Δευτέρα, Ιανουαρίου 24, 2011

And now what? – Possible scenarios for the Greek economy.

Although we are being bombarded with articles discussing the resolution of the Greek / European debt crisis, most tend to be either of a journalistic nature (who said what and who refuted it) or very one sided. One the one hand, we have super-pessimistic, primarily foreign, analysts which list as both inevitable and desirable a full blown Greek default and exit of the Euro, and on the other side, the overly “optimistic” official position that everything will magically sort itself out by 2013. Thus, I would like to list here my own thoughts, for whatever that’s worth since admittedly I lack the data and tools for a truly in-depth analysis.

Before exploring potential scenarios, we should first understand what will be the position of the Greek economy at the end of the current support package in 2013.

The big unknowns

a) The resilience of the Greek economy.

I personally believe that it is a good chance that the Greek economy will rebound to some degree because, despite the real hardship suffered by some sections of the population, there are still great amounts of wealth held by Greek households and private sector and individual debt levels in Greece are still reasonably low by European standards. The current slump in demand is only partly caused by the government spending cuts. Instead, much of it is caused by the bad sentiment and insecurity caused in the population due to the string of negative news and predictions for the country. It is likely that they will eventually start spending again, resulting in the well known rebound effect experienced in many other countries. Indeed, a little known fact is that the Greek economy actually grew in nominal terms in 2010 (due to the higher than expected inflation rate).

Moreover, due to the well known bureaucratic obstacles, there is, even know, a large amount of frustrated investment plans waiting for approval, in energy, tourism or real estate development. If the much advertised “fast track” approval process for investments does finally bear fruits, it can have a material effect on growth and sentiment, especially on the reasonably small Greek economy. The same is true if better use is made of the European cohesion funds that are still available.

b) The ability of the Government to reform the public sector

I am much more pessimistic about this as the corruption, mismanagement and bad working ethic in the public sector are too entrenched to change with a few ministerial decrees. Unless this is improved, it will continue to dissuade investment and suppress government revenues.

c) The state of the European and the world economy

As long as the European economy continues to recover, this will have a positive effect by raising Greek exports, improving tourist flows and strengthening the highly cyclical shipping industry. Moreover, an improved overall market climate is likely to increase investor confidence, even for peripheral economies such as Greece. On the other hand, higher interest rates arising from inflationary pressures in Germany or elsewhere, could squeeze further prospects for recovery in South Europe.

d) Greek Political developments

This is a very big unknown. Even if the current government manages to retain its cohesion without too many MP defections, there are national elections due at the latest at the end of 2013. Given how crucial a year 2013 is likely to be, it is possible that the government may declare early elections before that so as, for example, to avoid having to go to elections right after it has declared a (full or partial) default. Moreover, an early election avoids the need for a protracted pre-election period. However, an early election causes obvious political uncertainty, especially if, as currently expected, no party is able to obtain a full parliamentary majority.

OK, where will we be in 2013?

If the official predictions are not met by a considerable margin, then a rather messy default of Greece seems more or less inevitable. On balance, I still believe that this is unlikely as long as the current government remains committed to reform as seems to be the case now.

In the fortunate case where the Greek economy considerably outperforms these official predictions, then it may even be possible that the current “plan” of Greece returning to the markets in 2013 with no debt restructuring (apart from an extension of the repayment schedule for the 110bn from the IMF and the EU) may even be achievable. Again, I think that this is an unlikely scenario. Even if the Greek economy proves more resilient than expected, it is likely that the Greek government will use the breathing space provided to slow the pace of reform. Thus, it is pretty unlikely that, in terms of deficit levels at least, we can have a much better result than targeted in the current stability plan.

