(Dis)orderly default: Greece enters its endgame

Tuesday, September 27, 2011

This week, the ‘troika’ of officials from the IMF, European Commission and ECB resume their inspection mission -- interrupted mid-way on September 2 -- to decide whether Greece has met the conditions of its May 2010 bailout package and can therefore receive the next tranche of lending. Without this, Athens will run out of money to pay public sector workers and pensions in October, triggering a disorderly default whose domino effect would unleash havoc in the European banking system, threaten other euro-area member states and almost certainly push Europe and the United States back into recession.

The stakes could not be higher: recent meetings with EU officials seem to have convinced the Greek government that the troika is not bluffing -- at least one of its members, the IMF, could terminate its participation in the bailout. In response, Athens has unveiled its most severe austerity measures yet. This will hit ordinary Greeks hard, raising the risk that they rise up, making Greece ungovernable and its bailout untenable.

In this special Oxford Analytica Conference Call, our expert panel gave this assessment of the crisis in response to client questions:

Call summary

Are international lenders on Greece’s side?

The Greek government must re-establish credibility on the international stage. Prime Minister George Papandreou has visited Berlin where the focus has been on relationship mending. He has expressed his determination and absolute understanding that time is of essence for the execution and implementation of the bailout measures, so that the international community can feel confident that Greece is serious about finding a way forward. There is a strong element of brinkmanship: international lenders are no longer so willing to take Athens’s promises of better behaviour on trust, and before they agree on further support want first to see hard evidence that structural reforms are under way.

Opposition within the administration and determination to stick to its course

The government has so far stuck to its austerity policy, despite strikes and demonstrations. The stakes are high and parliamentary deputies from the ruling Socialist party are coming under immense pressure. The government has little choice but to push through a package of extra measures, that have become necessary because Greece’s deepening recession has shifted the programme’s fiscal targets. If Athens can satisfy the ‘troika’, it will get the go-ahead for the sixth bailout tranche of 8 billion euros (11 billion dollars). A successful outcome depends on resisting pressure from streets, maintaining party discipline in parliament and ensuring compliance in the civil service whose job it is to implement government policy.

Latest in a series of short-term fixes?

Polls are showing a considerable lack of public support and confidence in the government’s austerity measures. However 63% support the euro and don’t want to leave the euro-area. The government’s main failure is that it has not convinced the public that the austerity measures being taken are necessary, effective and vital. The government has also failed to provide any hope that things will turn round in a reasonable period of time.

How might the debt be reduced with a minimum of collateral damage?

Reducing the size of the public debt would be a clear advantage for the Greek leadership. Currently Greece needs to pay the equivalent of about 6% of GDP in interest payments, which is not conducive to long-term economic growth. However, it cannot impose a debt ‘haircut’ unilaterally. That would need the agreement of its euro-area partners and their political backing. Ring-fencing mechanisms would have to be in place to prevent destabilising the rest of the euro-area. If Greece defaulted in a disorderly manner, it would trigger panic in the markets and have immediate spill-over effects in the financial sector. The social consequences for Greece itself would be immense.

Can Greece make it until mid-2013, allowing an orderly default?

The euro-area’s top priority is to avoid Greece’s disorderly default in the near term. An orderly default could be managed in 2013, when the permanent bailout fund, the European Stability Mechanism (ESM), becomes operational. This includes collective action clauses allowing modification of debt repayment terms by majority agreement.

Effects of Greek default on other bailout recipients

Whatever happens in Greece has immediate implications for Ireland and Portugal. Although the causes of the three countries’ current difficulties are different, that difference is removed if one of the three countries fails. However, the first signs are appearing of positive economic change in terms of growth and development in Ireland. Portugal’s quarterly evaluation by the ‘troika’ is also positive.

Risks to French and German banks

A Greek default is being warded off for fear of the damage to the financial sector across the EU, but particularly in France and Germany. Exposure to sovereign lenders is a problem for European banks, especially smaller ones suffering from higher funding costs. Much debt is held at book value and so does not reflect the collapse in bond prices in Greece, Portugal and Ireland.

Possibility of leveraging the EFSF without involving the ECB

In this context, leveraging means ‘improving the financial capacity’ of the European Financial Stability Facility (EFSF) -- the bailout facility in operation until the ESM takes over. In July, euro-area leaders agreed to expand the scope and powers of the EFSF and to give Greece a second bailout of 109 billion euros. However, the agreement must be ratified by all 17 euro-area national parliaments, a process that could last until October and, due to continued haggling, is far from certain.

Greece’s stop-gap property tax system

In order to help Greece through a revenue shortfall, a property tax is being levied through household electricity bills, so that failure to pay will result in the electricity supply being disconnected. Extreme measures include confiscating the property of those who refuse to pay. As a large number of Greeks own property, this is a serious deterrent.

Will EU have to choose between more and less federalism?

Faultlines have appeared between EU member states that do not correspond to traditional splits between those favouring closer union and those opposed to it. However, the media have misinterpreted statements from Germany, Finland and the Netherlands as a rise in Euro-scepticism, whereas it is rather a demand for greater accountability. Europe faces a choice between just reacting to pressure from the markets, or attempting to get ahead of the curve by proposing greater fiscal and political union. For the first time, Germany has been taking the lead on greater fiscal union, a very new point of departure.

Timing issue

It is highly unlikely that the euro-area crisis will be resolved by the November 2011 G20 meeting, as was suggested by UK Chancellor of the Exchequer George Osborne. The second Greek bailout is still going through parliaments and the permanent bailout fund will likely be approved in early 2012.

Complexity of default

The insolvency procedure for a Greek default is an exceedingly complex issue, as it raises the question how a euro-area sovereign may default and how this would occur within the current framework. This is further complicated by a lack of procedure to facilitate default, despite the efforts of the IMF to create a mechanism ten years ago. Consequently, no uncontrolled developments may be allowed to occur, at the risk of precipitating a disorderly default. Over time, a mechanism will be developed within the ESM in order to assist in and prevent any future disorderly defaults.

Pessimistic scenario

However, there is nothing to say that an orderly default might not dissolve into disorder for both Greece and the wider euro-area. Lack of support from the main opposition party in Greece further fuels a pessimistic outlook. The lack of inclusion of the opposition in the negotiations with the IMF in the first bailout package is seen as an oversight, one that was corrected when the IMF came to meet the governments of Ireland and Portugal ahead of their respective bailouts. However, in both those cases, the opposition was poised to become the new government after elections.

Optimistic scenario

Discussion of default is still premature. In the optimistic scenario, the primary concentration should be on helping Greece to put its public finances on a sound footing, mainly by focusing on the structural and managerial issues that allowed the current crisis to occur. The Greek government should accelerate the adjustment in order to create positive growth and bring down the high level of public debt. In this positive scenario, the Greek government aims to have a primary budget surplus in the third or fourth quarter of 2012. An orderly Greek default could occur once Greece has achieved primary surplus; without that surplus, it would still have a financing gap that needed funding by willing lenders.

European solidarity

There is a growing sense that European solidarity and integration will provide a path towards recovery. Governments have been working with opposition parties and with each other in order to resolve the issue. Market analysis may have overlooked the euro-area’s political determination to end the crisis.