Will Greece stay with the euro?

Greece is negotiating with its creditors to gain a third bailout.

Greece’s parliament has approved the preconditions or reforms that its creditors deemed necessary for Athens to obtain more money. Under its interim settlement with creditors, the country has met the payments it missed to the International Monetary Fund (IMF), repaid the European Central Bank and will receive any money it needs to make other repayments that fall due before any third rescue is finalised. Greek banks have reopened and the European Central Bank (ECB) is allowing them to receive emergency assistance. Creditors have hinted at debt relief.

For all the recent brinkmanship, Greece is still part of the eurozone.

Some would say that the conditions surrounding any bailout, while harsh on Greece, solidify the credibility and future of the euro. Even at the most critical point of the showdown between Athens and its creditors, panic never spread to other European countries that have debt loads approaching default levels.

All appears calm.

Greece is still in trouble

Yet just about everything connected to the saga is in worse shape than it was before the recent confrontation between Athens and its creditors. Greece is set to swallow more of the austerity poison that has shrunk its economy by 25% since 2010 and helped boost Athens’ gross debt to an unsustainable 180% of GDP.

Even without more austerity, the bluster between Greece and its creditors has undermined confidence enough to intensify the country’s greater-than-Great-Depression depression, which wrecks efforts by Athens to attain the budget surplus it recently achieved before interest payments, the equation it needs to lower its debt load (or to default).

Greeks have pulled so much money out of their country that capital controls are needed to prevent a collapse in the banking system. The banks, while open, are operating under restrictions such as withdrawal limits.

The ruling Syriza coalition is spilt – about a quarter of its 149 members refused to support the conditions that are contrary to election promises but are needed to secure a bailout that promises to give Greece another 86 billion euros (A$125 billion) over the next three years. The government is likely to become more unstable as the economy disintegrates.

The numbers surrounding the proposed bailout don’t add up because they rely on the sale of state assets that Greece’s Economy Minister George Stathakis said “do not exist”.[1]

Greece is still left with an unsustainable level of debt for its creditors refused to write-off a large portion of the country’s liabilities, hinting only at possibly stretching maturities (a form of default, nonetheless, but one that is politically invisible).

Greek voters watched their leaders accept harsher conditions than the ones they voted against in the plebiscite on July 5. They saw their leaders cede control of their country for international lenders have the power to veto legislation. The humiliation of Greece augurs poorly for the fiscal and political integration that Europe’s monetary union needs to survive for it has added more venom across Europe for populists to exploit and pitted debtor nations such as Italy and France against creditors such as Finland, Germany and the Netherlands (and prompted the Czech Republic, Hungary and Poland to say they won’t join the euro as scheduled).

The three watershed events that point to a Greek exit

On top of all this, three watershed events that can’t be undone occurred during the negotiations. The seminal moments in order of occurrence were, firstly, the ECB’s decision not to act as a lender of last resort to Greece. The next was news that Germany had drawn up plans to entice a temporary Greek departure from the euro. The last was the IMF making public its advice that a large portion of Greece’s debt needs to be written off by other EU nations.

These pivotal actions on top of economically damaging conditions Athens is implementing point one way; towards a Greek exit from the euro.

Having said that, a well-constructed third bailout for Greece will defer any departure from the euro.

Another delaying factor is that Greeks, for all the suffering the euro has caused them, still want to stay in the eurozone. Perhaps confidence will return in Greece now that the risk of a Greek exit from the euro has lifted for now.

Greek Prime Minister Alexis Tsipras is still popular even though he’s broken most of his election promises, so perhaps Greek politics will be more stable than its economy warrants.

The forces acting to entwine the eurozone are still holding, even if that’s partly driven by concerns about the consequences of a Greek exit from the euro. International politics dictates that Greece, due to its location, will probably draw the foreign support it needs, however begrudgingly, to ensure that there is no failed state on the EU’s southeast flank or one that is beholden to anti-EU forces.

Much of the medicine inflicted by creditors will do Greece good in the long term. The showdown over Greece has intensified calls for Europe to achieve the fiscal and political integration it needs to ensure the survival of its currency union. Some say German Chancellor Angela Merkel plans to achieve such a fiscal and political union after the next German election in 2017. The problem, however, is that Greece is too unstable politically, economically and financially to hold together for that long.

The unwelcome truth for EU taxpayers

Greeks, since accepting bailouts in 2010 and 2012, came to detest the so-called Troika supervising these austerity-laced rescues; namely, the ECB, the EU and the IMF. They might perhaps now think more of the IMF for the body is pressuring the other two in the trio to agree to a large Greek default.

The explosive view was handed to EU leaders in a confidential IMF memorandum during their 17-hour pounding of Tsipras over July 12 and 13. The three-page memo, which spoke of “deep upfront haircuts” and perhaps “explicit annual transfers to the Greek budget”, stated that Athens’ debt could reach an unpayable 200% of GDP within two years because the economy is crumbling under the uncertainty surrounding Greece’s banking system.[2]

The memo came with the implicit threat that the IMF wouldn’t take part in any third bailout unless other European countries give Greece substantial debt relief, for the IMF can’t help countries unless their debt loads are projected to be on a sustainable path.

The absence of the IMF in any third bailout will make the rescue package far more expensive for EU taxpayers.

Basically, the IMF is pressuring EU leaders to admit to their taxpayers that a vast, but unknown, amount of their money must be spent to keep Greece in the eurozone. But such an admission would ignite voter fury against leaders who promised their voters that Greece could be saved at no cost to EU taxpayers.