Indeed, the more likely case remains that the Greek Economy will perform roughly in line with the official predictions of the current stabilization plan. So, let’s take this as our base case and see where does this leave the Greek Economy in 2013:

i. a running deficit still over 3% of GDP (primarily due to the interest costs of servicing the debt).

ii. a debt/GDP ratio of around 150% if not greater.

iii. public interest expense of over 7% of GDP and near 20% of the total government expenditure.

iv. GDP may have returned to growth but such growth is likely to remain weak and unstable due to the large outflows from the economy caused by the interest payments overseas and the continued lack of consumer and investor confidence.

v. a requirement to refinance all maturing existing debt, plus the existing budget deficit

1. The original official plan: start repaying the 110bn plus all debt that matures thereafter

This is so unrealistic that there is not even worth discussing it further. It is simply impossible for Greece to be able to borrow, at any sustainable interest rate, 200bn or more that will be required in the next few years (110bn from the EU/IMF loan plus new maturities plus new deficits). This is, in part, the reason why the markets reacted to the Greek “bailout” by further increasing credit spreads: the official scenario was simply not workable.

2. The new official plan: extension of the 110bn but market refinancing of the rest

The IMF and the EU have largely acknowledged that they will be willing to extend the repayment schedule for the 110bn rescue package of Greece well past 2013. Moreover, there is also some talk for a reduction in interest rates for this funding, although I expect Germany to resist doing so since anything agreed for Greece will need to be offered to Ireland and any other nation that, by then, will have made use of the EU rescue mechanism.

I think that this is still largely an unworkable scenario. The markets will be understandably very unwilling to fund Greece at any reasonable rate (or at all) with a debt ratio of 150%. As an example, Portugal, without the social unrest and credibility issues of Greece, is currently suffering from a lack of investor confidence with a debt ratio of less than 100%.

The reason Greece is currently managing to raise some short term funds from the market is that the maturity of these funds falls before the end of the current support package, hence bond holders expect that they will effectively be repaid by the 110bn fund. If the EU/IMF are indeed unwilling to provide more funds in 2013, it is very unlikely that the markets will be willing to do so.

3. Debt restructuring by extension of the tenor of all debt

This may, just about, be workable, especially if coupled with lower interest rates on the bailout package. In the short run, it should work because there would be largely no need to actually raise any significant amounts from the market:

i. The reduced interest expense may result in a roughly balanced budget

ii. The extension of the tenor of ALL debt would remove the need to refinance it in the short term

iii. A simple extension of tenor may not require the Greek (and foreign) banks to mark down their holdings of Greek government debt, thus avoiding the short term need to recapitalize them which would require additional funds.

iv. As the restructuring would happen with the consent of the EU, the ECB is likely to continue to quietly support the Greek banks with the liquidity and funding they need to stay alive.

v. The EU may even be willing to provide some additional funds to cover any residual funding needs.

In the long run though, things are less rosy:

a. Even on hugely optimistic assumptions (sustained real GDP growth, continued low interest rate environment, continued prudent financial policies by the Greek government, continued ECB/EU support, etc), the Debt/GDP ratio would decline only very slowly. It would take 15 years (2018) for the ratio to fall below 100%, even on rather optimistic assumptions (see table below). This is a very long period for a country to survive without real access to the financial markets.


















b. Lack of access to the financial markets has big repercussions not only to the state but also to the private sector: It is unclear how long would the ECB be willing to support the Greek banks. Also, it is unclear how long would Greek private companies be able to survive and grow without the ability to raise funds in the international markets.

c. Seeing how the EU operates, it is unlikely that they will consent to an adequate extension of tenor for the debt but instead they may favor an incremental approach, similar to the one of the current rescue package with frequent assessments, in part to make this politically palatable to their own electorates and in part to keep the pressure on Greece in order to ensure prudent fiscal behavior.

d. As a result, Greece would remain at the edge of the cliff for many years to come, with its economic survival still precariously relying on the whims of the European governments, the performance of the world economy and its domestic governance.

e. It is thus clear that, even after the restructuring, the financial markets are likely to remain very apprehensive with Greece, effectively keeping Greek banks and companies cut off from the international money market. This is likely to dissuade investment in Greece with obvious adverse effects on Greek economic development and growth.

f. The Greek public is likely to tire after a while of the constant rhetoric that the crisis is not yet over. At some point, they are likely to grow immune to such statements by politicians and economists, resulting in increasing pressure for fiscal loosening.

