04 February 2015

Tsipras looks over the brink – and seems to draw back: Phew!

Eight days after its appointment, the new Greek Government has shown clear signs of growing swiftly into the responsibilities of power. And so it should: the opportunity of gaining historic credit for a revolutionary change in the country’s fortunes is a prize indeed. It only requires innovative thinking and some more patience - but also great political courage. The most recent comments suggest that courage is available.

The opportunity

Few observers seem aware of the scale of the debt relief already granted by the EU. To re-state my recent comments: “The European Commission’s Autumn Forecast was very positive about the outlook for Greece. In 2016, Greece is expected to grow twice as fast as the euro area average, and its 3.7% growth would put it level pegging with Ireland as the top-performing economy. Employment would rise sharply and the unemployment rate fall from 27% last year to 22%. Correspondingly, the public debt ratio would fall from 175% of GDP to about 160%; hardly any borrowing from the rest of the world would be needed and the budget would be close to balance. Moreover, investment is set to boom. The government that can claim ownership of such a turnaround would earn great plaudits from the electors as `austerity’ would indeed have ended. 

Cutting the annual cost of servicing the debt: Public debt interest charges peaked in 2011 at 7.3% of GDP and fell to 4.3% last year. With little fanfare, the EU has already extended the maturity of it loans from the EFSF to an average of 32 years; at an interest rate of 1.5% (basically the EFSF’s borrowing cost); and given a 10 year moratorium on interest payments. As EFSF CEO Klaus Regling put it, these policies produce “annual budget savings of €8.5 billion per year, or the equivalent of 4.5% of Greek GDP - year after year. Consequently, there is no debt overhang in Greece over the next 10-20 years, despite very high debt to GDP ratios.” As this feeds through fully, debt interest in 2016 should fall to 4.0% of GDP. Plenty of opportunity to declare `victory'. Perhaps tie the start of redemptions to the debt ratio falling to the same as other heavily indebted states that are coping?

What exactly is a “debt haircut”? Some further extension of maturities and interest moratorium would naturally reduce the “present value” of the debt. Many leading EU politicians have shown themselves quite open to exactly that. Any worthwhile politician should be able to portray these changes as a “haircut”, especially by comparing the present value with the level before the initial maturity extension/interest moratorium.

However, this rosy, but plausible, scenario must now be hanging by a very slender thread as confidence threatens to evaporate. To paraphrase the English nursery rhyme, once the Humpty Dumpty of confidence has fallen off the wall, it will be impossible to put it back together again.

Social justice

Syriza talks about social justice, especially in the context of their desire to restore the minimum wage. It has announced it will restore the level to that of 2012 - reversing the 22% cut. However, Greece is by no means the poorest state in the eurozone. Based on Eurostat figures for 2013, Estonia, Lithuania, Latvia and Slovakia have a minimum wage that ranges from 42% to 47% of the current Greek minimum wage. Even Portugal’s is 83% of the Greek level.

These `poor’ states account for 3.4% of the ECB capital key – a good proxy for their share of the guarantees on loans to Greece. So a massive write-down of Greek debt to the EU could cost them €7 billon – or 2% of their GDP/approaching 4% of annual public spending. They may question the social justice of a Greek vote that imposes austerity on them instead of Greeks. Moreover, the Baltic states are those who feel most threatened by Russia, so `rich’ Greece may earn even less sympathy from states fearing that the EU’s hard line on Russia may be undermined by apparently pro-Russian statements from Syriza ministers.  

The risk: a `Run’ on the Greek banking system

Professors of macro-economics may find themselves unfamiliar with the hard-edged practical details of the mechanics of a financial system. When faced with the risk that their deposit may lose value through various possibilities, it is entirely natural for a depositor to withdraw their funds from the bank they feel is at risk, and move it to a safer bank. The cost of the move is a negligible insurance premium compared with the possible risks:

• At one extreme, the bank may simply become insolvent and shut. The deposit will then rank as an unsecured claim in a long, drawn-out liquidation.  Whatever else, the deposit has completely lost its basic function as a means of payment. Small depositors are guaranteed – but when the whole system fails, it is unclear how such guarantees could be honoured. Who would be seen as credible enough to make good on any unfunded guarantees?
• Nationalisation of the banks is part of the Syriza programme. How would the Government find the cash to pay depositors if they `run’? If Greece left the euro overnight – by some unknown means – and paid the `running’ depositors in `new drachma’ instead of euro, how big would the `haircut’ be on the deposits?

The evidence is that a run is getting underway. The Bank of Greece (BoG) reported a €4 billion drop in deposits during December and press reports suggest a further €10 billion outflow in January. The banking system’s liabilities to the Bank of Greece rose by €11 billion - about 25% - in December.  Where did the Bank of Greece get the money from? The answer is the ECB – an institution that has made it clear that it cannot `lend freely’ in the absence of an agreed programme with Greece.

Press reports suggest that the new Greek government is asking for an additional €10 billion on the ceiling of Treasury Bills that can be re-discounted at the ECB. However, the question of adequate collateral will loom large as the ECB is not permitted to run significant credit risk. The BoG has about €5 billion of gold and €25 billion of “other securities of euro area residents denominated in euro”. In a fire sale, what would these fetch for collateral valuation purposes? Understandably, the ECB seems nervous about further exposure.

This is the heart of the problem facing Greece in the next days and weeks. The precedent of the run on the Irish banking system in late 2010 suggests that 15% of deposits can run in three months. The example of the UK and the difficulty in stemming the run on just the fifth-largest mortgage bank is also instructive. The Finance Minster had to go on peak-time television and guarantee citizens blanket coverage of all deposits by the AAA-rated UK government. With no prospect of EU support, the Greek government would have limited ability to convince bank depositors of the credibility of its guarantee of the whole banking system.

The Greek banks have just passed the ECB’s stress test BUT such tests are designed for `ordinary’ macro-economic crises, and not a run on the entire financial system of a state driven by loss of confidence in the credibility of its government. For Greece, an Irish-style run may need a further €25 billion of cash in the near future. Stemming the run completely may require a cast-iron guarantee for the remaining €160 billion of deposits. The ECB certainly cannot do that by technical wizardry through the back-door. That would require a near-doubling of the total loans and guarantees already issued by the euro area. Such a dramatic show of overt political solidarity seems implausible for a government that claims a mandate from its electors to repudiate existing debts.

Instead, it should take the time to slash defence spending – still the highest in the euro area – and carry through its revolutionary plans for taxation. (Unfortunately, that may alarm some depositors even more.) These moves could provide the headroom to re-orient public spending rather than dramatically increasing the total. With that comfort, the euro area could roll forward the existing programme for a few months, thus enabling the ECB to drip feed the Greek banking system with liquidity.

The alternative is dire, so time is short for the new Syriza government to recognise the gravity, and imminence, of the peril and move decisively and unambiguously to do a deal with euro area on the generous terms that seem to be on offer. The acid test is regaining the confidence of Greek bank depositors. The Humpty Dumpty is already slipping off the wall. If he actually falls, then he cannot be “put together again by all the King’s men” – or even the EU - for a long time.

© Graham Bishop