Greek Debt Crisis: Where Do We Go from Here

VoxUkraine explains the background of the Greek crisis and its current stage. There are four possible scenarios of what might happen next – from Greece exiting the eurozone to restructuring of the major part of Greek debt.

How did Greece get here: From mid-1990s until the last year Greek government spent more than it collected in taxes. The deficit was covered by borrowing as Greece could borrow nearly as cheaply as Germany did. The lenders assumed that even if Greece is not able to pay, the rest of the eurozone members will step in to help. In October 2009, Greek government announced that for years it lied about budget deficit; the correct deficit was double of what was claimed before, 12% instead of 6%. The announcement undermined Greece’s credibility and raised its cost of borrowing. By April 2010, Greece was quickly approaching bankruptcy. The International Monetary Fund (IMF), the European Central Bank (ECB), and the European Commission (EC), so called troika, lent Greece the money to avert default. The aid came with conditions, requiring to cut budget spending and increase taxes (austerity), to liberalize labor and other markets (structural reforms), to eradicate tax evasion. The conditions were intended to help Greece to grow the economy and to pay off its loans, but the loans did not help Greece either to grow or to reduce its debt burden. By any metric, the Greek economy is in a big trouble: since the start of the crisis in 2009, GDP fell by 25% (!); the debt to GDP ratio rose from 112% in 2008 to 177% in 2014; and unemployment rate rose from 9% to 25%.

What is happening now:  On Monday, June 22 Greek government sent new proposal offering 1) significant (1.4% of GDP) pension savings by increasing worker and employer contributions to pension, 2) several new taxes, 3) increase of the value-added tax. The proposal got good initial reviews from European officials. From Monday until late Friday Greece and its creditors negotiated the conditions, expecting to reach an agreement on Sunday.  Unexpectedly, on Friday evening, the Greek government called for a referendum for voters to decide on whether to accept the terms of the latest proposal. On Saturday, European officials refused to wait for the results of the referendum and declined further talks. Scared by the breakdown of negotiations, Greeks lined before ATMs to withdraw their deposits in Euro while they can.   On Sunday, due to large withdrawals and the ECB’s decision to decline emergency lending, Greek Prime Minister  Alexis Tsipras ordered to shut down Greek banks for a week, to close the stock exchange, and to impose capital controls. Depositors were allowed to withdraw only 60 EUR per day. On Wednesday, Greek government reversed the course and offered to accept most of troika’s demands with minor changes under conditions that they are a part of a broader deal for next two years. However, most European officials now insist on seeing the results of the referendum.

What can happen next?  To answer this question, we need to understand positions of the Greek government and the Troika.

The Greek government was voted into office on the platform of ending austerity and getting a better deal for Greece (specifically, the government wants to write off  some debt). Accepting the troika’s austerity conditions is contrary to the government promise; rejecting them means taking responsibility for a default and the economic chaos that may follow. Hence, the Greek government hopes that the referendum will strengthen its demand to weaken the austerity and lower the debt burden.

But the troika cannot easily forgive the debt because this may open a door for defaults for other troubled countries such as Portugal, Spain, and Italy. Indeed, voters in these countries may  elect parties that promise to default on public debt. Furthermore, the IMF cannot forgive its loans because it will undermine the IMF’s operations in other troubled countries. If one country does not have to pay back the loans, why should other countries honor their debts?

So, what can happen next? We see four possible scenarios.

Scenario 1: Greece defaults and exits the eurozone. There are no historic precedents for a developed country to leave a shared currency zone and set up its own currency. The exit from the eurozone likely means major short-term problems. First, printing new money takes time (it took 6 month after the Czech-Slovak union broke down in 1993) and thus even the smallest transaction will be difficult. This problem however could be attenuated if the euro is allowed to circulate.

Second, the Greek new drachma will fall in value at least by half according to 2012 IMF estimates. A big fall of the drachma will make it hard for Greek banks and firms to pay back their euro-denominated debt. The lenders will refuse to accept weaker drachma and it will be hard to pay those debts back by earning drachma. One can expect a wave of bankruptcies.

Third, a weak drachma will make Greek goods cheaper on foreign markets thus helping the economy, but the effect may be limited in the short run. Greece is not an export superpower and its main exports – fresh fish, cotton, and tourism – all have constraints, both supply and demand (e.g. fishing quotas). In a longer run, weak drachma will lower Greek wages, making them more attractive for foreign companies, and therefore the Greek economy can restore its competitiveness.