4. Debt restructuring by extension of the tenor of all debt AND a small haircut

This is effectively a variation of the previous scenario. It has the following advantages and disadvantages:

a. It reduces the debt that the Greek economy has to repay.

b. It may actually increase the credibility of the Greek economy since the Debt to GDP ratio will improve (although a modest haircut would have only a limited impact).

c. However, market commentators have – rightly – been arguing that a modest haircut would not be enough since it would still leave Greece with an excessive Debt/GDP ratio. Moreover, once an EU country has been allowed to default, even in such a controlled fashion, the markets may interpret this as a precedent, resulting in much greater turmoil amid speculation for further defaults and haircuts.

d. If the haircut is modest, or if it is voluntary, Greek banks may not be endangered, especially after the capital increases most of them are currently doing.

e. It is likely that the IMF will insist that their funding has priority over other Greek debt (as is legally the case). If the EU does the same, this would mean that even a small 15% overall haircut would result in a haircut for other investors of close to 25%.

5. Haircut through optional debt repayment

This is a scenario that has recently gained in popularity in the media reports. It can take many forms but in summary it involves the EU providing funds to Greece allowing Greece to repurchase its existing debt at the prevailing market prices, i.e. a discount to par. This would have to be coupled with extension of tenor for the 110bn fund, probably at reduced interest rates.

This plan has a number of advantages

a. It allows Greece to improve its Debt / Equity ratio.

b. Because the repurchase of the debt is optional for the debt holder, it is not an actual default which would be a bad precedent for a Eurozone economy.

c. It achieves Germany’s objective of the cost of the Greek default to be, at least in part, be borne by the investors as opposed to the German and European tax payers.

The main problems with this plan are:

i. For this to allow a material improvement of Greece’s Debt/Equity ratio, it would require sizable funds, especially if the haircut is not very big. As this plan would have to be offered to Ireland and possibly Portugal and any other countries that may be in trouble, the funds required become truly enormous. Germany and the other richer countries are understandably reluctant to do so but they might be able to sell it internally by imposing stringent conditions on the bailed out countries and arguing that this is the only way to eliminate the lingering uncertainty about the Euro and the Eurozone which is damaging investor confidence.

ii. Interest rates in the new debt provided by the EU would have to be significantly lower than those of the current support fund. Otherwise, Greece may find itself paying higher interest after the debt repurchase than before. This would be so because all of the existing Greek debt was issued before the debt crisis and had very low interest rates.

iii. For this to work, it would require a careful balance in the expectations of investors: If investors think that this is really the perfect solution to the debt crisis, then they would be unwilling to sell their Greek bonds at a sizeable discount. If investors are unwilling to sell, then the program of voluntary reduction of the Greek debt obviously cannot work. This can prove quite tricky and may mean that this plan can never be a full solution of the problem since a full solution would mean full investor confidence and unwillingness to accept any haircut. The only way it can work is by being seen to be inadequate…

iv. Indeed, investor sentiment aside, Germany is probably unwilling to provide a full solution anyway because if they were to do so, they would lose most of their leverage on the rescued countries while at the same time a moral hazard situation would be created with countries feeling that fiscal imprudence would ultimately result in a bailout.

6. Additional funds from the E.U.

The E.U. could conceivably agree to provide more funds to Greece to the extent that Greece is unable to tap the financial markets in 2013.

This is an unlikely scenario (unless coupled with a haircut or other measures) because, as shown by the previous table, Europe would need to continue to fund Greece for close to 20 years until the Greek Debt / GDP ratio is nearer to what the market considers a sustainable rate. This is politically problematic given the magnitude of the funds that would be required (for Greece and all the other indebted countries). Also it effectively results in a protracted period of uncertainty that everybody wants to avoid.

