Germany finally admits to a third Greek bailout, but what form might it take?

It seems the German government has finally publicly accepted what everyone already knew – that Greece will need some kind of further financial assistance after its second bailout programme expires at the end of 2014. German Finance Minister Wolfgang Schäuble told a CDU election rally yesterday:

"There will have to be another [bailout] programme in Greece," in order to help the country "get over the hill" of debt repayments it faces.

Despite attempts from both the German Chancellor Angela Merkel and German finance ministry spokesmen to row back from the comments and suggest they are not, in fact, a change in stance, the remarks seem to have stuck.

What form might the third bailout package take?

• According to the IMF, Greece's total funding gap up to the end of 2015 is around €11.1 billion (5.8% of GDP) – so this can be taken as a lower bound of the funding needed. Privatisation receipts (which have notoriously fallen short) are expected to reach €7.7 billion over the next three years. Further shortfalls here could push up funding needs.

• A further extension of maturities and reduction in interest rates on the official sector loans, as suggested by EU Economic and Monetary Affairs Commissioner Olli Rehn also seems likely. However, interest on loans from the EFSF - the eurozone's temporary bailout fund - are already at cost and payments have been deferred for ten years. The IMF is also unlikely to reduce its interest rate as this would amount to a form of debt restructuring, which the IMF refuses to engage in due to being the most senior creditor. This leaves only the eurozone's bilateral loans from the first Greek bailout, the interest on which has already been reduced to around 1.5% (well below most eurozone states' long-term borrowing costs). Therefore, scope for further reduction is limited, and the benefit it could provide would amount, at most, to a couple of billion spread over a long period, as we have previously noted.

• Another widely touted proposal is to use the leftover funds originally allocated for Greek bank recapitalisation. So far, according to the IMF, Greek banks have received €40.9 billion out of an allocated €50 billion. Although it seems the EFSF expects this to increase to around €48.2 billion. It is likely some additional buffer will be needed, given the pace of increase in bad loans in Greece, meaning the amount available is likely to be between €2bn and €4bn max.

• A final idea, reported by Süddeutsche Zeitung, is that EU structural funds could be able to provide some of this funding. It’s not clear exactly how this would happen and, as we’ve noted before, we're sceptical of the idea that there is lots of excess money floating around to be easily reallocated in the EU's structural fund programme. Given that the new EU budget headlines for 2014-2020 are set, it's not clear how much more money can be squeezed out for Greece. One option would be to adjust the 'co-financing rate' (the amount the Greek government contributes to each project to gain funding) but this has already been adjusted and provided little boost to the take up of funds, which remains well below target.

Lots of questions to be answered then about the size and format of what may be the trickiest Greek bailout to date, given the tough political constraints and the on-going (very tenuous) premise of debt sustainability. An important consideration, as Schäuble suggested, will be to get Greece over its funding hump in the next couple of years (data from Greek debt bulletins):

The final point to note is the continuing German aversion to further debt relief for Greece, something the IMF and nearly all private observers accept is necessary. Within Germany, this seems to be a result of the government 'learning its lesson' from the first Greek debt restructuring, which patently failed. However, the German government seems to be learning the wrong lesson for the wrong reasons – it was not that restructuring was a bad idea in itself, but simply that all such a large amount of debt was held by Greek banks that the ensuing recapitalisation and bailout negated any benefit.

The German government clearly remains loathe to discuss any such details, meaning a clear plan is unlikely to emerge until the end of the year. In the meantime, we can’t help but wonder how the Greek public will react to the prospect of another bailout with another set of conditions attached. Could the big unknown outside the eurozone begin to look attractive once again? Maybe, or maybe not - but it may well start to factor into their thinking at some point.

Open Europe in 2012: a short summary of our achievements and a review of our eurozone predictions

2012 has been an important and very successful year for Open Europe, with Prospect Magazine judging us “International Affairs” think-tank of the year in recognition of our research and analysis’ increasing influence in the UK, Europe and beyond. This year, many of Open Europe’s research publications and ideas have had a direct influence on policy and decision making regarding the UK’s relationship with the EU.

We also hosted prominent figures from the world of politics, economics and business in our 2012 events programme, discussing a range of topics from the UK’s future role in Europe, Anglo-German relations to the finer points of the eurozone crisis. Perhaps the icing on the cake, in October this year, was the launch of a new independent partner organisation in Germany, Open Europe Berlin gGmbh.

To read the full review of our year, click here. Below we would like to focus on some of the predictions we made about the eurozone over the last 12 months (always a dangerous undertaking). Here is how we fared in predicting some of the key developments:

The bailouts for the Spanish banking sector and Spanish regions: In April, Open Europe’s Head of Economic Research Raoul Ruparel argued that Spanish “banks may be forced to tap the eurozone bailout fund” and highlighted that the build-up of debt by Spain’s regions would mean that they too could require bailouts. In June, Spain announced that it would request €100bn from the eurozone’s bailout funds to recapitalise its banks, while in July, several Spanish regions requested bailouts from the state which sent sovereign borrowing costs to record highs.

