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Grexit? The Final Act Of A Classic Tragedy

|Includes: Global X MSCI Greece ETF (GREK)

-Greek PM Tsipras broke off negotiations with creditors Friday night and called for a referendum on their bail-out proposal

-On Saturday, the Eurogroup rejected the Greek proposal for a bail-out extension to allow for the referendum

-Early Sunday, the Greek parliament OK'd the referendum. Later that day the ECB froze its liquidity support for Greek banks

-With a debt payment due to the IMF next Tuesday the Tsipras administration has steered Greece towards default and opened the gates for a bank run

-Referendum might become meaningless: dire circumstances will make a euro-exit increasingly likely, opposite to the apparent wishes of the Greek electorate

In a stunning and unforeseen move Greek (NYSEARCA:GREK) Prime Minister Alexis Tsipras on Saturday at 1 a.m. announced his intention to call a referendum due Sunday July 5th 2015 to consult Greek voters regarding the final proposal of TIFKAT, or The Institutions Formerly Known As Troika (sorry, could not resist). In his announcement speech, which sounded aggressive and uncompromising to me, he blamed the European institutions and the IMF for trying to force his government into a bail-out extension it could not agree to. The referendum will ask voters to choose 'yes' or 'no' to the question of whether or not Greece should accept the latest proposal of its creditors. He also said the referendum would be accompanied by an advice from his government to vote 'no'.

Greek PM Alexis Tsipras in a televised address last Friday night announcing the referendum

In a speech high on rhetoric and low on realism, Mr. Tsipras stated his intention to ask the Eurogroup for an extension of the current bail-out program in order to allow time for organizing a referendum: "I will formally request a few days extension of the (bailout) program so the Greek people can decide, free of pressure or coercion, as is dictated by the Constitution of our country and the democratic tradition of Europe. My fellow Greeks, To this blackmail-ultimatum, for the acceptance on our part of a strict and humiliating austerity (proposal), and with no end to it in sight nor with the prospect of allowing us to ever stand on our feet economically or socially, I call upon you to decide sovereignly and proudly, as the history of Greeks dictates."

The move was not only unexpected but also belated as the Greek government faces a payment of €1.6 billion due to the IMF this Tuesday (June 30th), which it is widely expected cannot be met without access to additional bail-out money. Under the last bail-out program, which runs through June 30th, a final €7.2 billion was still available for assistance to Greece, subject to its acceptance of certain conditions for additional reforms and spending cuts. If Greece had accepted the latest proposal, this program would have been extended by an additional 5 months and funds totaling €15 billion, which would have provided Greece with the opportunity to pay substantial debts coming due in the next couple of months. With their debt maturity profile turning much more favorable after this period, this effectively means Greece would have been helped by its creditors across this highly-demanding short-term liquidity drain and could have looked forward to more manageable debt maturities for a significant period after. The major issue for the Greek government was the fact that these proposals came with additional demands for reform, which the Syriza-led government probably felt they could not accept due to their election promises.

While the Eurogroup was set to negotiate for another day on Saturday, its agenda was effectively canceled by the Greek government's unexpected course of action. So unexpected in fact that Greece's own negotiating team in Brussels had to find out through Twitter (NYSE:TWTR). As a result, the Saturday meeting of the Eurogroup ended rather quickly with the almost unanimous decision to deny the Greek government's proposal for an extension of the current bail-out program to allow for the referendum. Out of 19 Eurozone countries 18 were in support of this decision, with Greece the only one opposing it (as evidenced by the note on the press release below).

Above: press release from the Eurogroup meeting of Saturday June 27th 2015.

The Eurogroup, through its president Mr. Jeroen Dijsselbloem, voiced its concerns regarding the unilateral break-off of negotiations by the Greek team. According to Mr. Dijsselbloem, the other Eurozone countries felt they could not agree to an extension primarily because of the Greek government's own negative stance regarding the institutions' proposals. Secondly, with the referendum one week from now the Eurozone members, the IMF and the ECB were effectively asked to provide financial support to Greece for another week (and possibly longer) under conditions of extreme uncertainty regarding the outcome. In case of a Greek 'no' this would have meant more European money had disappeared into a black hole, while a Greek 'yes' would have left an unwilling and so far extremely uncooperative Greek government in charge of further reforms and budgetary cuts it opposes. Not only would this have created a huge credibility problem for the Tsipras administration domestically, the Eurozone members also had little faith in the likelihood that its reform demands would have been thoroughly executed by the Syriza Greek government. In Dijsselbloem's words: "(…) but I think you have to realize that in the in-between period the situation in Greece will deteriorate very rapidly. There is no time to take that long (…). How does the Greek government think it will survive and deal with its problems in that period? I do not know. (…) But there are great concerns of credibility. Our experience is (…) that the only way programs will work, can be successful, if there is ownership. If governments believe that what they have to do may be harsh in the short run but will deliver results in the long run. And if a government has spoken so negatively about the package (…), so negatively about the approach then there is little credibility that even after a yes they will implement it in a right and conscientious way".

Developments during the rest of the weekend quickly escalated towards a Grexit scenario. After the Eurozone's refusal of the extension request made by Tsipras, the Greek parliament still spent many hours debating the referendum. After parliament approved the proposal for the July 5th referendum, there is good chance that the Greek vote will have become meaningless before it has been cast. The ECB on Sunday announced it had decided to freeze liquidity support to Greek banks under its ELA program (emergency liquidity assistance). Without a bail-out program the ECB felt it could no longer accept now increasingly-risky collateral such as Greek treasury notes in exchange for euro bills. This means the Greek banks will start running out of euros very quickly, with a full-fledged bank run already underway during the weekend. It seems to me, prior to being able to vote on the referendum, the Greek population is already voting with its feet (and running towards the euro). Somewhat comedic amidst this tragedy was a photo apparently picturing the Greek minister of culture standing in an ATM queue that circulated on Twitter this weekend.