This scenario is easier to imagine if Europe were to succeed in implementing a more centralized common fiscal policy because then such a bailout would not be seen to create moral hazard situations in the future. However, with Euro-skepticism on the rise throughout the continent, any considerable delegation of fiscal and economic powers away from the national governments is unlikely.

7. An uncontrolled default but still stay in the Eurozone

This is also a rather unlikely scenario. First, it would be a rather big failure of Europe if they are unable to organize, at the very least, an orderly default for Greece. Such a failure would have material repercussions not only at a political level but also in terms of investor confidence on the Eurozone and other peripheral economies. Second, if Europe did fail to act, it is unlikely that Greece could remain in the Eurozone.

This is so because all or most Greek banks would collapse, together with most Pension funds that hold Greek government bonds. Even if the Greek government had managed to balance its budget by then (especially if they stop paying interest on existing debt), the government would not have enough funds to keep the Greek banks and Pension funds afloat. Clearly it is unlikely that the EU would be willing to provide the needed funds since it was the EU’s unwillingness to act that led to the uncontrolled default on the first place. Thus, the only conceivable solution would be to return to the Drachma and fund the banks and funds (and possibly other private sector companies in trouble) through inflationary printed cash.

8. An uncontrolled default and exit from the Eurozone

Needless to say that this is a nightmare scenario since exiting the Euro would be extremely messy. Those who point out that the move to the Euro was rather smooth are missing the important point that this involved a move from generally weaker currencies to a stronger one. A move back to the Drachma, would be met with huge public resentment, capital flight and economic dislocation of enormous proportions. Needless to say that if after many years of recession and cuts, the result is such a debacle, there would be serious riots in the country and possibly a complete breakdown of law and order.

It is unbelievable how serious foreign analysts are suggesting that this is, supposedly, the best solution for Greece. It is more likely that this is a reflection of their –not always hidden- beliefs that Greece should never have entered the Eurozone hence this is a good excuse to throw it out. While the financial governance of Greece is giving, unfortunately, some justification to such opinions, one does wonder if there are some prejudices or even some kind of racism hidden in such assessments.

However, their argument is that after the initial shock, the depreciation of the currency may allow for a quicker return to economic growth through the rapid readjustment of the economic competitiveness of the country. Moreover, in the long term, having its own currency, Greece can avoid finding itself in such situations plus give it the ability to have its own monetary policy based on its own needs and circumstances. The example of Argentina is often mentioned as an example of a country that is currently experiencing decent growth despite its bankruptcy a decade or so ago.

These are definitely respectable arguments. My random thoughts on these are as follows:

a. The comparison of Argentina with Greece is not necessarily accurate. Greece is a first world country, member of the EU and the Euro. Argentina was seen even before its default as a largely developing country which had chosen to unilaterally peg its currency to the American Dollar. If Greece leaves the Euro, it will be a clear sign that Greece is a third world economy and this will have significant adverse economic consequences. On the other hand, the current publicity is so negative for Greece that one can argue that public perception cannot really get any worse than it is now…

b. In the long term, the ability of Greece to devalue its currency is not necessarily a good thing. It makes foreign and domestic investors apprehensive of investing in the country and it fuels inflationary pressures. Indeed, this is how the devaluation of the currency is meant to be helping: it allows for nominal salary increases without damaging the competitiveness of the country (or its public finances) because it can be financed through inflationary money and be mitigated by currency depreciation. Clearly, this is not a recipe for long term economic stability. Indeed, Greece spent a long time in the 90’s trying to control its currency depreciation in order to get inflation under control.

c. The shock of the bankruptcy is likely to leave scars, both economic and political/social, that will take very long to heal. It may also lead to a significant strengthening of the extreme left which up to now was making only small gains in the crisis. If people start to really have nothing to lose they are far more likely to embrace extreme ideologies.

