Grexit: The Default Situation

Greece's debt burden stands at 180 percent of their GDP, and rather than depending on a 30 percent write down on their debt, it seems its creditors - that being the IMF, ECB and European Commission - are more willing to negotiate maturity extensions and interest rate cuts. 

The probability of Grexit occurring has therefore risen extensively with the declaration of a six day bank holiday after creditor negotiations broke down over the weekend. Although it can be avoided if the citizens vote to accept the bailout terms offered by the EU and the IMF on the July 5 referendum. These terms include raising taxes and cutting pensions to pay off debt. However even so it is still possible Greece will return to the drachma, the most reasonable means in which the banks can reopen and avoid a malfunctioning banking system. Alex Tsipras, the nation’s prime minister, had accused the EU of blackmailing Greece in their endeavour to undermine democracy and this only pressures the Greeks to vote no.

This meant the EU stops its current bailout scheme on June 30, thereby causing the European Central Bank to limit the amount of emergency liquidity that Greece’s central bank can pass onto its lenders. It seems that Tsipras is resorting to the Greek people’s pride though it will be essentially what they think they are voting for that counts. If there is a belief that voting no equates to quitting the EU, they will most likely vote yes. However if they believe that the referendum is based solely on whether they accept the creditor’s terms, a “no” vote will be more likely. Tsipras therefore is arguing that rejecting the creditor’s terms will not lead to Grexit.

It seems therefore he is relying on the pressure of a vote against to negotiate for a more favourable deal with the creditors. However it will be difficult to maintain such hopes as by June 30 the IMF still will not receive 1.6 billion euros and come July 20 the European Central Bank will not be paid either. Plus, the government’s proposal included 8 Billion Euros in additional measures, eight times the agreed amount by the previous government to creditors.  

Furthermore the banks will become insolvent as not only are they direct creditors of the government, almost half of their capital consists of deferred tax assets – an allowance for their lower taxes given their past losses. Bad debt will also rise further with the state of the economy. Therefore to raise capital, without support from the ECB, IMF or EU, a portion of deposits would be converted into new bank shares. This occurred in 2013 to sustain position in the EU in Cyprus though in Greece those affected will not be the uninsured deposits over 100 000 euros. The banking system may furthermore collapse as the state owned banks would likely introduce the 1980s style lending practices where scarce credit was allocated to repay party favours.

The implications of voting no, and therefore bringing back the drachma, would be a fall in currency to 50-60 percent of the euro, imported commodities such as petrol, and huge inflation. Even if they vote yes Greece may not stay in the EU as the creditors will not favour deals with Tsipras, instead, new elections are introduced and if the opposition wins despite their current fragmented state, creditors may be more willing to restart negotiations. Greece also has yet to allow free competition in the market; the previous bailout initiative failed to pressure them to remove red tape that discourages entrepreneurship, and the power of protected oligopolies. Without EU pressure this is sure to remain the case.

Australia’s shares suffered a $40 billion fall as a result of potential Grexit and Greece’s default, as the collapse of debt negotiations led to global sell off. Most sectors were affected with the exception of gold miners, most likely being investors seeking safe haven assets. This had the ASX200 at its lowest since January. Japan’s NKY and HK’s Hang Seng likewise both fell more than two percent. However Greece’s exit should have longer term and larger impacts on debt laden nations such as Italy and Spain.

If this threat of default had occurred earlier when the EU nations were weaker, I believe Spain and Italy would have followed. If it is a successful exit then it may provide incentive or a precedent for other debt markets to follow. If Italy now was to commence deals over its debt and those were rejected then the entire integrity of the EU will be threatened as they are the third largest economy in it. With the markets predicting a 30 percent chance of Grexit, it should have been expected that the bond yields for Italy, Spain and Portugal increased 30 basis points to isolate the rest of Europe from the fallout. German bond yields fell, as these bonds are considered safe investments during crises. Other safe havens are the Swiss Franc and British Pound, particularly as the British banks are less exposed to Greece than three years ago.

Nonetheless most markets recovered, with significant one day moves still less than the last Greece debt related crisis in 2012.

The bottom line is without the EU, Greece will experience further income inequality and poverty. I believe those who argue for the upside of Grexit on the economy are wrong, as Greece has structural failings, rather than fiscal. Geopolitical risks will also be aggravated from default and Grexit. If the electorate votes no, implications will extend towards the stability of Europe from irresponsible politicking, and a lack of skills that other governments such as France rely on. A change of currency, geopolitical reorientation and bankruptcy will only expose this. Therefore I believe a vote for the deal, followed by government change, and a focus on the cause of the crisis rather than its symptoms, is the most reasonable means to commence a slow path towards recovery.

References:

Reuters, ABC news, Wall Street Journal, Financial Review