Second Greek bailout falling short...: In March, Open Europe predicted that, coming in at just 2% of GDP, the debt write-down of Greek debt under the country’s second bailout would be “far too small to allow Greece any chance of recovery”, with further assistance required in the future. In July, it became apparent that the second bailout had failed and in October, Greece received a two-year extension to its bailout programme, duly confirmed in late November. 

...but with Greece staying in the euro for now: While others put the risk of Greece imminently leaving the euro at 80%, Open Europe’s Mats Persson argued in January 2012 that “I doubt eurozone leaders will have the nerve to force Greece out this year.” 

Credit rating of France and eurozone bailout funds downgraded: In January, we predicted that “France could well be downgraded at least one notch…this would [also] hit the creditworthiness of the euro bailout funds”. On January 16, S&P downgraded France’s triple A rating, with Moody’s following suit on November 19, and on November 30 it also downgraded the eurozone’s two bailout funds.

LTRO would run out quickly: In December 2011, in a briefing looking at the potential impact of the ECB’s programme bank liquidly provision (LTRO), Open Europe’s Raoul Ruparel argued that while it may be welcome in the short-term, “hopes, and plans, that this funding will lead to a boost in purchases of sovereign debt look misguided.” By the summer of 2012, both Spain and Italy were seeing their funding costs rise quickly, and eventually the ECB would have to take additional action. 

Monti would struggle to fundamentally reform Italy’s labour market: In March, Open Europe’s Vincenzo Scarpetta warned of the risk that Mario Monti’s lack of a popular mandate could undermine his efforts to reform Italy’s labour market. With Monti set to step down in the coming months, the OECD has recently highlighted that Italy has undertaken limited labour market reforms, with its labour costs now amongst the highest in the eurozone. 

So not a bad record for 2012, click here to check out our predictions for 2013.

Greek banks and the Greek bond buyback

Yesterday we put out a flash analysis looking at the latest Greek deal and the prospect of Greek bond buyback. One of the many issues with the deal (and the buyback in particular) which we raised was that Greek banks will find it difficult to participate without needing extra capital.

However, Greek Finance Mininster Yannis Stournaras also said yesterday (in a timely statement):

The debt buyback "doesn't mean new capital for banks, given that they have recorded these bonds at lower prices than those that will be offered."

His suggestion then, is that the Greek banks have already marked their bonds to market prices on their books, meaning that they can sell them at the low prices involved in the bond buyback without needing new capital. This may make their participation more likely, but there are plenty of other reasons why we still see it as difficult and unpredictable. (We also still question why foreign holders will be involved, particularly previous hold outs and those who are holding to maturity, see our full analysis here).

Firstly, as Kathimerini reported today, the banks themselves are not keen to be involved in the buy back. Many feel that they have already done their part in terms of taking part almost ubiquitously in the first debt restructuring. If they were to take part in the buyback, they could seek adjustments in the terms of the recapitalisation and reform – something which the EU/IMF/ECB troika is unlikely to accept.

Secondly, taking part in such a scheme would need significant approval within the banks and other financial firms. This means board level and possibly wider shareholder approval. As the restructuring earlier this year showed, this takes time, with the process dragging for months. Given the 13 December deadline to have a bond buyback plan in place (i.e. to have a firm idea of who will take part, to make sure it is worthwhile) it is not clear how many bondholders will be in place to participate.

Thirdly, and possibly most importantly, is that the banks need their holdings of bonds (around €22bn) to gain liquidity from the Emergency Liquidity Assistance (ELA) through the Greek Central Bank (GCB). Looking at the GCB balance sheet, it seems broadly that Greek banks posted €247bn in collateral to gain €123bn in liquidity, an average haircut of 50%. Given that many of these assets will be loans or securities, sovereign debt (even Greek) is unlikely to be judged any more harshly than the average. So, if the banks sold these assets for a 65% write down (as suggested) they could purchase new assets (maybe other sovereign debt) but would be able to buy less of it (as not many other assets priced at a 65% discount) meaning they would not be able to gain as much liquidity under the ELA as with current Greek bonds.

Essentially, this could harm the Greek banks liquidity position which would further constrain their lending ability and possibly prompt further deposit flight – both of which would hurt the fragile Greek economy.

All in all then, this process could still be counterproductive for Greek banks even if they do not book new losses directly and they still could be hesitant to take part voluntarily. However, that is not to say that the political pressure applied behind the scenes will not be enough to force them to voluntarily join. Ultimately, it simply highlights that this policy may deliver a small benefit with some negative side effects but is at best a way of skirting the real issue of whether the eurozone can stomach permanent fiscal transfers to Greece. This will come to the fore again soon.

