Greece Government is Taking a Hard Line

Rampant inflation, political unrest, debt defaults and a possible "contagion" within Europe's financial sector — that's what Greece's new government might trigger if it does not get its way in its negotiations with the rest of Europe's finance ministers right now.  

Greece is taking a hard line, saying it won't compromise, so it's worth asking, what exactly will happen if Greece walks away without a deal, and runs out of euro-backed cash in a few weeks time?

The election of far-left Syriza in Greece has started a game of chicken with the rest of Europe. Syriza want Greece's debt burden reduced, and an abandonment of its current bailout deal (with its austerity conditions). Much of the rest of Europe wants nothing of the sort — they want Greece to honor its debts.

That deal is incredibly unpopular in Greece, where many people blame it for their current economic depression. But the agreement is also what keeps the government funded, and without it there's really not much money left.

Greece's finance minister is mired in negotiations with his counterparts from the rest of the eurozone, but they're not looking promising right now.

Morgan Stanley gives these probabilities of what will happen in the days and weeks ahead:

·         Greece eventually goes back to the bailout programme: 55% likelihood. In this scenario Greece gets no haircut on its debts (which the government wants), it gets its international funding but also has to implement continued austerity and economic reforms.

·         Greece has a "staycation": 25% likelihood. This would mean Greece implements capital controls - strict rules that halt the outflows of money from banks - like Cyprus did during its 2013 crisis. 

·         Greece leaves the eurozone: 20% likelihood. Without European assistance, the life support Greece's banks are on is pulled away. It's hard to say exactly what the risk of a Greek banking collapse is to the rest of Europe. 

The Economist Intelligence Unit puts the Grexit risk at more like 40%. No country has ever left the euro before, so there are huge unknowns here. 

What we do know is that Greece has a lot of repayments to make in the next few months. Here's how that looks (the numbers mean millions of euros):

On top of the possible sudden disappearance of the bailout money, Greek tax revenues have also tumbled, down 23% below the budget target in January. 

So what happens if Greece can't fulfil these payments? Capital Economics, a consultancy that won the Wolfson prize in 2012 for its plan of how Greece could leave the euro, Barclays and Oxford Economics have all discussed this in recent research notes:

·         The drachma would be back. The euro would be effectively abandoned, and Greece would return to the drachma, its previous currency (it might take a new name). The drachma would likely tumble in value against the euro as soon as it was issued, and how much the government could print quickly would be a big issue.

·         It would have to be fast, with capital controls. There would be people trying to pull their money out of Greece's banks en masse. The Greek government would have to make that illegal pretty quickly. The European Central Bank drew up Grexit plans in 2012, and might be dusting them off now.

·         European life support for Greek banks would be withdrawn. Greek banks can currently access emergency liquidity assistance from the ECB, which would be removed if Greece left the euro.

·         Likely unrest and disorder. Barclays expects that this sudden economic collapse would "aggravate social unrest", and notes that historically similar moves have caused a 45-85% devaluation of the currency. Capital Economics suggests that the drop could be more mild, closer to 20%, and Oxford Economics says 30%.

·         Greece would resume economic policymaking. Greece's central bank would probably start doing its own QE programme, and the government would likely return to running deficits, no longer restrained by bailout rules (though investors would probably want large returns, given the risk of another default).

·         Inflation would spike immediately, but both Capital Economics and Oxford Economics say that should be temporary. It might look a bit like Russia this year — with the new currency in freefall until it finds its level against the euro, prices inside Greece would rise at dramatic speed. The inflation might be temporary, however, because with unemployment above 20%, Greece has plenty of spare labour slack to produce more.

The short-term effects would be painful and fast, but Oxford Economics analysts note that Greece "might be better off leaving the Eurozone in the long term". Capital Economics similarly argues that a well-managed exit "could even end up as a favourable economic development for both Greece and the rest of the euro-zone". 

And for the rest of Europe and the world, Wells Fargo analysts think that the effects may be manageable: 

Obligations to “official” creditors such as the IMF, the ECB and the governments of other European economies account for the vast majority of Greece’s $500 billion worth of external debt, so these institutions would bear the brunt of foreign losses from a Greek default. Foreign bank exposure to Greece totals only $46 billion, which is widely dispersed among countries, so the direct effects of Grexit on the private sector in other countries should be manageable, at least in theory. Of course, financial markets may react negatively if Greece were indeed to leave the Eurozone, and we worry that contagion could spread to other European countries.

In 2011 and 2012, Greece's fate seemed closely tied to the rest of Europe. Losing Greece would have signalled the first domino falling, followed by perhaps Portugal, perhaps Spain or Italy, unravelling the whole project.

Right now, however, Greece looks like its own separate case, and very few people think that Grexit would force that chain reaction.