One consequence of the IMF’s memo is to make a Greek exit from the euro a more palliative option for EU leaders for under many circumstances less EU taxpayer wealth would be squandered on Greece if the country no longer used the euro. Another is that it reinforced the view among hardliners that a Greek exile from the euro would force other euro-users to fix their finances and thereby strengthen the euro’s future.

The bombshell: Germany tried to induce Greece to leave the euro

During the negotiations among EU leaders in mid-July, it emerged that Germany’s finance ministry had drafted a plan to entice Greece to leave the eurozone for five years. Greece was offered the option of a transformational debt default if it quit the eurozone and then undertook reforms before being allowed back. The so-called “time out” condition was even in the first draft of the Eurogroup leaders’ statement that they traditionally release after such summits.

The German finance ministry plan, even though it was scotched by Chancellor Angela Merkel under pressure from other countries especially France, destroyed the mantra that Europe’s integration can never unravel and that leaving the currency union was taboo.

While these are far-reaching events in themselves, in the context of a Greek exit, the message from Germany’s finance ministry was that it would only consider the German national interest being served if eurozone members follow rules on budget deficits, debt and free trade.

A Greek exit is more likely because Athens over time won’t be able to meet the German-enforced straightjacket that creditor nations appear determined to enforce on debtor countries.

Much of Germany’s elite think that, since a Greek exit is inevitable, it’s better to let Greece go before too long for the sake of the euro. Since the EU leaders’ summit, German Finance Minister Wolfgang Schäuble has said a Grexit (i.e. Greek exit) is the best solution to the Greek debt crisis.[3]

Days later Germany’s most respected economic body, the academic German Council of Economic Experts that advises policymakers, called for a mechanism to enable indebted countries to leave the euro as a “last resort”.[4]

Apolitical?  The controversial ECB decision

Sitting among all the political pressure swirling around Europe is the ECB. In these days of so-called independent central banks, the watershed the ECB crossed can be deemed outrageous.

Central banks are distinct from other banks in many ways but especially by their ability to act as lenders of last resort to their governments or banks during a crisis. Central banks perform this for governments by meeting repayments (by printing money in the original sense) and do it for banks by providing emergency lending.

The ECB’s problem is that due to its supra-national role it can only half fulfil this lender-of-last-resort role, which is why it’s regarded as a pretend central bank. It has some lender-of-last-resort powers for governments under its yet-to-be-used bond-buying Outright Monetary Transactions program that was set up to back President Mario Draghi’s pledge to do whatever it takes to save the euro. But these powers are conditional and limited.

The ECB can help eurozone banks under its Emergency Liquidity Assistance program, whereby the ECB allows national central banks to keep their banks alive by giving them money against collateral, often the bonds of their government. But the ECB’s role is limited to assessing the creditworthiness of the collateral. It does not do the lending.

The ECB had supported Greek banks by regularly raising how much help the central Bank of Greece could provide under the emergency lending program since the Greek crisis intensified when Syriza was elected in January.

The controversial ECB decision is that on June 28 it refused to raise the level of emergency help for Greece after Athens called for a plebiscite on whether voters were prepared to accept the latest deal on offer and urged voters to vote “no”.

The ECB’s decision to withhold emergency lending predictably forced the closure of Greek banks and the introduction of capital controls, events that have done untold harm to the Greek economy.

Perhaps even worse, many think the ECB acted to pressure Greeks to vote “yes”.

No doubt the ECB, due to the constraints under which it was established and under pressure over the amount of EU taxpayer money at stake, was manoeuvered against its wishes by creditor nations into being a political weapon.

But that’s what happened, which makes the ECB a perverse as well as a pretend central bank.

It is inconceivable, for instance, that foreign governments could force the Reserve Bank of Australia to undermine our banking system to influence an Australian election.

Quitting the euro the only way for Greece to have control of its financial system

The ECB’s decision argues for a Greek return to the drachma because it reaffirms that the only way for Greece to have control of its financial system is to quit the euro.

If there were to be a fourth watershed event surrounding the latest Greek-EU showdown it would be the news that Greece’s government had a secret plan to switch to the drachma if talks with EU leaders had failed to garnish a third bailout (which, while looking likely, is still not guaranteed).[5]

Given all that’s happened and the damage done to Greece’s economy, Athens would be foolhardy not to form similar clandestine plans, no matter how calm Greece might look now.

by Michael Collins, Investment Commentator at Fidelity (Reproduced with permission)

Note: Financial information comes from Bloomberg unless stated otherwise.

[1] Bloomberg News. “Greek assets to be sold in bailout ‘don’t exist,’ minister says.” 15 July 2015. http://www.bloomberg.com/news/articles/2015-07-14/greek-assets-to-be-sold-in-bailout-don-t-exist-minister-says

[2] IMF memorandum. “Greece: An update of IMF staff’s preliminary public debt sustainability analsys.” Undated. http://graphics8.nytimes.com/packages/pdf/business/IMF-Greece.pdf

[3] Politico. “Schäuble undermines Greek deal.” 14 July 2015. http://www.politico.eu/article/german-finance-minister-schauble-undermines-greek-deal-grexit-merkel/

[4] German Council of Economic Experts. “Special report of the council.” “Executive summary” in English. Point 8. 28 July 2015. http://www.sachverstaendigenrat-wirtschaft.de/fileadmin/dateiablage/download/sondergutachten/executive_summary_special_report07-2015.pdf

[5] Financial Times. “Varoufakis unplugged: the London call transcript.” 27 July 2015. http://blogs.ft.com/brusselsblog/2015/07/27/varoufakis-unplugged-the-london-call-transcript/

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