Greece: an entirely political crisis
Posted by Sergio Capaldi, Intesa Sanpaolo - Research Department, on 18 May 2012
Now that the latest attempt at forming a national government has failed, the Greeks will be voting again on 17 June. If surveys of voting intentions are anything to go by, the crisis is only just beginning to get really nasty.
The example of Greece is evidence of the need for reforms to be consolidated and socially fair, since – not least in order to secure greater popular support – it would have been better had the rigour been coupled with a more substantial helping of social justice. The discontent generated by the adoption of measures that have hit many of the people hard has fuelled the rise of opposition parties that are more critical of what the government is doing or are manifestly populist in nature. In seeking to get the public finances back on track (failing which, it needs to be said, the country as a whole will be plunged into the abyss) Europe has not given sufficient attention to the issue of social cohesion in a country that has been swindled by a corrupt and incompetent ruling class. As the squeeze takes hold, Greece is already playing a very dangerous game of blackmail and more or less credible threats. Greece's destiny is largely in the hands of its people. If the anti-bailout front win the day, the country's exit from the Euro will happen in a matter of weeks. The parties of the radical left overestimate the scope for renegotiation and have been pushing for an unacceptable modus operandi that has forced the rest of Europe into a more rigid stance.
If Alexis Tsipras' radically left-wing Syriza party does as the results of some polls suggest, it could be the biggest party, and, given the majority premium (50 seats), a government without its support will be unsustainable. Even in that case Syriza might not, however, be able to form a parliamentary majority opposed to the bailout. The latest surveys show a marked downturn in the performance of the Communist Party (KKE), whose seats could be vital in surpassing the 151-seat threshold. The next election, then, could bring in a highly fragmented parliament that would find it difficult to govern the country, and could exacerbate the crisis by potentially setting the status quo in stone and not offering Europe a partner with whom to engage in dialogue on reforms.
Whatever the new government turns out to be like, it will seek to renegotiate the terms of access to financial aid, but will find it impossible to change the direction of fiscal policy or reverse the progress made on many fronts as part of the country's reform process. Europe may well be able to give more attention to the structural imbalances by acknowledging the progress made over the cyclically adjusted targets, but will not accept outright abandonment of the policies adopted. The election of France's President Hollande and Italy's support for measures to sustain growth will not be sufficient to change the direction or nature of the financial constraints within which Europe has to manoeuvre. If Syriza becomes the glue in a majority coalition made up of Dimar and the KKE, then, given the radicalism of the approaches adopted by both these parties, it may well be that the future government will become even more confrontational and ignore the requirements of Europe and the IMF.
If that happens, then events in Greece are likely to take more or less the following course: 1) it is likely that the external financial support would be suspended, so the country would again default in the course of only a few weeks; 2) a long time before that happens, the prospect of the country leaving the Euro would prompt households and businesses to withdraw their deposits in massive amounts, and, without support from the ECB, the runs on banks would cause many of them to fail one after another; 3) the government, faced with this state of affairs, would be obliged to close off access to the credit system; 4) the economic recession would become even more severe and would eventually make the original situation even worse, with the state, in a matter of weeks, being unable to pay either salaries or pensions, and the crisis taking on the characteristics of a profound depression before the Greek central bank, having reassumed the power to print and mint the drachma, would flood the economy with liquidity; and 5) the drachma would immediately lose value, while inflation would simultaneously rise and adversely impact the purchasing power of salaries and pensions.
In the best-case scenario, the process of regaining equilibrium will take years and the social and economic costs be well in excess of what Europe and the IMF are asking to bear. Access to foreign financial markets will be made more difficult by reputational and legal issues, and the country will be obliged to finance much of its own deficit by monetisation, thus adding to the depreciation of the drachma while fuelling inflation and rising interest rates.
If the crisis were to spread wider within Europe, it could well have a considerable impact and would require even bigger buffers to defend the Euro than exist at present. The primary contagion channel would be the financial system. Greece accounts for a modest share of the Euro zone’s GDP and carries negligible weight in terms of exports. The withdrawal of foreign capital from the countries undergoing macroeconomic rebalancing would cause significantly more disruption, the ongoing sale of securities would drive up the cost of financing for families and businesses, and the ECB would be obliged to counteract this by bringing in new quantitative easing measures. The recessionary effect would be likely to put the public accounts in an even worse state, to such an extent as to delay the achievement of financial equilibrium in many states. Spain is likely to ask the EFSF for help with the recapitalisation of banking system, while Italy, too, will probably find itself obliged to ask Europe to take preventive action to isolate the source of the crisis. The idea that the Greek crisis could affect only Ireland and Portugal on the grounds that those countries are under a financial assistance programme is somewhat feeble. Both Ireland and Portugal are starting to reap the first benefits of their fiscal consolidation efforts and their access to funding by the EU and the IMF has not been a matter for debate. In order to isolate the risk of contagion, the EFSF/ESM would have to commit something of the order of EUR 300 billion, yet to be raised, of which something slightly less than one-third could be used to recapitalise the banking system. According to the BIS’ statistics, foreign banks (nearly all of them European) hold some EUR 70 billion worth of Greek assets, and considering also the extra funding need of the Spanish banking sector the EFSF/ESM could inject something not much less than EUR 100 billion into the system. The residual financial capacity could be used to extend the aid programme to Portugal and Ireland and in due course to prop up Spain as well. However, the most significant cost of contagion would be in terms of lack of growth, estimates of which depend on reactions from the markets and the likely loss of confidence on the part of consumers and European businesses.
Finally, it is also worth considering what will happen to Greek government debts with other states, the EFSF, the ECB and the IMF. Adding up the 53 billion from the first aid programme and the 108 billion already spent by the second, approximately 40 billion in government bond and 78 billion of the ECB net exposition to the banking system, the result is an official net exposure of the European institutions amounting to some EUR 280 billion. Taking it as read that Greece is not Zimbabwe (one of the few countries not to have repaid the loans made by the IMF), we assume that the emergency finance received by Greece will be repaid in full like the other obligations entered into through the Euro zone’s monetary authority. Given that Greece’s membership of the European Union itself would be an open question if the country were to decide not to pay its debts to its official creditors, we think it unlikely that it will not discharge its obligations in full. There is, however, doubt only as regards the government bonds held by the ECB under the SMP, which might not be redeemed at face value. Overall, the recovery rate for the governmental share of Greek public debt will probably be close to 100%. This makes the prospect of an exit from the Euro much less appealing to Greece in that the service of this debt would be extremely onerous if its new currency, the drachma, were to be seriously devalued.
By way of conclusion, the effects of the crisis on a Euro zone without Greece in it might well not be long-lasting, and so, after a period of greater volatility, investors could well start to become interested again. Once the initial panic was over, Greece’s abandonment of the Euro might well be seen in a favourable light by the markets if it led to greater integration across Europe. If that turns out to be the case, then the Greek lesson will not have been in vain.