problem, it merely takes the problem outside the bloc.
Having said that, Grexit could also take the form of a friendly divorce in exchange for some financial support from the creditors or continued liquidity support from ECB in defending the new currency, or both. Thus, what will finally come out of Grexit is a bit hazy at the point because this will probably be the first example of a country breaking from the union and going back to a weaker currency.
Option 2: Default but No Exit
Given the maximalist position on both sides, it is quite plausible that Greece reneges on its debts, yet remains in the bloc, thereby causing a domino effect. Investors will get increasingly nervous about the credibility other highly-indebted nations (Portugal, Ireland, Italy and Spain) whose outlook have improved and have recently been issuing debt at extremely low rates. And once mass debt dumping starts, it would seriously strain Eurozone’s $800 billion bailout fund. The problem could get exacerbated by savers and investors moving cash from these vulnerable economies to safer heavens such as Germany or the Netherlands – debt defaults tend to come in clusters!
This would be disruptive for Greece too. The ECB has already threatened to stop swapping Greek sovereign bonds in exchange for cash by Greek commercial banks. And in case of default it may cut off liquidity support to the entire banking system including the central bank. Once collaterals become worthless, and equity wiped out, confidence in the entire banking system will be undermined. Plus there are political costs. Antagonized Eurozone may treat Greece as an ostracized member at the table where other EU-related decisions are made, to the extent that it remains a member at all.
There is a much discussed possibility that lack of liquidity, post default, would induce Greece to introduce a virtual parallel currency IOU (I owe you), in lieu of payments in euro, along with enforcing tight capital controls to avert any flight of capital. The IOU (coupons with a claim on future government revenues) could be used to settle for domestic expenses (such as salaries and pensions) to free up scarce euro to pay for imports.
But such suboptimal outcome could spark chaos if people fear that the IOUs will never be cashed. And even if they accept, with little or no access to ECB and bond market liquidity, the experiment will be short lived. International creditors will never accept repayment in a virtual currency and residents receiving incomes in IOUs, while withdrawing their euro savings from banks, will pay their taxes through the same medium. Thus, it would not be long before banks go bust and economy runs out of euros.
Consequently, the stressed liquidity situation may significantly increase pressure on the Greek government, making snap elections a possibility, which in turn may produce a referendum on complying with the proposed bailout agreement or pave the way for an eventual Grexit.
Option 3: No Default and No Exit
Renewal of Old Package: In case Greece renews the bail-out package under old terms, locked in a currency union, it will take years of painful austerity to bring the debt at sustainable level and reduce domestic wage to a point where it re-gains its competitiveness on the world stage. Being as member the union, it cannot unilaterally stimulate its economy with monetary policy, like the U.S or Japan quantitative easing program that created new money and injected it into the system by purchasing outstanding debt.
The Greek economy has already shrunk by a quarter from its peak and some 25% of work force is out of job, resulting in revenue shortfall for the government. And unless a recovery takes hold, the country will slide into deeper financial hole, making the recovery even more painful and tricky. So the Greeks will bite the austerity bullet and pay through the funds sponsored by the troika, and the markets will relax safe in the knowledge that the global financial system would keep on spinning for at least another day.
A New Deal: There is another benign possibility though. Despite the acute level of frustration with Greece’s negotiating stance, an amicable resolution of the current stand-off is a conceivable because, first, support for Eurozone membership amongst Greeks remains high, second, there are many uncertainties that Grexit involves, and finally, an exit would represent the rollback in a process of European integration and would create a dangerous precedent.
Thus, it is likely that the current negotiations could go down to the wire but an durable new bail-out agreement is agreed upon that includes a mix of structure reform agenda and funds injection (i.e. fiscal stimulus) into the Greek economy, unlike now where much of it is getting recycled into debt repayments. A likely deal could include a relaxation of budget surplus target relative to the existing fiscal position and some relief in debt burden in NPV terms (i.e. through maturity lengthening and interest rate reductions to make loans profit-neutral). In turn, the Greek government could avoid rolling back current austerity programmes completely, show modicum progress on structural reform agenda, and agree to monitoring by troika.
The longer the negotiations continue, brighter are the chances of a revised bailout deal. At the same time, the ratification of third bailout programme, if agreed, would require unanimous approval from 19 Eurozone governments and their national parliaments, which thus shorten the potential maximum negotiating time available for a deal.
The time constraint, thereby, gives rise to the intriguing yet remote possibility. That, an agreement is reached only after a shock occurs. Such an event could be, imposition of capital controls in response to ECB cutting off the liquidity tap to Greek lenders, Greek government misses a payment/defaults or Syriza government calling for snap elections. The shock would then provide an extra push on both sides to conclude the negotiations and push through a deal.
Greece is Running out of Time, Money Strategies and Sympathizers….
Though the view that the Eurozone would be better off without Greece than with an uncooperative Greece is gaining currency, it is unlikely to be smooth sailing whatever path the euro bloc chooses. Thus, a viable and amicable agreement that inspires confidence in Greece’s economic recovery is still a possibility despite all the barriers and time constraints. It will, however, require a patience negotiation, which unfortunately is in short supply given the pervasive atmosphere of distrust and panic, and in midst of this, there is a lingering danger that one side might cross the red line.
The monetary confederacy of Delian league did not end well for its nascent central bank (the Temple of Apollo), 2388 years since, will the story be different?
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