Buying back Greece: another ad hoc deal or a step towards a solution?

Early on Tuesday morning the eurozone and the IMF reached an agreement which has been widely billed as their most comprehensive package to aid Greece. Now that the dust has settled somewhat, Open Europe has published a new flash analysis assessing the key components of the deal.

For all the talk and all the figures flying around there is still only one that really matters – 124% debt to GDP ratio in 2020, clearly this is not sustainable. Further measures will be needed and the ad hoc nature of this deal, particularly the way it skirts the big decisions, suggests that fears over a ‘Grexit’ will return as soon as Greece begins missing its targets once again.

Although reaching some deal was better than nothing, there are still significant doubts over the deal. The mixture of measures do provide some short term relief but in most cases fail to solve any of Greece's real solvency problems. The policy with the most unanswered questions is probably the most important one - the debt buy back.  A key question is: who actually owns Greek debt now? Below we break down the shares of Greek debt (click to enlarge):

We expect that the only bonds actually eligible for the buyback would be those held by foreign financial institutions (€30bn). However many of these bondholders may be reluctant to take part for a multitude of reasons.

See here for the full analysis.

Trying to find two more years for Greece

Ahead of today’s meeting of eurozone finance ministers we thought we’d (finally) get round to posting some of our thoughts on the last week’s leaked Troika report on Greece. The report, as may be expected, left much to be desired – and we’re not just talking about the copious glaring gaps where the eurozone and the IMF could not agree (the missing new debt sustainability analysis being the more prominent). The firefighters are fighting amongst themselves as one paper put it.

The report suggests that the cost of providing Greece with a two year bailout extension will be €32.6bn – very much in line with our estimates of between €28.5bn and €39bn. Interestingly, up to €20.3bn of this total is due broader problems with the original bailout programme, with the troika suggesting only €12.4bn will specifically be for the fiscal adjustment. This may not seem like it matters much but it highlights that the financing issues don’t just come from fiscal issues but also low growth, increasing arrears, banking sector problems and more.

Below we list a few other concerns from the report:

- The unemployment figures, as in the recent Greek budget, seem to be hopeless optimistic – potentially more so than before, since the Troika see unemployment in 2014-2016 being 0.4% below where the Greek government does. Elstat (Greek Statistics Agency) put unemployment at 25.4% at the end of August, while the Troika expects it to be 22.4% by the end of the year. A 3% drop in unemployment in a few months? That seems impossible anywhere but particularly in the current Greek economy.

- The report expresses some deep concerns over the banking sector not least the “plummeting” deposits and the likely need to run down capital buffers due to significant levels of bad loans. However, it still concludes current levels of recapitalisation should be sufficient – we’re sceptical.

- Despite, finally cutting defence spending, Greece still spends the third most (as % of GDP) in the EU. This continues to seem an obvious place to make savings, particular with NATO still going strong.

- The collapse in real investment of 40% since 2009 is staggering if not surprising, yet the forecasts for investment both in the troika and budget reports only looks ever more optimistic because of it.

- Government arrears continue to mount up, topping €8bn now. Despite presenting a significant challenge to wind down in the near future, these could also represent a drag on the domestic economy since most of the money is owned to domestic firms. 

That is to name but a few from an incomplete report – i.e. there are plenty more to come.

As for the outcome of today’s meeting, we have low expectations as usual. The target is for a political agreement on the releasing the next two tranches of Greek funds (worth €44bn). This doesn’t sound much of a stretch but it will require confirming Greece has completed the necessary ‘prior actions’, as it claims, while the IMF is hesitant to release any more funds until it has settled on a plan which sticks to its view of Greek debt sustainability. The final part will be tricky with the IMF and the eurozone still seemingly someway apart on what they see as sustainable (despite the two of them also being someway apart from the rest of the economic and financial professions).

A deal on how to fund the two year extension in the Greek bailout will likely need another meeting, while the release of funds still has to withstand the hazardous approval process of the German, Dutch and Finnish parliaments.

Expect the debate over the issues above and more to dominate for another few weeks.

Economic realities push Europe closer to a Greek decision

We have a piece in City AM today, which look's  at the impact of this week's crucial votes in Greece, see below for the piece in full:

One down, one to go. The Greek government has got through one crucial vote this week and looks likely to ride out the budget vote on Sunday. Although markets and eurozone leaders will breathe a sigh of relief as Greece makes it through another crucial week in its economic crisis, the government has not been left unscathed.

Pushing through the latest, and supposedly last, package of stringent economic reforms and budget cuts has exposed deep cracks within the governing coalition, as the Democratic Left and Pasok parties put up a fight to slow the process of public sector cuts led by Prime Minister Antonis Samaras’ New Democracy party. It took two days to push the package through parliament, while a reported 100,000 Greeks took to the streets in Athens to protest against austerity, once more leading to violent clashes with police.

