Summary: A Greek default is a distinct possibility, but a key problem is that many people in Europe are fatigued by the negotiations. The Troika requires Greece to achieve a primary budget surplus in exchange for its bailout, but Greek ruling party Syriza disagrees with its creditors on the best method to hit these budgetary targets.
Key take-out: A compromise is still possible, but if we do see a Grexit, I don’t think it would be entirely bad news for retail investors. Market turmoil would present a buying opportunity and real contagion is all but impossible.
Key beneficiaries: General investors. Category: Economy.
Well, here we are again – another deadline, another looming Greek crisis.
Unlike past episodes though, there is actually a heightened chance that Greece could default and be forced out of the eurozone now. This time it is different because a default is a distinct possibility.
The debate has evolved though. Gone are the arguments as to why a Greek default would actually be good for Greece – and the eurozone. There is a broad consensus now that a default would be less than desirable for Europe and an outright disaster for the Greek.
Yet and as Italian economist, Francesco Giavazzi, argued persuasively last week – if the Greeks want disaster then they should be allowed to have it. In his view the Greeks don’t want to reform. It’s that simple. They don’t want to sell off state assets, they don’t want to pursue social and economic reform and they don’t want to modernise their economy.
On my read of things that’s not entirely true, however, and as you’ll see below there are elements of truth to it. Sticking points as it were. If Giavazzi is right though then there is nothing left to discuss with Greek creditors. They can either continue to underwrite the Greek economy, accepting there will be no reform. Or they can continue to demand reforms, which the Greeks won’t undertake, in which case Greece will default at some point.
The latter is what many argue has been happening over the last five years anyway. The problem now is fatigue.
It’s this fatigue that makes this flare up that is a little more serious, notwithstanding the fact that a Grexit is the worst case outcome. Many people in Europe just want the whole saga to end and are sick of the ongoing games. Greece is only 0.5 per cent of the world economy and 1.8 per cent of Europe’s and it attracts far too much attention.
So what’s actually happening?
The crux of the issue is this.
When the initial bailout was agreed with creditors back in 2012, Greece was to achieve a primary budget surplus of 3 per cent in 2015 and 4.5 per cent in 2016. Greece went a long way to achieving those goals and even late last year, the Greek government was on track for a 3 per cent surplus this year as required under the agreement with the Troika. Indeed as late as April 2015, the IMF was still forecasting that Greece was on track to meet the 3 per cent primary surplus this year and 4.5 per cent next.
So far so good. Problems began when leftist radical party Syriza was elected in January on a platform of renegotiating the bailout agreement of 2012 and ending the ‘humiliating’ austerity measures that were demanded in exchange for bailout funds.
Greece was initially given till the end of February 2015 to come up with a list of reforms and make a new deal with creditors. This deadline was subsequently extended by four months when no deal looked likely.
This brings us to where we are now and without a new deal, Greece risks default by the end of the month. They owe roughly €3 billion by the end of the month and so need a release of €7bn in rescue funds to meet those payments. Creditors of course won’t release those funds unless a program of reform is agreed to.
Now since all of this began there have been a number of proposals and counter proposals made, each rejected for various reasons. As it stands now, the Europeans have proposed that Greece be allowed to lower its primary budget surplus target from 4.5 per cent of GDP to 3.5 per cent of GDP over the medium term (a primary budget surplus is effectively the budget balance not including interest repayments) and be given two years to achieve this target. So a primary surplus of 1 per cent this year and 2 per cent in 2016. The Greek government has already agreed to those targets.
So the sticking point isn’t so much the budgetary targets – it’s the method proposed to achieve those targets that is the problem.
Creditors don’t think Greece can hit those targets without widening the value-added tax (VAT) base, making further reductions to pensions and reducing public sector wages. The last two are key to a credible budget target in the eyes of creditors given that they account for about 75 per cent of primary spending. By itself, spending on pensions accounts for 16 per cent of GDP.
So what creditors want for is for further cuts to public servant wages and pension spending to be reduced from 16 per cent of GDP to 15 per cent of GDP, which they believe can be done without hurting the poor.
Syriza have rejected this and said that they can hit these budgetary targets without a widespread increase on VAT. Instead they proposed other reforms to VAT and:
- A special 12 per cent tax on corporate profits over €1m
- An increase in the corporate tax rate from 26 per cent to 29 per cent
- Cuts in defence spending.
In turn, creditors don’t think the Greek proposals will actually cut spending by the amount required – the key issue being pensions and public sector wages.
Overall the respective parties don’t appear to be that far apart and it’s still very likely that some sort of deal will be nutted out – eventually. It may require another extension though.
Which brings us to this issue of fatigue.
Yet while the chance of a Grexit now is the highest it’s ever been and we have to take it very seriously, it’s still the least likely scenario. Talks are set to recommence on Thursday European time. A compromise is still possible.
Longer-term there is still the issue of debt sustainability, although the Europeans don’t seem too fussed about that at this point. The IMF is and suggests Europe needs to agree to further debt relief to keep debt at sustainable levels. Not that this issue is at the heart of current negotiations. But it does ensure that even if an 11th hour deal is reached, again, the Greek crisis will surely flare up again. Fatigue!
In the event that we did see a Grexit though, I don’t think it would be entirely bad news for retail investors. Equities would slump certainly, yet rather than sell into that, investors should use it as a buying opportunity – after the dust had settled. Why?
Because Greece is tiny and ultimately doesn’t matter for the global or even European economy. There would be massive market turmoil but contagion, real contagion, is all but impossible with the ECB buying up all bond issuance for the year. Even if that wasn’t enough, they could restart other programs that would have the same effect.
For the short-medium terms equities would sell off and peripheral bond yields would spike. Safe haven flows would likely see US bonds, German bunds and Aussie bonds rally hard. Yields would fall further as the Fed delayed its rate hike and the RBA cut rates. Not great for cash holdings – but it would eventually be very positive for the equity market.