The IMF-led troika will return to Greece on Wednesday to resume their assessment of the Greek economy and progress in meeting budget targets. The stakes could hardly be higher as Greece teeters of the edge of default, although the reality is that the real crisis now centres around Italy as Greece is a dead-man walking. Greece will default and the question is how best to manage this to minimise collateral damage to the rest of the eurozone.
Ironically, the euro is liable to suffer even more over the next few weeks if Greece is saved as there will be a high risk that effective measures are not implemented which will further corrode confidence in the euro area as a whole. Political and economic fractures will also continue to widen. A surgical Greek default and euro exit would certainly be a very high-risk strategy and the euro could slump initially, but ultimately such a move would be more likely to protect the currency. A euro bounce if Greece does secure further support would be likely to fade very quickly.
The logic in trying to keep Greece afloat for a little longer will be to prepare the ground for an orderly default and euro exit while bolstering the defences of those countries which need to stay in the euro. There would also be efforts to strengthen the banking sector so that losses on Greek bonds do not prove terminal. The difficulty the eurozone faces is that it may be impossible to make the necessary moves due to political and economic constraints. The German government as well as Finland and the Netherlands is rapidly losing the goodwill of the electorate and the industrial sector which will make it even more difficult to provide additional funding for the weaker eurozone economies.
If there is no decisive action, then capital flight will continue and the banking sector will suffer even more which will make a disorderly euro break-up even more likely. If Greece is saved again, then there will also be a clear moral hazard threat as countries will feel less pressure to meet budget targets. In this scenario, medium-term confidence in the eurozone will deteriorate even further and it will develop into a position where it will be financially impossible to keep the euro afloat.
The Greek government has estimated that the cash will run out by early October so the next loan tranches is vital to avoid a full-scale default. The German Finance Ministry has stated that Greece will not get the next loan tranche unless Greece is on track to meet the budget targets laid out in the original agreement. There have also been warnings from the coalition partner FDP that Greece should consider an orderly debt default.
In contrast, Chancellor Merkel is still trying to keep Greece in the game with a promise that all will be done to safeguard the euro.
The Greek government has also announced a new property tax in an attempt to raise additional revenues, although the unions are threatening to block collection.
Officially, the economy contracted over 7% in the year to the second quarter and conditions were certainly no better in the third quarter. There will, however, have been a further move to an underground economy and tax evasion will continue to increase. In this context, it is almost impossible to gauge how deep the recession actually is. Overall, It continues to be highly unlikely that Greece will come close to meeting budget targets, especially with the eurozone economy weakening. The Greek government may still decide to simply walk away and unilaterally default.
The troika will have to decide whether to ignore the hard data and issue a ‘political’ favourable report on Greece and provide the fig-leaf for additional support. Alternatively, they could admit that the fiscal goals are un-reachable.
If the troika states that the loan conditions have not been met then the German government will have to decide whether to carry through the threat of abandoning Greece to its fate.
In reality, the debate has moved beyond Greece. There is no hope of the country repaying its debts and the market has correctly concluded that it will default in the medium term.
It is actually Italy and Spain that are critical to the equation as the euro would be unlikely to survive the exit of either of them and certainly not both. There will, therefore, be strong pressure for Greece to be saved again in order to prevent a further contagion threat.
The added dilemma for Germany is that if Greece is seen to ‘get away’ with not meeting budget targets, then there will be even less incentive for Italy and other countries to follow the path of austerity and the whole bailout mechanism will be shattered.
To this end, there is still a very high risk that Greece will be sacrificed and allowed to default immediately in order to send a clear message to other countries over the need for appropriate policies. In return, it is likely that Germany would agree to provide increased financial support to other peripheral countries that can be salvaged.