BofA's Modest Proposal For Greece: "A Negative Shock May Be Necessary"
Via BofAML's Athanasios Vamvakidis,
Time for Tsipras to be Greece’s Lula?
Greece has less than two weeks to persuade the rest of Europe of its commitment to reforms. We previously argued that President Lula’s case in Brazil—a former union leader from the left, who was credited with impressive economic performance despite initial market concerns—suggests that Greece’s Prime Minister Tsipras could similarly surprise markets positively by implementing market-friendly, structural reforms. Official data suggest that the Greek government will run out of its cash buffers by the end of March—press reports in Greece suggest that the government has a funding gap of €1.5bn in March and €2bn in April. The Greek government has committed to submit details of its reform plans following recent meetings with European leaders, which the European institutions and the IMF will evaluate. Now may be the time for Prime Minister Tsipras to show to the rest of the world that he is Greece’s Lula.
We believe that a strong commitment to reforms will be what could cut Greece’s Gordian knot. We have argued in the past that Greece had to implement more austerity in recent years because of weak implementation of reforms. The Tsipras government has a unique opportunity now to stop the negative feedback loop between austerity and growth and build trust with the rest of Europe by accelerating and broadening reforms. We do not see a scenario in which Greece receives more official loans, for less austerity and without more reforms. In contrast, reform implementation could allow an agreement on new official loans, help address tail risks, and increase long-term potential growth, a win-win situation.
The reform list in the Eurogroup agreement of February 20 is a very good starting point in our view. Reading the list, it is almost impossible for us to disagree with any of these reforms. However, the Greek government has to prove ownership of these reforms and show determination to get the job done. Success will increase the government’s credibility and could lead to an agreement that will include a growth-friendly fiscal consolidation looking forward.
Needless to say, and consistent with recent commitments, the Greek government should avoid rolling back any of the past reforms or introduce measures that would worsen fiscal conditions or could threaten financial stability. New policies will have to wait to be part of an agreement for a new adjustment program and be consistent with the new fiscal targets and plans to bring the financial sector back to health.
Progress in negotiations with the rest of Europe and the IMF based on a reform agenda could help address funding pressures. We believe that the European institutions will not allow an “accident” in Greece because of funding pressures in the sovereign or the banks, as long as they are converging towards an agreement for a new arrangement with the Greek government. However, our view is that funding pressures in Greece will become much stronger in early April if this round of negotiations fails. Time is very short.
The end of the road
We believe that Europe and Greece may not be able to “kick the can down the road” beyond June. The European governments will need to approve a new program for Greece that will include new official loans (the exact amount will depend on the fiscal targets, but press reports in Greece suggest €30 to €50bn). The Greek government will have to approve a new package of measures and reforms, some of which could be unpopular and against pre-election promises.
Absent the latter, we don’t see how the former can take place. The Greek government needs to demonstrate a genuine reform effort to persuade the European parliaments to approve more loans. One could argue that saving Greece increases the chances of the European institutions and the IMF getting their money back. Moral hazard considerations also suggest that saving Greece if the country fails to deliver on its reform promises could cost more in the long term.
Either Greece will stop trying to save the failed past and look into the future, treating the crisis and the adjustment program as opportunities to finally implement urgently needed reforms, or the country will be eventually forced to exit the euro, in our view. The crisis took place because Greece had policies that were inconsistent with being in a monetary union. The crisis has been so severe because Greece has been trying to save these policies. Program flaws also contributed to the crisis, but other periphery countries had much better implementation record than Greece and have started recovering. The trigger of the worst moments of the Greek crisis has been domestic brinkmanship and political uncertainty. Economics 101 teaches us that an economy can survive within a monetary union only if it has fiscal policy room and structural flexibility to respond to asymmetric shocks. In our view, Greece had none and has none. We see no solution for Greece within the Eurozone without reforms.
Three possible scenarios
In what follows we consider three possible scenarios for Greece.
- The good scenario is the Lula scenario, in which Greece commits and implements key reforms, stays in the Eurozone, starts seeing positive growth surprises, and regains market access.
- The bad scenario is another effort to kick the can down the road, with Greece doing just enough to persuade the rest of Europe to keep the country in the Eurozone and the Europeans giving to Greece just enough loans to repay existing loans; we argue that this scenario is not sustainable.
- And the ugly scenario, in which there is no deal between Greece and the European institutions, leading to a bank run, capital controls, and eventually Euro exit.
It could also be the case that triggering the bad, or even the ugly scenario would force a political consensus in Greece to move to the good scenario, but the situation will likely have deteriorated in the meantime.
