From Societe Generale
The Greek Parliament is due to vote on the Medium-Term Fiscal Strategy (MTFS) on June 28 and the associated implementation law on June 30. If all goes well, the Eurogroup will then meet on July 3 to finalise a new 3-year program for Greece. If the Greek Parliament votes No (a scenario to which we attach a 30% probability), the much need next €12bn tranche of the EU/IMF would be blocked and Greece would be left grappling for funding in a political vacuum pending a likely general election. In such a scenario, the EU would have to take aggressive action to stem contagion; and this could include reactivating the ECB’s SMP. Even in a best case solution, the euro area debt crisis seems likely to run from one issue to the next with the over-arching solution of a new credible fiscal policy infrastructure coming into place only very slowly.
If all goes well …
A yes vote in the Greek Parliament to the MTFS will no doubt bring a sign of relief, and the immediate focus will shift to the Eurogroup meeting on July 3.
What shape will the new program take? We expect the Eurogroup to define a 3-year package effectively removing the need for Greece to access bond markets before 2015. While there is no final number as of yet, a package of €85-120bn seems likely split between new EU/IMF loans worth €40-70bn, Greek privatisation receipts of around €25bn and private creditor participation of €20-30bn.
How will private creditors participate? At last week’s Eurogroup meeting a subtle change to ESM seniority, making loans to Greece, Portugal and Ireland exempt from the rule (pending approval by national parliaments) brought a small first concession to private creditors. However, press reports suggest that private creditors (and this mainly concerns banks, who hold the bulk of the shorter dated Greek paper) want more enhancements before agreeing to some form of maturity extension. An additional concern is not to trigger a credit event in the process, which the ECB rightly fears could have unintended consequences. Press reports last week (Bloomberg) suggested a solution under which banks roll over 70% of the expiring amount, placing 50% in Greek 30- year paper and 20% in very high quality securities that would then back the Greek bond.
One idea that has popped back up in the debate, but only to quickly disappear again is lending to Greece to buy back its bonds cheaply in the markets. The idea hold substantial appeal from an economics points of view in that it would partially help solvency as opposed to just funding. Politically, however, the idea has been met with substantial resistance, and notably in Germany. This could nonetheless be one of the last minute jokers in finalising a deal for Greece.
Also, keep in mind that the voluntary private creditor solution put in place for Greece could well serve as a blueprint for Portugal (the EU/IMF agreement on Portugal, explicitly notes that Portugal should negotiate with private creditors to maintain their exposure to Portugal).
Will Greece fail at the first hurdle? Any new package for Greece comes with strict conditionality and with a review by the “troika” of the IMF, EU Commission and ECB every three months. Even with the best of will, Greece will find it very difficult to meet the targets and much relies on the ability of Greece to effectively collect taxes and privatise. Unions are already planning strikes for next week with the threat of disruptive power cuts. There is thus every risk that Greece will at some point fail to meet the targets set out. The question then becomes just how much tolerance the EU/IMF will adopt towards Greece. Even with a package in place, repairing the situation in Greece will be a long and painful process, and one fraught with risks.
Can Greece ultimately avoid default? The sustainability of Greek public finances depends critically on the snowball effect, i.e. the difference between nominal GDP growth and the funding rate and the level of the primary surplus. Greece’s public debt today stands at almost 160% of GDP, with a primary balance forecast at -2.8% in 2011 and nominal GDP forecast at -3.1%. Even with the attractive funding rates provided by the EU and IMF (just under 4% at present), the situation is clearly not sustainable.
Making a back of the envelope calculation, we find that if Greece can sustain a primary budget balance and enjoy nominal GDP growth that exceeds the implicit interest rate on its debt by 1pp, it would take Greece 100 years to reach a debt-to-GDP ratio of 100%. If Greece in addition could sustain a primary budget surplus of 1% of GDP every year, it would take 50 years.
Theoretically, Greece can avoid default, but it depends critically on the ability to achieve growth, run a primary surplus and achieve a cheap rate of funding. If the rest of Europe wants to avoid Greek default, it seems it may be funding the country for many years to come.
Can the euro area avoid contagion? The risk of contagion from Greece is substantial. In building a new fiscal framework for Europe, the hope is one day to allow for an “orderly default” within the region. Last week’s EU Summit brought good progress on the ESM and EFSF, and the Six Pact (the new stronger version of the Stability of Growth Pact) is near completion. In our opinion, however, there is still considerable more work to complete and we maintain our view that ultimately a single euro bond and a single bank resolution mechanism (similar to the US FDIC) is required. Such mechanisms are still far out (years) on the political horizon leaving the euro area open to new bouts of tension.
…if Greece says No
A No vote to the MTFS by the Greek Parliament will cast Greece into turmoil and threaten wildfire contagion throughout the euro area.
What happens in Greece if Parliament says No? The country would be thrown in a political vacuum with an election then most likely being called. The centre-right opposition, New Democracy led by Antonis Samaras, is well positioned to win in the event of an early election. We note that Samaras is not opposed to austerity per se but wants a “different economic policy” not based on excessive taxation and with a strong focus on growth. Once in place, a new government would then have to renegotiate a new deal with the EU/IMF. The most likely outcome – similar to what we have seen in Ireland and Portugal – is that the new Greek government would in the end sign up for austerity.
Will Greece automatically default? A No would block the much needed next tranche of the EU/IMF loan of €12bn, leaving big question marks as to how Greece would fund coupon payments and bond redemptions in July and August.
Over the weekend, German MoF Schaeuble was very clear that a No vote from Greece could mean no funding for Greece from the EU. For funding, Greece would then have to rely on short-term paper until a new government could be formed and a new MTFS negotiated. The EU may in such an event ultimately agree to some form of bridge loan (similar to Portugal). The IMF could also agree to credit line. Any help from the EU/IMF would come reluctantly, and there is a nonnegligible risk that a No vote could put Greece in default.
Can contagion be stemmed? Contagion would run through government bond markets and via interbank funding markets. In both cases, the ECB is best placed to respond reactivating its Securities Market Program of government bond purchases and offering adequate liquidity to banks.
These measures will be primarily effective in tackling shortterm market tensions, but the euro area are still potentially at danger from seeing more countries (and notably Spain, and potentially even Italy) making recourse to the EFSF. Such a negative scenario would threaten not only the financial stability of the euro area, but the global financial system with severe consequences for the global economy. This also explains why, even in the event of a Greek No, euro area leaders would be keen to avoid experimenting a Greek default.
Conflicting time horizons
The main issue for the euro area remains one of conflicting time horizon. Fixing solvency for countries with weak public finances and shaping a new credibility fiscal policy framework for Europe will take time. Markets have little patience, and policymakers have every interest to accelerate wherever possible.