It's Baaack: Looming Greek Elections Threaten To Re-ignite the Euro Crisis

If at first you don't succeed, try, try again......  aka third time unlucky.

The Euro crisis has all the signs of being back amongst us, and this time it may be here to stay. After two earlier false alerts - one in July around the collapse of the Portuguese Banco Espirito Santo, and another in October over the state of the Greek bailout negotiations - the announcement in early December that the Greek presidential selection process was being brought forward to the end of the month sent  markets reeling off into a complete tizzy.

In a development reminiscent of the heady days of 2012 yields on Greek 10yr bonds surged over a percentage point in the two days following the announcement, while the stock market fell by the most on a single day since 1987. 5yr CDS on Greek debt were also up sharply, and even more significantly, the yield curve inverted with 3 year debt started to move above that on ten year debt. Yield inversion on sovereign bonds is often seen as a symptom of potential default as investors demand ever more for holding short term debt.

And the chaos continued all week with 10 yr bond yields rising above 9% and stocks falling another 7.35%, taking the total drop in equities to over 20% (chart from Mike Bird at Business Insider).

 The reason for the market panic is obvious, since investors didn't need long to study the Greek constitution and realise that should the current government be unable to summon sufficient votes for their candidate to be approved in the final vote on 29 December, then general elections would become inevitable.

With yesterday's vote this possibility has now become a reality and elections are to be held on 28th January 2015. What's more there is a significant possibility that the radical left coalition - Syriza - will win, and in that eventuality some sort of confrontation or stand-off with the EU Commission and the Troika would become inevitable.

What is worrying investors most is not the fact that Syriza have renegotiation of the country's debt in their programme - with government debt at over 175% of GDP and the economy in deflation some sort of restructuring is inevitable - but the kind of economic programme the new government would try to implement since it would surely be based on a kind of "anti Troika" formula - higher salaries, higher pensions, more government employees, and repeal of the new labour law, just for starters - and these kind of "reverse reform" measures would be hard for Europe's leaders to swallow.

Formally the party do not seek to leave the Euro, their aim is rather to run an alternative economic model within the Euro structure, based on the assumption that faced with the threat of Greek exit Europe's leaders would back down and become more flexible. Investors are nervous since they fear that they may not do so, and that Greek exit may actually ensue.

Long Term Depression

Despite the fact Greece's economy grew by 1.6% over a year earlier in the 3 months to September (making for the third straight period of quarterly growth) this welcome "green shoot" comes on the back of six years of contraction during which time the economy fell by around 25%. The country - and it's citizens - is a lot poorer now than it was then, not to mention the fact that it has been burdened with a lot more debt.

So while growth has returned, it is very modest growth in relation to the fall which preceded it. In addition the country's economy is suffering from deflation, with consumer prices falling by 1.2% in November over a year earlier, the 21st consecutive month of negative inflation. The IMF now forecast that Greek GDP will grow by 0.6% in 2014, but prices will fall by 0.8% meaning that nominal (non inflation adjusted) GDP will be stationary. And this kind of situation could go on for years and years as the country exists a horrendous recession only to enter an extended period of secular stagnation.

Despite the timid, but much applauded, recovery, the macroeconomic data is far from being encouraging, as this screenshot taken from the statistic office website illustrates.

Industrial output is back where it was in 1976, and was down 1.7% over a year earlier in October.

 Greece's current account has made huge strides in the right direction, and the balance was even positive in 2013, but this improvement has largely been the result of a reduction in imports (and living standards) and not due to export growth.

As a result the country still runs a sizable goods trade deficit.

So Greece isn't having an export lead recovery, which is what the country really needs. In fact massive sacrifices have been made, many people's lives have been made a misery, yet there is really very little to show for it all. Which is why Syriza is doing well in the polls. With 26% unemployment continuing, surely (the thinking goes) anything would have to be better. Why not try a long shot in the dark?

Whom The Gods Would Destroy They First Make Mad

The horrid little secret about the common currency experiment is that it provided a structure wherein it was very easy to get into trouble (cheap interest, good credit ratings, no current account supervision) but desperately hard to get out of it (no currency to devalue). The big problem for Greece now is to find a way to get the country back to where it was before they got into the current mess while staying inside the currency union? Some would say quite simply they can’t and the conclusion to be drawn is that they should leave the Euro. This isn’t as easy or as obvious a solution as it seems, and in addition many of the other member countries are effectively counter-parties on much of the large external debt that has been accumulated, so in the event of non-payment part of the problem would simply change hands. Any decision by a member country to cut loose from the Euro is unlikely to be welcomed by the creditor nations, making the idea of a voluntary, negotiated departure pretty unlikely, particularly after Mr. Draghi made his promise. The exiting country would have to do so unilaterally, and face the consequences on debt default and sustained lack of access to international capital markets.