Our baseline remains that Greece will choose to reform and will therefore stay in the Euro, but brinkmanship so far suggests to us that risks of negative scenarios have increased. We are getting increasingly concerned that a negative shock may be necessary to force the Greek government to achieve a consensus for the reforms that the country needs. Our optimistic baseline scenario is based on the strong support for the Euro in the polls in Greece.However, we have been on the way towards a negative scenario so far and something will have to change in the negotiations to bring Greece back on track.
The good scenarioIn this scenario, Greece starts implementing key reforms, consistent with the February 20 Eurogroup agreement. For the first time since the crisis started, the Greek government could own the reform program, which should lead to better implementation. Moreover, all mainstream opposition parties have already committed to support these reforms in the parliament, which means that for the first time since the crisis started Greece will be approving reforms in the parliament by an overwhelming majority. In return, Greece will receive immediately more official funding to deal with the heavy loan maturities in the next few months, the ECB will start accepting Greek assets below investment grade as collateral again, and the rest of Europe will provide a strong commitment to do what it takes to keep Greece in the euro. After August, Greece will participate in the ECB quantitative easing. And later this year or early next year, Greece and the Europeans will agree on an OSI (official sector involvement, in the form of loan maturity extension of official loans to Greece). In this scenario, we would expect Greece to re-gain market access by the end of 2015 or early 2016, to experience a fast recovery starting in 2016, also benefiting from the weak Euro and the low oil prices, and to increase its long-term growth potential.The bad scenarioThe bad scenario is a slow-death scenario, similar to what Greece has experienced in recent years, but with increasingly higher risks. Greece commits to just enough reforms to persuade the rest of Europe to extend just enough loans to avoid a default in the short term, but not enough to support a recovery and persuade the Europeans to agree on a sustained solution. The OSI remains a distant hope, Greece has no market access, and the Greek banks remain at the mercy of ECB liquidity support. The uncertainty persists, perhaps with a small break when the loan agreement takes place, the economy suffers, the two sides do not trust each other, and any new shock could trigger the ugly scenario that we describe below. Absent a strong commitment by the ECB to remain the lender of last resort for the Greek banks, we would be concerned that this scenario will prove to be unsustainable. The economy will not be able to survive prolonged uncertainty and persistent risks for a sovereign default and a bank run, in our view.The ugly scenarioIn this scenario, Greece fails to demonstrate a credible commitment to reforms in the next few weeks. In this case, the Europeans and the IMF suspend the current program, the ECB refuses to continue increasing the ELA (or just lets the Greek banks run out of eligible collateral), the loss of bank deposits accelerates triggering a full bank run, and Greece defaults to the IMF and the ECB. Unless any of these shocks force the Greek government to go back and seek a deal with the rest of Europe, Grexit within this year becomes inevitable in our view. Either Europe will offer it as an option, allowing Greece to remain in the EU, or it will become Greece’s only option to avoid a complete collapse of the economy and even a failed state.
And everything between
Greece may have to start in the bad or even the ugly scenario, before we see the good scenario. This is not ideal, as the economy will have suffered in the meantime. We also believe that Greece will need substantially more official funding in this case. Moreover, the probability of an accident (bank run and default) would be very high in this case.
Greece may have to start in the bad or even the ugly scenario, before we see the good scenario. This is not ideal, as the economy will have suffered in the meantime. We also believe that Greece will need substantially more official funding in this case. Moreover, the probability of an accident (bank run and default) would be very high in this case.
The question of whether the Greek government coalition will reach a consensus to implement the reforms that Greece needs is still open. It is now becoming clear that the government cannot deliver on pre-election promises to stop austerity, restructure the Greek loans to the official sector, and roll-back some of the most unpopular reforms of the adjustment program. This could have political costs and could lead to a rejection of the new program by the Greek parliament. However, Syriza has also promised to keep Greece in the Euro and to implement structural reforms that previous governments failed to implement because of vested interests. Indeed, tax reform and safeguarding fair market competition by fighting corruption and eliminating monopolies and oligopolies are flagship reforms in Syriza's program and are prominent in the reform list in the Eurogroup decision. We believe that delivering on these reforms will allow the Greek government to keep some of its pre-election promises, which are those that matter the most. Some of the government parliamentarians may have different views and a government reshuffling, or even a new government coalition may become necessary to reach a deal. We could also see a referendum on a new loan arrangement following an agreement with the European institutions and the IMF, which we believe will have a positive outcome given the strong public support for the Euro.
Another problem is that the Greek government has been trying to replace the institutional framework of the adjustment program with something more informal. We do not believe this is possible. Legally, the ESM and the IMF cannot disburse money without a proper program, including targets, conditions and a monitoring mechanism. The Eurozone’s crisis resolution framework and its functioning are very specific and have been approved by European institutions and country parliaments. We expect the European institutions to insist that all sides should respect this process and framework.
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So, that's it - a few days to solve all this... with no possibility of a snow-job (because the Germans won't accept it)...
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