Grexit now more likely after latest Eurozone ‘deal’

The Eurozone has announced  what the headlines refer to as a ‘deal’ on Greece , emerging  from yet another all-night negotiating session. History suggests that agreements reached in the wee small hours by sleep deprived participants can look very different to at least some  bleary eyed negotiators in the clear light of day, but that aside the agreement is  quite extraordinary, and breaks new ground in terms of euro zone governance. Indeed, such is the departure from previous discussions with debtors that, if anything, it increases the risks of Greece leaving the euro.

The text of the Euro Summit on Greece opens with a statement on  the need to rebuild trust with the Greek authorities and to that  end  Athens has to pass legislation, by Wednesday 15 July, on a range of measures, including pension reform , changes to the VAT system, the independence of  the state statistical service and the setting up of a Fiscal Council. In addition the legislation should include ‘quasi-automatic spending cuts in case of deviations from ambitious primary surplus targets’ and by the following week new laws  changing the civil justice system. The ECB will maintain the existing level of ELA for a little longer, to focus Greek minds, while the banks will remain shut.

Upon a satisfactory conclusion of the above, and subject to the approval of ESM member states, negotiations may start on a new loan, but Greece has also to set out a timetable for the implementation of  another raft of reforms, including further changes to the pensions system and  significant moves to liberalize retail markets , the professions, labour markets and the financial system. The energy transmission mechanism is also to be privatized, and in that context the text also proposes  an unprecedented step, in that Greek assets are to be sequestered into a separate fund for privatization, with the intention of raising €50bn, to be used to finance the recapitalization of the banks, to run down debt and to fund investment.  Moreover, Greece also has to undo some of the legislation brought in by the new Administration  and is required to ‘consult and agree with the Institutions on all relevant areas before submitting it for public consultations or to parliament’

The Hellenic Republic will also have to seek a further IMF loan and a total bailout figure of €82bn to €86bn is envisaged, although the text also notes that fulfilling the initial conditions does not guarantee that a  loan will follow. The Eurogroup may consider debt extensions and changes to interest rates but ‘ nominal haircuts on the debt cannot be undertaken.’

Some might consider all of this a move to shift Greece towards a Northern European style market economy and one consistent with euro membership  while others have already branded it as a ‘coup’, with the Eurogroup  accused of seeking regime change . The degree of interference and control from Brussels is certainly a new departure as is the idea of preconditions before negotiations can even begin. The latter certainly increases the risk that political support in Greece will not materialise, particularly as the electorate have already rejected a less severe version of the measures now mandated. In addition, implementing reforms, even if passed by parliament, may prove extremely difficult , if not impossible.  A debt write down is also not on offer, even though many, including the IMF, see the debt situation as effectively unsustainable.

Perhaps the most striking development over the weekend was the German proposal that Greece could take a 5-year timeout from the euro area. Leaving aside the practicality of such a move the fact that it was put into the open ( although not in the final text)  shows that Grexit is no longer seen by some creditors as a disaster, Indeed, the ‘take it or leave it ‘ tone  of the offer is also striking (‘the risks of not concluding swiftly the negotiations remain firmly with Greece’) and one can only conclude that the probability of a Greek exit from the eurozone has increased, either  through a Greek rejection of the proposals or via some creditors still  baulking at what they see as the futility of throwing good money after bad.

When Debtor Fatigue meets Creditor Fatigue

The euro has always been a politically driven project, and the inevitable economic fault lines that emerged  as it expanded  have been met with a surprisingly strong will on the part of  member governments to maintain the single currency. That determination has surprised markets and often confounded analysts , although  any decisive political action has often emerged from crisis meetings in the early hours of the morning. Decision making in such an environment raises issues of democratic accountability and  risks serious policy errors ( for example the determination to prevent a sovereign default within the EA) and  post-meeting disagreements on what was actually signed off ( see Ireland’s belief that the ESM would be able to retrospectively recapitalize banks). The euro is also now left with fiscal rules  and constraints which are  both extraordinarily complex and lacking in credibility; no one believes that a euro member will be fined for a breach and the Commission has repeatedly backed down when faced with one of the larger member states, notably France .

In the absence of a fiscal union the euro member states have funded bailouts for sovereigns who have lost market access, first directly (as per the first Greek loan) and then through the EFSF. Initially the loans carried relatively high interest rates ( as a form of punishment for fiscal impropriety) but that soon changed as debt sustainability came to the fore, an issue of particular importance to the IMF, which was brought on board  to help design loan programmes and the incorporated conditions.

The Fund’s modus operandi is to  project what it considers to be a sustainable medium term debt ratio  and then derive the required primary fiscal surplus needed to get to that target, given other assumptions including economic growth. Those assumptions can prove spectatularly wrong , and they did in Greece ; the  negative impact on the economy of the required fiscal contraction was much greater than envisaged (  GDP fell 25%, a depression rather than a short lived recession) and  the  forecast €50bn receipts from privatization failed the matrialise ( the figure to date is around €3bn).

Such programmes also assume that creditor governments can deliver the required primary surpluses, however large and sustained they are deemed to be , and ignores the electorates role. Debtor fatigue can set in. In most  countries that has been confined to  (growing) opposition parties but in Greece resulted in a new government pledging an end to austerity, new loans, a debt write down and ongoing euro membership,

Much of that is not in the gift of the Greek authorities to deliver (who knows what electorates can decide )  and that debtor fatigue is now meeting creditor fatigue, which has not been eased by the unusual negotiating stance adopted by the Hellenic Republic, which some characterise as driven by game-theory and others see as inconsistent and bordering on farce. The creditors are not united, it has to be said, with France notably sympathetic to Greek requests, although most , to date at least, appear willing to see Greece exit the euro, such is the lack of faith in Greece’s ability to deliver reforms or to meet the terms of any new loan. Some of that hostility emanates from other debtor countries fearful of the impact of a perceived Greek success on their own political futures- we are all creditors now, it would seem.

Any new money, should it materialise,  will come from the ESM, and that requires a unanimous decision by the Board of Governors, made up of member states. Consequently  any one country can prevent disbursement. In addition, ESM debtors are required to be in a programme which it is envisaged would involve the IMF, so Greece’s default with the fund poses a difficulty.

The Greek crisis has also highlighted the Lender of Last Resort issue . The ECB is not willing to fulfill that role unconditionally and has limited the amount of emergency liquidity the Central Bank of Greece can provide to its banking system. So the ECB, despite its claims to the contrary, emerges as a key player; its actions put pressure on the Greek government to reach an agreement with the creditors and could be the  catalysts for  Grexit, as the pulling of ELA would require Greece to print its own notes to fund the economy.

The markets have shown little in the way of panic reaction to  the Greek saga  and probably feel that some compromise will emerge to keep Greece in the euro, if only because such last-minute deals have been the norm in recent years. Whatever the outcome the stark emergence of debtor and creditor fatigue into the light is a profound  development , and one which is likely to have significant longer term implications for the euro regardless of any short-term fix.