Besides the fact that Greece's financial system now becomes exceptionally vulnerable to a liquidity drain, the likely inability of the Greek government to fulfill its debt obligation to the IMF will mean it will go into default by Wednesday. This will cut the Greek government off entirely from capital markets and its banks from European Central Bank support. In my opinion, Greek banks will be faced with a short-term liquidity crunch that will force the government into action. Without money to support those banks, it seems highly likely that we will see bank closures and perhaps even capital controls. Since the Greek banks hold substantial amounts of Greek government bonds and treasury notes, the entire situation will leave them squeezed between a tidal wave of deposit-withdrawals and seemingly worthless government debt holdings.

In my opinion, this will force the nationalization of several Greek banks by the Greek government. Since they do not have the euros needed to save them, it seems exceptionally likely this will force a euro-exit. If this scenario unfolds the government will have to start paying people in IOUs, which will effectively become Greece's new currency. How this will work out precisely is impossible to predict. It could be that Greece will adopt a two-currency system, with unofficial use of the euro and official use of the new drachma. Continued membership of the Eurozone seems impossible under current circumstances, while relying on the unofficial use of the Euro (like Balkan state Montenegro and micro-state Andorra) will leave the Greek government without the monetary tools necessary to allow for more flexible government spending. My bet would be on a dual system, with the government paying in new drachmas while the euro will become unofficial but highly-desirable currency.

The Greek referendum seems likely to have become meaningless as a result of developments now highly anticipated by economic and political observes alike. Complicating matters further is the more than decent chance that the Greek population will actually vote 'yes' to the proposals of its creditors. In that case the Tsipras administration will be faced with a seriously impaired electoral mandate, since its decisions will by then have steered towards an exit its population does not want. Which leaves us outsiders with the question why this course of action was chosen in the first place? Calling a referendum on the outcome of negotiations with its creditors is an idea that holds merit. The timing and the way it was proposed however is where the Tsipras administration seriously stumbled. Tsipras' electoral promises of bringing an end to austerity were irreconcilable with the demands of its creditors for fiscal responsibility and reforms. In fact, the Tsipras administration wanted debt reductions and a halt to further spending cuts without delivering anything in the way of economic reforms.

In my opinion, Tsipras' promises to his voters were outlandish and unrealistic. Its creditors were effectively asked to bankroll an economy and a government that have displayed a serious amount of dysfunctionality over many decades. There was no way the European institutions and the IMF would go along with any of this without asking for improvements in Greece's economic and political institutions. Tsipras meanwhile probably felt he could not back tread on his electoral promises, or get a compromise with the creditors past his own members of parliament. A very interesting article by Politico analyzed his decision to call a referendum as a maneuver intended to save his own political skin rather than secure Greece's prospects as a Eurozone member. If the Eurogroup had allowed the extension and Greek voters subsequently rejected the institutions' proposal, he would have gained a better bargaining position. A Eurogroup rejection meanwhile allows him to shift the blame for a Euro-exit to the institutions rather than the failures of his own government. Despite all his rhetoric on democracy, dignity and sovereignty, Tsipras' course of action has now effectively taken the Greek people down a road it never wanted to go. So much for his democratic principles; these strangely enough also never seemed to include voters' interests in the countries that provided the bail-out funds to Greece. Meanwhile the Greek people will likely be confronted with a euro-exit, while Eurozone taxpayers are left out of pocket to the amount of hundreds of billions.

While I am not highly informed on theatre the events of this weekend do appear to closely resemble the theatrical form of tragedy that came into existence in ancient Greece. According to this summary on a PBS Empires program on Ancient Greece a tragedy "dealt with the big themes of love, loss, pride, the abuse of power and the fraught relationships between men and gods. Typically the main protagonist of a tragedy commits some terrible crime without realizing how foolish and arrogant he has been. Then, as he slowly realizes his error, the world crumbles around him."

The unwillingness of the Tsipras administration to realize the weakness of its negotiating position and its desperate attempt to maintain its newly-gained position of power have taken Greece down a course that will quickly see the evaporation of many things currently taken for granted. The disintegration of its financial system has already begun, which is something I highly doubt Syriza supporters would have wanted. Tsipras' refusal to cut pensions, which seemed one of the largest points of difference with creditors, is also set to become a pyrrhic victory for his voters. Pensioners in Greece will quickly find out that a 1000 drachmas pension will not go as far as one of €1000. In fact, all those on fixed incomes will come to understand this in due course. Come Sunday Tsipras may also be confronted with a vote that opposes the situation already created by him. In that situation he will have lost both his political credibility and perhaps Greece's position in the Eurozone as well. The Greek people will be left in total confusion, with a financial system in ruins and likely headed for new elections, once again confirming their tragic script of electing politicians who seem intent on serving their own interests rather than the common good.

(Author's note: I realize the situation in Greece has created a lot of human suffering, to which my article may not appear sympathetic. I would argue that the opposite is actually the case with a sincere desire on my part to see a better future for Greece. Under the current administration (and most of those in the past) I do not see much improvement on the horizon, which in my opinion necessitates painful reforms. By electing Syriza to power the Greek people, or at least substantial part of them, have chosen to believe their membership in the Eurozone was fully compatible with an end to austerity and reforms. This has turned out an illusion).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.