However, a bigger problem for the government is the flurry of economic figures which have again exposed deeper flaws in the Greek economy, propelling talk of a Greek exit from the eurozone back into the headlines. The new budget projects Greek debt peaking at 192% of GDP, rather than the 167% estimated previously, but even this revision seems to be built on optimistic assumptions. Unemployment, investment and exports are all projected to stabilise, despite most indicators predicting the opposite. In fact it is now abundantly clear that Greece will need an extension to its current bailout.

The questions to ask then are: how much would such an extension cost and how could it be funded? We estimate that slowing the Greek fiscal consolidation programme by two years could cost an extra €28.5bn (rising to €39bn if Greece fails to borrow from the markets – something which looks increasingly likely). The main options being proposed include: reducing the interest rates which Greece pays on its current bailout loans (which could raise around €3bn over two years) or putting a hold on interest payments for a few years (which could raise €10bn+, but would be much trickier legally). These options would likely be combined with some further austerity and increased short term debt issuance by Greece – both of which could actually increase Greek debt levels, not exactly what is needed. The kicker is that even this is unlikely to be enough.

The question of an extension then, drives home that a larger decision on Greece’s position in the eurozone is closing in on EU leaders. Even talk of using bailout loans to buy back Greek debt at a discount and then retire it, to provide extra funding, would require a big political decision on further loans to Greece. However the funding is found, it will likely involve breaking a taboo – either by the ECB (in terms of helping to fund states) or more likely by eurozone countries in allowing permanent transfers to a country whose future funding is far from assured.

The Greek government and the eurozone will make it through this week but this short-term success is likely to belie the massive decisions ahead.

A big week for Greece - but still few answers

As we noted in our press summary today, this week is lining up to be another big one for Greece.

The Greek government faces two crucial votes in parliament – first on Wednesday to push through the latest package of structural reforms (as demanded by the EU/IMF/ECB) troika and second on Sunday to approve the latest and, according to Greek PM Antonis Samaras, the last austerity budget for next year.

Since the governing coalition was formed after the second summer elections, such votes have usually passed without much fanfare. However, this time around the Democratic Left (which holds 16 seats in parliament) has said it will not vote with the its coalition partners. Pasok (which holds 31 seats) is also facing a period of internal strife with one MP already leaving and up to five others threatening to at least vote against the government. New Democracy (127 seats) should have an easier job pulling its MPs together.

The votes should pass but the margin for error is tiny, possibly only two or three votes, notably provoking unrest amongst financial markets and other eurozone leaders. In the end, given that the end of the government would very possibly signal the end of Greece as eurozone member, the (perceived) fear factor is likely to be enough to once again push the vote through.

This clears the way for the release of the next €31.5bn tranche of bailout funds and a potential two year extension to the Greek bailout. Today’s FT notes that the extra funding for the extension is likely to come from an increase in short term debt issuance by Greece and possibly a reduction in interest rates on eurozone loans to Greece – exactly as Open Europe predicted in its recent flash analysis on the issue.

The FT article also includes a potential plan for the ECB to return profits from its purchases of Greek bonds to Greece via eurozone governments to avoid the thorny issue of the central bank directly financing a state. This sounds plausible on the surface since the returning of profits to national governments should happen naturally anyway under the ECB rules. The only issue being that this can only happen overtime as the profits accrue as the bonds are paid off, so its unlikely to be paid out in a single chunk at one time (as is needed here).

One final point on the cost of the extension. We put it at around €28.5bn, although estimates range from €15bn to €40bn. We didn’t include a delay in Greece’s return to borrowing from the markets, which is looking increasingly likely. If Greece doesn’t return to borrowing until after 2016 it could add a further €10.6bn to the cost of an extension.

So although this is a big week for Greece, even a clear government win in both votes will do little to answer questions over Greece’s future in the eurozone.

Has Draghi really saved the universe?

So it continues.

During a highly anticipated press conference, ECB head Mario Draghi - the man tasked with saving the universe after eurozone leader's consistent failures - announced today that the ECB will buy 'unlimited' government debt, albeit short-term.

So the central bank that once wouldn't touch government debt with a bargepole, has now said it's willing to underwrite governments, in theory indefinitely. In fairness, we're talking short-term, sterilised bonds from countries who enter an EFSF/ESM bailout programme - so there are several catches. Still, this is a big move, which is why markets have reacted positively.