It would be a very messy affair, and in some ways not a decision a person applying a rational calculus would be likely to arrive at. There are so many losses to offset against the gains. Under these circumstances the only conceivable way a deliberate decision to leave could credibly be envisioned would be as a result of one or more of the respective agents being effectively driven “insane” by the constant painful efforts involved in trying to carry out the very large competitiveness correction required while remaining within the currency union. This indeed was the argument I advanced in my essay submission to the Wolfson Prize: a procedure for orderly exit is essentially a worthless document since if anyone does leave the affair won't be orderly, but bitter and fraught with conflict. And this phenomenon of growing political instability was what characterized Argentina before it went careering off the tracks in December 2001.

So just because many might question the rationality of such a decision doesn't mean it won't happen, or couldn't happen as an unwanted side effect of a conflict which gets out of control. Economies on the southern periphery are not recovering (in any normal sense of that word), they are condemned to either frequent recessions or one very long depression, depending on how you classify things, together with protracted deflation and unacceptably high levels of unemployment. The degree of lost competitiveness that was inflicted during the early years of the century - and which is as much an institutional and reputational issue as it is a price one - imply that a decade or more may pass before daylight is seen.

If it ever is. This outcome is proving very painful for the respective populations. Too long and too painful, which is why we are now seeing a surge in support for organizations like Syriza, or Podemos in Spain, or the 5star movement in Italy. Confidence has steadily eroded in the old political elites, who were trying to convince voters that pigs really could fly (while in many cases lining their own pockets in the process) and more radical political movements are emerging. It isn't that hard to understand. This was always going to happen.

Some, like the FT's Kerin Hope, try to draw comfort from the idea that Syriza may be moderating as the responsibility of holding power looms.

"....the recent market panic belies the fact that Mr Tsipras has softened his rhetoric since Syriza came first in May’s European elections, cementing its lead over the governing New Democracy party in opinion polls. He professes devotion to the euro while his economic team now holds regular international conference calls in an effort to reassure fund managers that a leftwing government would be able to tackle Greece’s debt problem and would not oppose foreign investment."

But this may be mistaking tactics for strategy. These movements are not about to get incorporated in the mainstream. And the key issue is not likely to be the debt one. As I explained (here) in the summer of 2013 formulas exist for handling this question. What is most likely to divide Athens and Brussels if Syriza win the elections is the nature of the economic model the country will adopt. In this sense Ambrose Evans Pritchard has this one right.

As matters stand, it is more likely than not that a defiant Alexis Tsipras will be prime minister of Greece by late January. His Syriza alliance vows to overthrow the EU-IMF Troika regime, refusing to implement the key demands. A view has taken hold in EU capitals and the City of London that Mr Tsipras has resiled from these positions and will ultimately stick to the Troika Memorandum.... But the fact remains that he told Greek voters as recently as last week that his government would cease to enforce the bail-out demands “from its first day in office”.

 In fact they go further, describing Troika representatives as "criminals" who work to convert the periphery into "German colonies". If you listen hard enough you can hear Podemos leaders saying similar things in Spain.

As Ambrose also points out, Mr Tsipras will be banking on the idea that the EU leaders will back down, and talk turkey. But what if they don't? Their room for manoeuvre on this front is far more limited than it is on the debt one, since others in the south would surely want to follow a similar path if they thought they could. Grexit may be something that no one actually wants to happen, but sometimes things no one wants to happen do.

 Postscript

The above arguments are developed in detail and at far greater length in my recent book "Is The Euro Crisis Really Over? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.

Greek Re-entry (or Grentry) Not The Game Changer Many Think It Is

There is no doubt that Greece's recent bond sale was an exciting and even invigorating moment for many people. The WSJ's Simon Nixon, for example, called it "a symbolically important moment for the euro crisis". Reuters' Marius Zaharia suggested the speed of the come back could even be a game-changer for the heavily indebted southern European country. Certainly there can be little doubt that, as Nixon puts it, the turn round in market fortunes was a remarkable achievement, illustrative of just "how far market sentiment toward Southern Europe has changed". 

 "For the country at the center of the crisis to draw €20 billion ($27.77 billion) of foreign demand for a five-year bond yielding under 5% shows that the market now believes Greece will stay in the euro zone, that it won't collapse into chaos and that any further debt relief will be provided by official rather than private lenders."

The pace of the fall in Greek bond yields has been little short of astonishing, and Nixon is surely right, market participants now believe that the country isn't about to collapse into chaos (although we'll have to wait and see just how far this belief survives any further evidence of increasing support for Syriza). Possibly more importantly, they are now convinced that future debt relief will come from the official and not the private sector. So swift has the turnaround been, that it is now quite probable that Antonis Samaras's promise the country would wind-up its bailout process in 2014 may well be fulfilled.

In fact, it is hard to understand the present turnaround in Greek financial fortunes outside of the context of (i) the widespread belief that the ECB will eventually be forced into a sovereign bond buying QE programme; and (ii)  the agreement by the country's Euro Area partners (pressurized by the IMF - see this post) to meet any shortfall on the country's debt reduction programme over and above 110% in 2022 provided it fulfills ongoing EU Commission reform  requirements. Following publicaton of the latest EU report in April the FT put it like this:

Under a hard-fought deal reached in November 2012, Greece’s lenders agreed to provide additional debt relief after Athens achieved a primary budget surplus – which excludes interest payments. Jeroen Dijsselbloem, head of the eurogroup of finance ministers, said these talks were set to begin after the summer. The EU official declined to speculate on how eurozone governments would help to lower Greece’s debt levels, insisting this discussion was not part of the just-completed review. 

