Greece, six years on

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As we close in on 2 May 2016, the six year anniversary of the first Greek bail out, here we are again still discussing the same fundamental problem of how to put the Greek economy back together again after a catastrophic economic crisis. After the resolution of last summer’s tense stand-off between the Greek government and her creditors, in which the government seemingly contemplated leaving the eurozone before capitulating and entering a programme, Greece may have dropped off the market’s radar screen.

If you weren’t personally invested in Greece then perhaps you concluded that you no longer need to worry about whether the Greek government was on track to meet its latest targets or not. We are about to find out whether that assumption is valid. In this note we discuss the contours of the latest round of negotiations, what’s at stake for Greece and whether there are broader implications for European assets.

Greece is back in the spotlight so soon after reaching agreement on the third bail-out package because the creditors only disburse funding to Greece in tranches when there is evidence that the government is on track to deliver on the terms of the bail-out. The reform programme that was enshrined in the summer 2015 package was based on four key pillars:

1) Restoring fiscal sustainability by working towards a medium-term target for the primary surplus of 3.5% GDP through a series of reforms – in particular to the VAT and pension system;

2) Safeguarding financial stability through recapitalisation of the banks;

3) Supporting growth, competitiveness and investments through product and labour market reforms;

4) Building a modern state through reforms to the judiciary, the public services, tax collection and so on.

The first review of that programme is upon us. The creditors are looking for confirmation that Greece is in compliance with the terms of the agreement and on a sustainable footing. The Greeks are looking for a disbursement of cash so that they can meet upcoming redemptions to the International Monetary Fund and European Central Bank. It is hoped that an agreement will be reached by the time of the 22 April 2016 Eurogroup meeting but experience suggests that the process of negotiating and implementing a deal might not run so smoothly.

At face value the negotiations are about flows: the appropriate level of ambition on fiscal policy – what size surplus the Greek government should be aiming for – and the identification and implementation of specific measures which can deliver the required level of savings. However, the real debate is about the stock and whether and how to provide debt relief and that debate is taking place between the creditors. The IMF no longer seems willing to fudge the basic question of debt sustainability and wants a credible path to a manageable debt burden over a reasonable time frame. Indeed, it is not supposed to lend to countries that are effectively insolvent.

There might have been grounds for looking the other way during the acute phase of the crisis, but that argument no longer applies. The Fund’s continued participation may therefore involve a more manageable surplus target, and given the more modest pace of debt reduction, that would imply movement on debt relief too.

The European creditors would prefer to keep the IMF involved and it should not prove too hard to reach a compromise on the primary surplus. However, haircuts on the face value of the debt are problematic given the ‘no bail-out clause’ in the Treaty. Of course, there are other ways to provide debt relief and if a compromise exists it likely involves terming out the loans far into the future: Greece pays less and pays later. However, if there has been a fundamental shift in strategy among Europe’s creditors on debt relief it is hard to detect. German Finance Minister Schaeuble is confident that a deal will be done but has commented, “This solution has nothing to do with debt forgiveness but with the fact that Greece needs to do more to return to a competitive economy.”

Whatever deal is agreed would still need to get parliamentary approval. The creditors will demand concrete action on specific measures to deliver the new fiscal targets and the parliamentary arithmetic in Athens looks pretty challenging. Prime Minister Tsipras’ coalition has a wafer thin majority and safe passage of further measures cannot be assured. We cannot rule out the possibility that fresh elections might be required to approve that package. In the meantime there would be another bout of destabilising uncertainty.

Of course, if a deal can be agreed and implemented there is a big potential upside for Greece. Within the financial sphere, the Greek banks access to the ECB’s standard refinancing operations would improve, allowing the banks to scale back their use of emergency funding. Capital controls could be removed. Greek government bonds could feature in the ECB’s quantitative easing programme. More importantly in the real economy, the combination of debt relief, implementation of reforms and more harmonious relations with her creditors could have a powerful impact on sentiment.

Nothing is guaranteed. The creditors may not moderate their demands on the fiscal targets. The negotiations may drag on. Tsipras may not be able to get a deal through the parliament. The question we posed at the beginning of this piece is whether Greece still has the capacity to shock European markets.

There is no direct parallel between events in Greece and the fate of the rest of the European periphery and the working assumption of many investors is that the ECB’s quantitative easing programme will insulate the rest of Europe from any localised stress in Greece. However, the political situation is fragile throughout much of Europe. The momentum behind fiscal consolidation and structural reform looks to have stalled. Recent elections have had a nasty habit of throwing up inconclusive results from which it is hard to engineer stable governments. Referenda loom on the horizon. Thus far, the market has paid little attention to these inconvenient political facts. Another Greek tragedy might provide an unhelpful reminder at a most unfortunate time of Europe’s Achilles heel. [divider] [/divider]

This article was written in London and first published in the Weekly Intelligence Report on 19 April 2016

Richard Barwell

Head of Macro Research

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