PORTFOLIO POINT: There's no political will within Greece for a eurozone exit, and even if there was, the economics simply don’t stack up.
Recent elections have brought the thorny issue of Greek membership of the eurozone to a head. Speculation has obviously waxed and waned over these past two years, but political commitment to austerity made this speculation academic. Things have changed, however, and now we find ourselves in a new chapter, given the prominence of radical parties (some of which have run on anti-austerity platforms). For instance, some investment banks have allocated a 75% probability to such an event, and recent surveys show over 50% of investors reckon that Greece will exit the EU at some stage.
But a Greek exit is not inevitable, as the analysis below will show. My best bet at the moment is that austerity will be softened at the margins. And what if they did leave? Well, there are several very good reasons why we would avoid a Lehman moment.
Firstly, let’s have a look at the reasons why a eurozone exit is unlikely. The first one is simple and has nothing to do with economics (which I’ll discuss in much more detail below). Simply, there is no political will to do so. Consider that even the main anti-austerity party, Syriza, touted to come first in the June 17 election with just over 20% of the vote, does not itself wish to leave the eurozone, under any circumstances. More to the point, it still doesn’t even seem likely that they’ll be able to form a working coalition. Recall that pro-reform parties were only two seats short of governing and actually received, in percentage terms, sufficient numbers.
They just need to be able to channel those votes to the major parties. Anti-austerity parties in contrast did not receive sufficient votes, and they are too polarised in any case. There is little chance of a coalition here. That’s not to forget the fact that 80% of Greeks want to stay within the eurozone (not a small point).
In my opinion, the political situation alone would argue against an exit. But even if the political will did exist, the legal hurdles are enormous – and for a country on the brink of collapse, insurmountable. It’s not as simple as just waking up one day and issuing a new currency. This would take some time, and it’s questionable whether the Greek central bank even has the legal right to do it. Euros are legal tender in Greece, and that is protected by Greek and European laws. Greek citizens would have recourse against their own government if attempts were made to switch holdings of euros into drachmas. Bond holders would have the same recourse if euro-denominated Greek debt was to be switched into drachma. Ever had a flick through the European treaty? It’s a legal nightmare; it would take months, if not years, to sort through the necessary legislative changes that the Greek government would need to make, especially with any fractured coalition that emerged out of the next election.
For instance, on the comparatively 'simple’ issue of capital controls – which advocates of a 'Grexit’ acknowledge would be essential in any decision to leave – Article 63 of the European treaty prohibits restrictions on capital flows between member states. Furthermore, Article 59 suggests that any capital controls that are put in place need the approval of the European Commission. Obviously that isn’t going to happen before domestic bank deposits have been devastated, and Articles 63 and 59 suggest that pre-emptive approval isn’t really possible. This is probably why European finance ministers have said any talk of Greece exiting the Eurozone is nonsense – 'propaganda’ even.
Why don’t they just leave the EU, you ask? The short answer is it would cost them too much. Since 2007, Greece has received the better part of €40 billion from the Common Agricultural Policy and structural grants alone. That represents about 5-6% of Greece’s public revenues and then there are the legal and structural impediments.
Now, the counter to all of this is that an exit is unavoidable. The economics of Greece being in the euro just doesn’t make sense and an exit is the only solution. Everything else the Europeans try is just 'kicking the can down the road’. At the core of this issue, Greece has a balance of payments problem – of which the budget deficit, public debt and the broader crisis is merely a symptom. Accordingly, Greek competitiveness is the real issue and this can only be resolved if Greece devalues the currency and increases exports.
Its sounds intuitive enough, but the flaws are immediately apparent when you look at historical context – even when they had the drachma, Greece experienced current account deficits.
Chart 1: Greek current account deficit (% to GDP)
Also consider the Australian experience: we have had a floating exchange rate since 1983 and have run current account deficits ever since, even in periods when our currency has depreciated sharply. There are two reasons for this, the first being that trade deficits often have less to do with export weakness and more to with import strength.
Chart 2: Greek export growth
You can see from the above chart that there is nothing wrong with Greek export growth. Apart from 2009, it’s quite strong and the Greek economy is clearly quite competitive.
It’s when you take a look at imports that you can see where the problem with the balance of payments lies (in terms of goods traded). Literally three items drive the trade deficit here: oil, ships and investment income paid abroad (interest on corporate and sovereign bonds, and dividends). Oil by itself represents 40% of the current account deficit and with that in mind, what would leaving the euro achieve? Well, we know that the value of imports will surge. Think of the cost increase a devaluation would bring – the deficit would likely balloon – and only a marked slowdown in growth would ease it. That’s why in the chart below you see that import growth has slowed significantly over recent years.
Chart 3: Greek import growth
The second reason, of course, is that the trade deficit is only one part of the current account, or this balance of payments problem that people talk about. Income (dividends and interest paid to foreigners) and current transfers (usually payments between governments) are also key drivers. The problem is that this net income deficit funds economic growth and it underpins Greece’s key exports, such as tourism. Greece has a sizeable net income deficit and while it could default 100% on its debt to eliminate it, the country would then have to eliminate a sizable chunk of its imports, exports and therefore growth, defeating the whole purpose. The central bank could try by printing drachma, I suppose, but again this is self-defeating – assuming that they could do this before the economy completely collapsed (which, as discussed above, is unlikely). The exchange rate would fall further, sure, but imports would be more expensive, leading to a larger funding gap – and one that clearly wouldn’t be met. The only result would be inflation, which in turn would eat away at any benefit devaluation might have provided on the export side. And so the downward spiral goes.
As for the rest of us? Well again, things would certainly be messy, but I think we would avoid another GFC. To see why, consider that contagion would be the big problem in a Grexit and especially contagion into Italy and Spain. It’s fair to say this would be immediate, and yields would soar; the euro would drop sharply. But recall my first piece showing how Italian and Spanish balance sheets aren’t that bad. Solvency isn’t the issue with Spain and Italy – liquidity would be the main threat, and certainly this would dry up. But the response from policy makers would be equally dramatic and swift. Major central banks would flood the market with liquidity. The ECB, having not bought a single European bond for some time, would instantly be back in the market. They would certainly provide another long-term refinancing operation, which was so successful in stabilising things previously. Italian and Spanish bond yields would fall. Recall also that Europe has €500 billion available as a firewall.
In conclusion, I doubt Greece will present as another Lehman moment. There is no political will for Greece to leave the eurozone, and even if there was, the legal hurdles are insurmountable. Finally, the economics just simply make no sense. An exit would not make Greece more competitive as many proponents have claimed.