Another question to consider: Is Greece simply playing a shrewd game of extracting as much cash from the EU as possible before giving in to the inevitable? Greeks are not exactly the most stupid people I have come across. They are in fact very astute business people. They can do the same maths as Citibank and others have done. They can see the writing on the wall. But precisely when you realise that a default is inevitable, milking the cow for as long as possible seems to be the optimal strategy.
Consider also the fact that four of the five PIIGS are dependent on one and the same industry for much of their foreign income – tourism. A Greek euro exit would give it – in the eyes of Spain, Italy and Portugal – an unfair advantage and could force those countries to exit as well. How big a role does that play in the ongoing negotiations?
Or consider Ireland which is very dependent on its status as a financial centre. Many investment funds are denominated in euros and domiciled in Ireland. I have asked a number of people as to what would happen to those funds if Ireland exited the euro. Would they suddenly be denominated in the new Irish currency only for investors to be some 20- 40% worse off due to the inevitable devaluation? Not one person has given me a straight answer.
These and other questions are the reasons the whole thing is so difficult to unravel which is why they will fight for the euro’s survival as if their own lives depend on it. That doesn’t necessarily guarantee its survival, but it all but guarantees a long and painful battle. The depressing reality is that the authorities continue to treat the issue as if it is a liquidity problem, not a solvency one. A rollover buys them a bit of extra time but it doesn’t fix anything. Even a default doesn’t fix anything, as it won’t make Greece, Portugal or Ireland any more competitive, and increased competiveness is a necessary condition for long term fiscal improvement.
Conclusion
If Portugal and Ireland, and eventually also Spain and Italy, increasingly get dragged into this crisis – and everything I see on the horizon suggest they will – the €400 billion the ECB has pumped into the banking sector in those countries so far will be pocket money compared to what will be required going forward. At some point the creditor countries will say enough is enough. And if the politicians don’t know when to say no, the electorate will do the job for them.
The ECB’s strategy for now seems to be one of buying time. As you can see from chart 7, over 40% of Greek sovereign debt is now owned by the ECB, the IMF and the Bank of Greece between them. Speculators should remind themselves that to be entitled to a payout on a CDS, you must deliver the underlying bonds, and if all bonds are in the hands of the ECB and the IMF, a default may not have any consequences as far as the CDS market is concerned. If Greece were the only problem, such a strategy might actually work, but it completely ignores the fact that Portugal, Ireland, Spain and Italy are all lined up behind Greece in the crisis queue.
Assuming the objective is for the euro to survive in its current form, the only sustainable solution is a political/fiscal union, but I see zero appetite for that at this stage. A fiscal union will require referendums in all member countries, and Northern European voters will never agree to enter into a fiscal union with a country as systemically corrupt as Greece (if I just upset any of my readers with that statement, I suggest you read this article from the Los Angeles Times).
Therefore the question is not whether Greece will default but what will happen once it has. If Greece defaults but stays in the euro, not only will it not solve the underlying lack of competitiveness, but markets will immediately turn their attention to Portugal and Ireland and force those countries to default, and once they fold, Spain and possibly Italy will be next, so a Greek default on its own could quite possibly make matters worse for everyone.
If Greece defaults and exits the euro at the same time, the market reaction won’t be much if any different to begin with, but things may actually take an interesting turn in one particular respect. Once the people of Portugal, Italy, Spain and Ireland see how the Greek economy actually benefits from the exit, they may in fact demand an exit in their countries too. It is therefore fair to say that a Greek default, with or without an exit from the eurozone, achieves nothing if the aim is to keep the eurozone intact.
However, there is another way forward. Welcome the neuro (on further reflection, perhaps not an ideal name for a new currency). A couple of years ago I advocated a German exit from the euro, as Germany in many ways is the outlier in the union, but I have come to realise that a European currency without Germany will never succeed. What Europe needs to do instead is to create a new currency built around Germany and based on a fiscal union from day one. As Germany will effectively be underwriting such a currency, it shall have the right to choose who it wants in the club.
I think that will be the ultimate way out of this mess, but there will be plenty of pain beforehand, as nobody is yet prepared to make this jump. This implies that yield spreads on Portuguese, Irish, Spanish and Italian government bonds will continue to widen relative to German bonds, perhaps dramatically so.
Niels C. Jensen
8 July 2011
© 2002-2011 Absolute Return Partners LLP. All rights reserved.
Post Scriptum
As an afterthought, it was quite a gutsy move by the ECB to raise its policy rate yesterday from 1.25% to 1.50%. The ECB is desperate at the moment to demonstrate its independence and retain its credibility as a dedicated inflation fighter. And the damage done to the crisis countries is probably negligible given the fact that the normal financing channels are all but closed to them anyway.
Footnotes:
1 The primary deficit is defined as the budget deficit net of interest payments.
2 I do recognize that Greece has meaningful exports to other eurozone countries, but since Greece cannot devalue its currency against other eurozone members, such exports are in fact domestic.
3 “A Plan B for the Euro Periphery”, Citi Investment Research, 24 July 2011.
4 GDP is a measure of total output (production of goods and services) in a country over a given period. Output equals output per hour worked (i.e. productivity) times the number of hours worked (which is a function of the number of people in the workforce). So, when economists project the growth rate of a country over time, productivity and population growth are two fundamental factors in such assessments.
5 Italy is the reason PIG is spelled PIIG these days!
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