How long it'll last is, as ever, an open question. You can read our full take on the decision (and all the technical details) here. The key concerns / questions:

• Purchases of short term debt don’t tackle the rising cost for Spain and Italy of refinancing long-term debt, and may force countries to focus more short term funding, making them more susceptible to higher borrowing costs.
• Despite all the talk of conditionality, can the ECB really cut off bond purchases from a country when it is already in trouble? We doubt it, at least not without causing huge problems in the markets (which the policy is meant to avoid).
• The sterilisation (removal of the money created) is almost irrelevant given the already unlimited lending provided by the ECB.
• Although it claims to no longer be senior to other bondholders, would the ECB really take losses, meaning that it crosses the mark for directly financing governments, if push came to shove?
• With the interbank lending market still dead and buried will a few sovereign bond purchases really restore monetary policy to ‘normality’?
• These purchases tackle a symptom not a cause of the crisis, lack of competitiveness, poor growth prospects, unsustainable debt and undercapitalised banks still weigh down the struggling countries.

The markets might be buoyed, but this one will drag on for much longer.

'Communication problems' between Angela and François?

A bit of mystery ahead of this evening's meeting between German Chancellor Angela Merkel and French President François Hollande. A French diplomatic source told AFP yesterday that, before their working dinner, the two leaders will make a short statement to the press, but will take no questions from journalists.

However, the source went on to suggest that Hollande was quite keen to hold a proper press conference, since he "has not talked about Greece for a long time and wants to communicate." But apparently his request fell on (Merkel's) deaf ears.

Needless to say, the diligent Steffen Seibert - the German Chancellor's spokesman - moved swiftly to clarify that the decision not to open the floor for questions had been made "by mutual agreement". Hollande's office also stressed that the chosen format mirrors the one used during Merkel's previous visit to Paris at the end of June.

Mystery solved? Maybe, but the fact remains that Hollande has reportedly planned a separate press conference at the French Embassy in Berlin after his dinner with Merkel. 

Will a common position on Greece be easier to agree on than the format of a press conference?

Germany's Summer of discontent?

Over the last few weeks, a range of German policymakers have fired broadsides against further German involvement in the eurozone crisis, and against further aid to Greece in particular. Referring to September’s troika report on Greece, Michael Fuchs – the deputy parliamentary leader of Angela Merkel’s CDU party – yesterday told Handelsblatt that:

“Even if the glass is half full, that won’t be sufficient for a new aid package. Germany cannot and will not agree to that. We reached the point where the Greeks must show they are capable of delivering a shift long ago.”

Last week, Horst Seehofer, Prime Minister of Bavaria and leader of the CSU, the Bavarian sister party and coalition partner of Angela Merkel's CDU (which has been getting increasingly agitated by the eurozone bailouts), proposed a series of referenda:

"We must involve the people... First of all: on the transfer of important competences to Brussels. Secondly: on the accession of new states to the European Union. And thirdly: on German financial aid to other EU states."

In particular Seehofer cited debt pooling such as eurobonds or a debt redemption fund, adding that "with the CSU there won't be any United States of Europe".

Merkel's other coalition partner, the liberal FDP, is also stepping up its rhetoric, with its leader and deputy Chancellor, Philipp Rösler and also its leader in the Bundestag, Rainer Brüderle, saying they were reconciled with a Greek euro exit. Bavarian Economy Minister Martin Zeil has gone even further arguing that: 

"...a country needs to leave the euro, when it doesn't fulfil its duties. If necessary, two or more [countries] could leave." 

From the other side of the political spectrum, former German Finance Minister Peer Steinbrück (SDP) last month stated that:

"in certain cases, I have increasing doubts whether all countries will be able to be kept inside the eurozone (...) I can see how certain countries will be unable to close their competitiveness gaps [with Germany]"

However, the SPD have also recently publicly come out in favour of eurozone debt pooling - albeit it with strict conditionality in terms of national financial policy-making.

Otmar Issing, former chief economist of the ECB, added his voice to the chorus, saying some eurozone member states might have to leave:

 "Everything speaks in favour of saving the euro area [however] how many countries will be able to be part of it in the long term remains to be seen."

The question is whether all of this is rethoric, or the beginning of something else.

A summit plus for Greece?

Given that Greece lacked any real political presence at last week’s EU summit, discussions on the crisis in Athens were fairly minimal and it was largely overlooked during the ensuing press coverage.

However, Kathimerini has an interesting report today suggesting that Greece could attempt to get the cost of its bank recapitalisation removed from its sovereign debt levels – in the same way that Spain is hoping to do. This could well be seen by eurozone leaders as a way to quickly reduce Greece’s debt burden – although we don’t think it will change any of the fundamental problems which it faces.

A large amount of the second Greek bailout – around €50bn – is actually going to Greek banks to help them absorb the large losses they faced from the Greek debt restructuring. With Greek debt currently standing at around €327bn or 160% of GDP, removing €50bn from this figure could provide a significant boost to Greek debt sustainability – bringing the figure down to 136% of GDP.

