Two things I have written recently stand out as I contemplate what will happen in Greece. The first is that the institutions formerly known as the Troika had accepted Greece’s reform list sooner than I expected and that was positive. The second is that Greece could default before the end of April and that is negative. Unfortunately, the negative highlight is where talks seem to be heading.
Here’s the crux of the argument from my 25 February piece:
I am positive about European assets on a cyclical basis. European shares are cheaper than their American counterparts and European QE provides an underpinning for European sovereign debt. As long as Europe continues to muddle through, markets will continue to stay elevated. The biggest near- and medium-term risk remains Greece, however. Despite progress in negotiations, I still think an eventual Grexit is likely. How soon it occurs and under what circumstances could have a meaningful impact on asset values elsewhere in Europe.
I am not sure how much impact a Greek default would have on other eurozone economies and markets given quantitative easing. But I do believe a Grexit would have a medium-term negative impact. But how likely is a default? Here’s the thinking I want to focus on from 27 Feb and this is the negative thing I wrote which I mentioned at the outset:
The risk for Europe remains Greece because, despite the agreement and Bundestag approval, it is not clear to me that the Greek interpretation of the loan extension is in accordance with the Troika’s understanding. German finance minister Wolfgang Schäuble is selling the deal to his German compatriots by saying things like, “Greece will not get a single penny until it complies with its obligations.” At the same time, the Greek finance minister Yanis Varoufakis is telling the press that “the Memorandum is finished! Because you know what the Memorandum is? It is a series of conditionalities and criteria that needed to be fulfilled. These criteria are now over!” These two statements are mutually exclusive in my view. Someone is going to see their interpretation of events not being fulfilled. And that is going to set up another roadblock.
My view: The German interpretation of the extension is untenable politically for Syriza. And if it comes to implementing on those lines – as the IMF and the EC voiced concerns too, we won’t even get to the end of April before this agreement collapses. The Greeks need to be preparing their economy and financial system for capital controls and default right now. This is very important because, even if we get past April, there are going to be no writedowns in June. That’s clear from the German side. And that’s not going to fly in Greece politically. A longer-term agreement has a high likelihood of failure. And so default is a good probability then. Greece should be working on parallel currency options as well as ways to prevent deposit flight and bolstering bank capital including the prospect of turning to the Russians as Cyprus seems to have just done. This could be explosive politically.
And then the question becomes redenomination for Greece and whether that same risk lies elsewhere, with the Spanish elections looming large in this debate later in the year. Europe is not out of the woods by a long shot.”
I think default is highly likely here if the German view is taken on board because it is not politically viable for Syriza to reform along the lines that Wolfgang Schäuble thinks they should. I don’t know if he recognizes this and is just trying to force the issue or if he truly believes his talking points, that the new Greek government can and will implement austerity and reforms under the watchful eye of the Institutions just as the former governments have done. It doesn’t matter really. Any useful analysis of what’s happening tells you that his talking points are unworkable in Greece politically.
And so that gets me to the second thing I wrote which was positive. After the deal was done, I wrote on 23 February that “I do expect the Troika to reject Greece’s reform proposal and for there to be iterations before we lock down an agreement. But we will get there eventually. That’s my base case.” Well, right now, this base case is blowing up. The iterations on the reform list are looking fraught with peril and there is a real risk that Greece and the Institutions do not agree on that list and Greece defaults because it runs out of money. That’s where we are right now.
If Greece and the Institutions do manage to get through the present reform list, we are always going to have a problem with a new loan agreement in June because Varoufakis wants to reduce the NPV of the bailout terms. And the only ways to do that are through some sort of derivatives structure like GDP-linked bonds or through outright principal reduction via default, writedowns or debt forgiveness. I don’t see this getting through German parliament.
And so I anticipate either default in the hashing out of the reform list during the extension or default when the new bailout agreement is under discussion. In short, my base case is Greek default. But again, Europe has turned the corner economically and a default will have less impact on the rest of the eurozone as a result. Unless we see Grexit, I expect European assets to continue to do well. That leaves Greece out in the cold, while the rest recover, a perfect way for the ECB to highlight the perils of not toeing the line.
This post was first published in Credit Writedowns Pro on 11 March