Fourth, the initial depreciation of the drachma will create one time inflation hike (similar to what Ukraine has had in recent months). As the government prints new money to support banks and pay wages and pensions, more inflation is likely. Historically, Greeks were not good at managing inflation: the value of drachma fell from 30 per the U.S. dollar in 1970s to 300 per U.S. dollar in 2002.

Overall, problems of banks, inflation, and no money to facilitate transactions together will most likely result in a large drop of GDP (about 8% according to 2012 IMF estimates), overall decline in households’ living conditions, and rising inequality.

Scenario 2: Greece defaults but does not exit the eurozone. In this case, the Greek government will not have access to borrowing from either the private markets or other governments. Although Greece has a modest primary fiscal surplus (that is, if we exclude interest payments, public spending is smaller than tax revenue), the government will likely have to issue IOUs (“I owe you”; that is, an informal surrogate for public debt, or for own currency) to rescue critical sectors of the economy, pay government employees, and pensioners. Since people prefer the euro to an IOU, most likely IOUs will trade with a discount, which implies indirect cuts to wages of government employees and pensioners and prices for goods exchanged for IOUs.

The default eliminates a large share of debt overhang for Greece thus removing a need for further austerity. But because most Greeks will prefer euros to IOUs, deposit outflows and therefore problems in banking system will continue undermining any hope for growth. Also, the IMF and EU will not take a refusal to pay debts lightly. The Greek government will not have access to international financial markets until it pays back to the IMF. If Greeks do not pay back to the ECB, the ECB will not accept Greek bonds as a legitimate collateral which undermines the Greek banking sector. Finally, not paying back to the EU may result in loss of substantial subsidies to agriculture and other sectors.

Perhaps, most problematically for Greece, this solution is unlikely to quickly restore competitiveness of the Greek economy as long as it continues to operate in the eurozone.

Scenario 3: Greece stays in the eurozone accepting further austerity demands. The troika demands primary budget surplus (without interest payments) of 3.5% of GDP by 2018. Such a budget surplus requires further budget cuts and increases of taxes. But, this exactly what troika was imposing on Greece since 2010 with catastrophic consequences of five years of depression. Furthermore, this deal contradicts the central promise of the current Greek government. Thus, the Greek government will lose credibility with the voters and then a new political crisis is imminent. Whether new elections will produce a winner willing to keep the promise of the discredited government is not clear. So the crisis is likely to continue.

Scenario 4: Greece stays in the eurozone and creditors restructure a major part of Greek debt. In many ways, this scenario is the best case for Greece: Greek banks will continue to have access to emergency lending from the ECB, inflation will be low, the debt overhang will be alleviated, the government can stop fiscal austerity. This scenario will also minimize adverse effects for other countries in the EU. Many economists–including Nobel laureates Paul Krugman and Joe Stiglitz–support this solution. In fact, even U.S. President Obama said, “You cannot keep on squeezing countries that are in the midst of depression.” With a hindsight, one can say that Greece perhaps should have defaulted in 2010: the Greek debt was not sustainable in 2010 and it is not sustainable now. A default in 2010 would have created problems for German and French banks that held Greek debt but those problems could have been addressed directly by the ECB.

It “only” takes the EU to agree to forgive some debt and inject fresh liquidity into the Greek economy. Greece is a small country and the capacity of the EU to raise money is far larger than the Greek debt. Whether the EU will do it and lend more resources to Greece is an open question.

We do not believe that scenarios 1 or 4 are likely. The majority of Greeks want to stay in the eurozone and so abandoning the euro is unpopular. At the same time, the EU leadership appears to be terrified by the prospect of triggering defaults in other, much larger countries (most importantly, Spain and Italy) and thus likely will refuse to make any considerable concessions.

This leaves us with scenarios 2 and 3 as potential outcomes. Scenario 2 is most likely outcome if there is a no vote on the referendum. Scenario 3 is the most likely if there is a yes vote.

In either scenario Ukraine is likely to feel minimal impact from the fallout in Greece: Ukraine does not borrow in private markets (so there is no run on Ukraine’s debt), the banking systems are disconnected, there is little trade between Greece and Ukraine. In fact, Ukraine may even strengthen ist position in negotiations with Ukraine’s creditors as the Greek default can signal that it’s OK to default.