There are, however, a few important caveats to note here:

• Firstly, 136% is still an unsustainable debt level, even with this reduction the Greek debt burden is still huge and the need and demands for austerity are not likely to waiver . 
• Secondly, and possibly more importantly, is that this will only be an adjustment on paper for all intents and purposes. Greek banks are dead on their feet, living off liquidity from the ECB and the Greek Central Bank. They will never be able to repay this money and it will still ultimately be underwritten by the Greek state. So, even if this debt is shifted off the official figures it will still be a burden of the state – in reality little will have changed. 
• Lastly, this process will not happen anytime soon. The bailout funds cannot lend directly to banks until the ECB is in place as the eurozone’s financial supervisor, and as we have noted, this will be at the earliest the start of next year. This also happens to be the period by which we have suggested that leaving the euro may become more attractive from a Greek perspective. 

An interesting development which seems to have mostly slipped under the radar then. We wouldn’t be surprised to see the eurozone and Greek leaders take advantage of this opportunity to gain a large reduction in the superficial figures on Greek debt – it would make for an effective headline figure and would likely buy them some more time in terms of making Greek debt look sustainable in their and the IMF's models. Ultimately, though, it would only be window dressing, further shifting of funds around to try to make the situation seem better than it is. In the end, as we have always said, there are no easy answers to the Greek or eurozone crisis.

A euro exit may benefit Greece eventually but it won't be an easy ride

Over the weekend, we published a new briefing looking at the implications and likelihood of a Greek exit from the euro. We argued that an imminent Greek exit isn't inevitable, nor that it would solve Greece's problems - though, if managed, leaving the single currency could potentially be beneficial for the country in the long-term. Over on Telegraph blogs, we argue:

"if Greece defaulted and left the euro – perhaps following a failure to reach a compromise after the Greek elections on 17 June – it would be bad news all around:

• The Greek banking sector – woefully undercapitalised since the losses it took as part of the second bailout – would instantly collapse. Pensions would take a massive hit too. In order to avoid a complete economic – and social – meltdown, between them, banks and pension funds would need an instant €55bn injection of fresh capital. At the same time, full nationalisation of Greek banks – which has been mooted by the ‘radical left’ Syriza party – could prove pretty disastrous. The balance sheets of the six largest Greek banks are equal to 113pc of the country’s GDP – taking on all their liabilities would send Greek debt to GDP skyrocketing once more, potentially eliminating the benefits of the debt write-down.
• The new Greek Central Bank would also need to create at least €128bn worth of the new currency (63pc of Greek GDP) in liquidity to help keep Greek banks afloat as the Eurosystem withdraws its support. Hello inflation.
• Contrary to popular belief, a euro exit wouldn’t mean the immediate end to austerity for Greece either – the country would still have to find savings of at least €12bn to pay various bills, including hospital and social security expenditure vital to uphold social order.
• At the same time, the new Greek currency could devalue by around 30pc, which in theory increases chances of growth in the long-term (as the country is no longer stuck with a hopelessly over-valued currency), including a potential boost to exports equivalent to 10pc of GDP. But in reality, any potential export gain could be diminished if the ‘stub euro’ weakens (Spain springs to mind) or demand in Europe decreases further. Unlike previous devaluations in Argentina and Iceland – often used as comparisons – Greece has few natural resources or industries to fall back on, which may limit the benefits of devaluation. And remember, devaluing or removing a currency peg is not remotely the same as introducing a whole new currency. The latter is far more challenging.

So where does that leave us? Well, if Greece left tomorrow, we estimate that it could still need between €67bn and €259bn in external short-term support just to stay afloat. This could be split between the IMF, the Eurozone and non-euro countries.
The UK could potentially be involved in such a rescue package, via its IMF participation. In addition, the EU’s so-called ‘balance of payment’ fund – designed to help non-euro countries (which Greece technically would be) and in part underwritten by Britain (to the tune of 13pc) – could be activated. If the UK can get away with underwriting between €4bn to €6bn, which would be one scenario, it should count itself lucky. These would be loans, not up-front cash gifts, and if it served to stem contagion from a Greek exit, such loans would be justified.
To minimise the need for external support and risk of contagion, two steps need to be taken before Greece should even contemplate a euro exit: first, the banking sector should be recapitalised, shrunk, consolidated and restructured. Second, a primary surplus should be achieved to allow the Greek state to fund its day-to-day running costs without external help. Though this would make an exit far more appealing and – with a lot of luck – potentially beneficial for Greece in the long-term, the truth is that for Greece, whether inside or outside of the euro, the road ahead looks very rough indeed.
This is also why a new government in Greece – no matter what such a government would look like following the Greek elections – will likely reach a deal with its creditors, allowing it to remain inside the euro for now.
In European politics, the safest money is always on another fudge."