What this basically means is that the Greek headline Eurostat sovereign debt figure of 175% of GDP is a very misleading one. 40% of this debt is in the hands of the European Stability Mechanism (ESM) on very favourable terms -  capital repayments are not due for 25 years while interest payments have a waver till 2023. As Klaus Regling, head of the  (ESM) put it in an interview with the Greek newspaper To Vima, "There's no debt sustainability problem for the next 10 years. This is very good news for investors."

Greece's public debt currently stands at about 320 billion euros, or 175 percent of GDP. About 80 percent of it is in the hands of the European Union and the International Monetary Fund, at very low interest rates and on a long repayment schedule.

Regling's ESM, which holds about 40 percent of Greece's debt, is charging Athens about 1.5 percent to cover its own financing costs. ESM rescue loans to Greece have a 25-year repayment schedule and Athens starts paying interest on them 10 years after they are disbursed. The EU and the IMF have so far extended 218 billion euros of bailout loans to Greece over the past four years and Athens stands to get 19 billion euros more by the end of the year.

In other words, investors, irrespective of whether or not the ECB introduce QE, can safely buy new Greek debt without worrying too much about whether they are going to be paid back. Between now and 2023 there is no real problem in that department given the de facto Euro Partners guarantee. As I point out elsewhere (On The Trail of Italian Debt) Greek and Portuguese sovereign debt issues are comparatively small beer, and will not threaten the common currency, but the same cannot be said for Italian, or ultimately Spanish, debt. So Greek debt, even at current interest rates looks, frankly, attractive. Doesn't Mario Draghi constantly advise investors not to underestimate the determination of EU politicians to hold the Euro together. Well, there you are.

Real Economy Hits Bottom But Muted Rebound Ahead

Life is rather different, though, within the typical Greek "oikos" (or household). While Greece's economic slump is now hitting the bottom and while, following a pattern seen elsewhere on the periphery, there has been a great boost for the financial sector, there has been relatively little in the way of real gains for the country's hard pressed population at large. Bond yields have fallen sharply, shares are up (or here), and banks are even able to sell bonds (for an example of what they then do with the money see this NYT piece from Landon Thomas), but little of this has trickled through to participants in the real economy.

The economy was down by 1.1% in the first three months of the year when compared with 2013,  the lowest inter-annual  Q1 drop since 2010. The economy is now something like 25% than it was at the q1 peak in 2009. Since the Greek statistics office STILL don't produce quarterly seasonably adjusted data (is that a measure of the progress they have made?) we don't know for sure, but it does look like the economy actually grew from December to March on an sa basis.

But there is little improvement visible in either retail sales or industrial output.

Unemployment has clearly peaked, but so far only fallen marginally.

A lot of the external correction has now taken place, and the current account balance was positive in  2013.

Exports turned positive on a year on year basis in March, but the country country still runs a sizeable goods trade deficit.

Credit gowth remains negative.

So, it is important to bear constantly in mind that the fact the economy has stopped contracting is not at all the same thing as it returning to growth. On that front we will need to wait and see, but there is little that is especially encouraging to date. The problem with having the Euro as a currency was never how to stop the economy contracting. It was always the difficulty which would exist in subsequently returning the economy to growth. Italy and Portugal pre-crisis didn't see their economies shrink, but they did remain stuck in low growth.

The most serious problem facing Greece right now is evidently deflation.

Inter-annual inflation has now been negative for 14 months. Curiously, in the Greek case the main problem with deflation is not going to be that debt levels are pushed up, since as we have seen above excess Greek debt is now effectively guaranteed by the Euro Area partners. A deflationary debt spiral this isn't likely to become the problem it could be in non-debt-guaranteed countries like Spain or Italy.

Deflation will, most likely, push up the level of non performing loans in banks, but even these can be recapitalized and some of the cost passed on to the common currency partners. The real problem in the Greek case is that people will constantly feel that the amount of money in their pockets is shrinking, which it will be (turnover can be down while sales volume is up). This creates a very important mismatch between the positive discourse about  economic improvement coming from the government and the official sector generally and the amount of money people see in their tills and wage packets. Naturally, deflation in this sense is not conducive to political stability, and it is here the main risk to the Greek recovery is to be found. In the meantime, a two tier Euro divided between those who have acquired some sort of implicit debt guarantee and those who haven't has effectively been created, yet few have so far seen fit to notice the fact. As the IMF stated in their latest (eleventh) Portugal Program Review:

"While staff considers public debt to be sustainable over the medium term, this cannot be asserted with high probability. However, systemic risk from contagion to other vulnerable euro area countries, should the sovereign fail to service its debt, continues to justify exceptional access......Nevertheless, commitments by euro area leaders to support Portugal until full market access is regained—provided the authorities persevere with strict program implementation—give additional assurances that financing will be available to repay the Fund".