d. The main benefit of the default and depreciation scenario is that it allows for a fast adjustment so that the country can, supposedly, get back in a sustainable growth course. This benefit is mitigated considerably if the country has successfully implemented austerity measures which have largely already achieved the adjustment of competitiveness and balanced budgets. In other words, while depreciation might have made sense in 2009, the longer we wait, the less it makes sense. Certainly in 2013, if the government has succeeded in implementing all the required reforms and cost cuts, there are far less traumatic ways to resolve the debt crisis than the disaster scenario of exiting the Euro.

Conclusion

If I had a clear and definite conclusion, I would obviously be a rich man. Clearly Greece, and Europe as a whole, are in a difficult and complicated situation with no precedents to look back to and many political and economic uncertainties to evaluate. On balance, it looks as if the moderately optimistic scenarios 3, 4 or 5 are currently the most likely, through some evolved form of the European Support Mechanism, be it Eurobonds, guarantees or debt repurchases at a discount.

However, it is also likely that the European governments lack the ability and perhaps the willingness to fully resolve the issue. Indeed, it is very likely that there will be at least a couple more iterations of the European rescue package. For example, it is not impossible to contemplate a scenario where Greece through one means or another continues for two, three or even ten years and then finally declares bankruptcy. This will depend not only on the behavior of the Greek government and the international financial and economic climate but also on the prevailing political situation in Europe. Currently, an ugly default by Greece is feared to lead to a domino effect and hence everyone is ultimately motivated to avoid it. If in a few years, the other countries have fixed their own problems, a failing Greece may be easier for the markets and the European politicians to accept. On the other hand, if indeed, all other countries are no longer in trouble, the funds necessary to simply bail out Greece would not be that big in a Europe-wide context and the EU may well decide that it is easier to do so than take the risk of a financial turmoil.

Addendum

There is a lot of fear mongering in European and international press about the risk of moral hazard arising from quick and easy bail outs of the debt ridden Eurozone countries. My humble personal view is that such concerns are blown out of proportion.
Even if the profligate countries are generously bailed out, the humiliation from the foreign governance, the enormous bad publicity and the resulting deep recessions are enough to make any government and any politician with half an instinct of self-preservation unwilling to put themselves in such a situation again.

It is true that such bad memories are likely to quickly fade out. However, the same is true from any memories of bailouts while any strict rules that are passed now with this in mind, are also likely to be amended several times over the coming years as political balances and economic priorities change.

Moreover, many of the strict rules that are being proposed are clearly unworkable. I fail to see how a constitutional prohibition of large deficits would stop anyone from doing so. This is certainly true in the case of countries such as Ireland which collapsed not so much due to government deficits but because they were forced to bail out their crumbling financial sector. Even in the case of Greece which is closer to the example of a country with a profligate public sector, it is unclear that the Greek government in 2008 or 9 would have behaved much differently if such a constitutional prohibition existed. On the contrary, the only thing that such a constitutional rule would achieve is to compound the uncertainty and chaos of a financial crisis with constitutional and political mayhem.

Similarly, imposing financial sanctions on debt-ridden countries is similarly counterproductive since it would compound their fiscal woes.
Germany’s suggestion to remove voting or veto power from deficit countries is more workable but it still sounds more punitive than truly preventive. Moreover, extensive use of such measures is very dangerous since they could considerably undermine the democratic legitimization of the already rather flimsy EU institutions at a time of increased euroscepticism.

The solution I can think of is not very original and has been mentioned many times over: a single currency requires greater economic and political integration for it to work. And for such greater integration to be possible, it requires the trust of all European people in the solidarity and democratic nature of the Union. Indeed, an outside observer to this crisis could say that this is a unique opportunity for Europe to show just that. Policies that focus on punitive measures and on regional bartering, however justified they may be, ultimately undermine the concept of a unified Europe.

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