Letting the cat out of the bag

Update 2.15pm:  At least two more European Commission spokespersons have denied Commissioner de Gucht's claim. After Mina Andreeva (see below), Olivier Bailly tweeted,

The European Commission denies firmly being working on exit scenario for Greece. The Commission wants Greece to remain in the euro area.

Then Simon O'Connor tweeted,

We're not working on the basis of a scenario of Greek exit.

So it's settled then...

Here's our original blog post:

It's Ascension Day today, and the EU institutions are closed. Still, someone at the European Commission felt the need to say something on Greece.

In an interview with Belgian daily De Standaard, EU Trade Commissioner, Belgium's Karel de Gucht, said,

"A year and a half ago maybe there was a risk of a domino effect. But today, there are [people] in the European Central Bank, as well as in the Commission,  working on emergency scenarios if Greece shouldn't make it."

He also added,

"A Greek exit does not mean the end of the euro, as some claim."

De Gucht's comments were not appreciated by his colleagues at the Commission, however. Within hours, European Commission spokeswoman Mina Andreeva moved to deny the existence of any such plans, saying,

"[The European Commission] is working on scenarios to keep Greece within the eurozone, not to make it leave."

According to the spokeswoman, Commissioner de Gucht was speaking "in his personal capacity". This isn't the first time Karel has annoyed colleagues by letting the cat out of the bag (well, on a potential Greek exit, the cat wasn't exactly in the bag). He was the first one to admit, 

"We knew that Greece was cheating [on its public accounts]."

That was in May 2010.

Is the ECB trying to push Greece out of the euro? We’re not so sure…

A story seems to have taken hold today that suggests the ECB may be indirectly trying to push Greece out of the euro by reducing its liquidity support to its banks which, the theory goes, would threaten a banking collapse and cause Greece to leave the euro in order to use its own central bank to support its banks. This seems par for the course with many of the headlines doing the round at the moment, but after some further inspection we're not certain that any decrease can really be seen as the ECB trying to force Greece out. 

The story started from an overnight report from Dutch daily Het Financieele Dagblad which claimed that, according to unnamed central bank sources, the ECB is winding down its lending to Greek banks due to concerns over their capital levels. According to the article the liquidity provision from the ECB to Greek banks has dropped by almost half since they last publicly recorded level of €73bn in January.

Now, the report could be accurate but there are some caveats here which need to be noted.

First, ECB lending to Greece was always going to fall post restructuring.

Most of the €73bn borrowing by Greek banks from the ECB uses Greek bonds as collateral, when these were written down by over half, the banks were always going to have much fewer assets to post as collateral. This problem has also been exacerbated by the fall in the value of the new Greek bonds, which would have ensured that they were subject to huge haircuts in value at the ECB’s liquidity operations.

So, the Greek banks would probably have always had to cut their borrowing from the ECB simple due to collateral constraints.

The slack will naturally be taken up by the ‘Emergency Liquidity Assistance’ ( ELA, provided by the Greek Central bank under less stringent capital requirements, see here for a full discussion) resulting in a decrease in the level of lending by the ECB directly to Greek banks. Some lending would have been maintained by the €35bn in guarantees which the EFSF provided to help insulate the ECB against additional risk. However, these fall far short of covering the entire €73bn borrowing by Greek banks from the ECB (against which they would have needed to post around €100bn in collateral due to the large haircuts which the ECB applies).

One of the motivations for the ECB's supposed reduction in lending is the slow progress in the bank recapitalisation. This could well be true, however, the fact is that without this new capital the banks will continue to be short of collateral to use at the ECB, meaning lending must take place under the ELA in the interim.

Lastly, the size of the balance sheets which Greek banks need to service would also have been reduced by the restructuring meaning they may need less liquidity than before.

In summary, a fairly large decrease in ECB lending to Greek banks would have been expected in the aftermath of the restructuring, even if it were just moved onto the ELA. It could in fact have been motivated by constraints on the banks themselves rather than the ECB.

Now, that’s not to say that the ECB is not annoyed by the lack of progress in the Greek bank recapitalisation but we all know that the correlation of these events does not mean causation. Things will be clearer when the full figures are released, but until then we’d be very wary of suggestions that the ECB is trying to force Greece out the euro, it’s not like the eurozone is short of dramatic headlines anyway.

No Good News From Greece

Today's negotiations in Greece on the creation of a government of technocrats have broken down. Talks will resume tomorrow morning, but only in order to appoint a caretaker cabinet which will remain in office until new elections take place - in all likelihood as early as mid-June.

Although widely expected, the outcome of today's meeting is going to create further political and economic uncertainty over the future of Greece in the eurozone. So what could happen now?

First off, it's by no means certain that a stable government will come out of the next elections. The latest polls indicate that left-wing SYRIZA could be the biggest party, but it would still have to form a coalition government. However, following the latest tough round of talks, the outspoken leader of SYRIZA Alexis Tsipras (in the picture with Greek President Karolos Papoulias) doesn't seem to have many friends - the Communist Party has ruled out a left-wing coalition since the very beginning of the electoral campaign, and Democratic Left leader Fotis Kouvelis said yesterday that he would no longer cooperate with Tsipras, even after new elections. On the other hand, Tsipras has repeatedly said that he doesn't want to become a 'complicit' of New Democracy and PASOK - the only two Greek parties that insist on the need for Greece to stick to the EU-IMF bailout programmes.

Needless to say, this would complicate Greece's position vis-à-vis its eurozone partners. As Eurogroup Chairman Jean-Claude Juncker told reporters in Brussels yesterday, there could be some room for Greece to negotiate a relaxation of its deficit targets if a serious new government can be formed. As we pointed out here, Greece may well be heading towards a series of inconclusive elections. This would make it very difficult indeed for Germany and the others to justify the disbursement of future tranches of bailout money.

Greece's euro exit is becoming increasingly likely - not just because it's being talked about by a growing number of top European politicians - although we still think that Greece's anti-bailout parties may ultimately soften their stance, potentially paving the way for a compromise. What's most interesting is the fact that figures are being put on the impact of a Greek euro exit (and consequent default). A couple of hours ahead of Francois Hollande's inauguration ceremony, outgoing French Economy Minister Francois Baroin told Europe 1 that Greece's euro exit and default "would have a net cost of €50bn" for France, "plus the debt held by banks and insurance firms in their portfolios." Le Figaro did its own estimates, and put the cost at up to €58.5bn - that is, €895 per Frenchman.

Quite a busy eurozone day. As usual, you can follow our live updates on Twitter @OpenEurope, and continue to check out our blog for updated analysis. 

Four out of five Greek voters still committed to the euro: Will the Greek anti-austerity parties blink first?

Over on the Telegraph blog, we argue: 

There’s a paradox at the heart of the Greek euro debate: voters have comprehensively rejected EU-mandated austerity – parties that are (more or less) in favour of ripping up the bailout conditions mustered 68pc of the votes. And yet, according to a new poll, 78pc of Greeks are still in favour of the new government doing “whatever it takes” for the country to stay inside the Eurozone.

On one level, this phenomenon is an extreme case of having your cake and eating it. Clearly, Greece needs root-and-branch reform if it’s going to have any hope of remaining inside the euro, and naturally, Germans and other creditors will want guarantees in return for putting up cash.

But this paradox may also hold three clues to Greece’s future inside the eurozone.

First, it illustrates the conflicting view inside Greece of "Europe". The country has been an EU member for 31 out of 38 years as a democracy (at least in modern times). EU membership is still associated with stability, prosperity and democracy, which explains why four out of five Greeks remain committed to the euro. Therefore, when German ministers, central bankers and others dare Greece to tear up the bailout deal and face an imminent euro exit, they also dare Athens to risk all which marks the break from its chequered past of colonels and instability. Rhetoric aside, are Greek parties really willing to pull the trigger?

 At the same time, though, on the current austerity path there must be a tipping point for Greece, when the euro and/or the EU becomes predominantly associated with a whole range of negatives, including undermining democracy, meaning Greece will almost certainly decide to leave. Though we’re not there yet, there are plenty of signs already.

Secondly, the Greek population is in some ways rational in its opposition to a euro exit. Yes, the country is stuck with a hopelessly overvalued currency. Yes, it was a mistake to allow it in and the rest of it. But whether staying or going, Greece is in for a very rough ride. Just to illustrate: the Greek banking sector is completely reliant on the eurozone for recapitalisation and liquidity (via the EFSF and ECB). If Greece exited, the newly independent Greek Central Bank would be forced to fill this void by essentially printing huge amounts of money, perhaps equal to half of Greek GDP. Hyperinflation would be a real threat as would the collapse of the banking sector. Would SYRIZA and others dare to risk it?

Thirdly, the Greek population isn’t entirely irrational in its opposition to the EU/ECB/IMF programme either. This programme is based on unrealistic assumptions and is choking off any chance of growth. This is not an endorsement of debt-funded growth à la Hollande – which is what put Greece in this mess in the first place – but of giving Greece some flexibility to enact structural reforms, for example via a full restructuring (which is now much harder due to the ‘private sector involvement’ in the second bailout). If the Troika could loosen the reins slightly, and a new Greek government use that to boost chances for growth while also and saving face at home, perhaps there’s a compromise to be had between Greece, Germany and the IMF – and Greece can live another day inside the euro. Though the euro still would have plenty of issues, at least, this could give Greece time to recapitalise its banking sector and achieve a primary surplus, both of which would make managing an exit easier.

In any case, in the ongoing game of chicken between Germany and the Greek anti-austerity parties, given the huge stakes, it may well be the Greek parties that blink first.