No Grexit, No Haircuts, but Difficult Negotiations Ahead

Financial markets let out a sigh of relief when they learned that the new Greek leftist government led by Prime Minister Alexis Tsipras has put aside its earlier demands that a large share of its debt be written down, that is, forgiven. Instead, the new Greek Finance Minister, Yanis Varoufakis, offered a surprise proposal of bond swaps. European rescue loans would be exchanged for debt linked to future GDP growth, and bonds now owned by the European Central Bank (ECB) would be exchanged for perpetual bonds, that is, bonds without a maturity date. This move takes imposed haircuts off the table. The possibility that Greece would exit the Eurozone (“Grexit”) now also looks very unlikely. Greece does not wish to leave the Zone; the cost would be too great; and its Eurozone partners have indicated they want Greece to remain.

What lies ahead is a difficult negotiation process between Greece and its creditors on the terms and conditions of a plan to address Greece’s debt situation and the dire condition of the Greek economy. This process will surely take a number of months. Indeed, German Chancellor Angela Merkel signaled that while she is willing to give Greece more time to meet its obligations, she is not in a rush to enter into negotiations, preferring to wait until the country faces a cash crunch, which appears likely when a €3.5 billion payment comes due in June. Greece’s bailout funding runs out at the end of this month, but it will have some resources to carry on for a while. The Greek finance minister has proposed a bridge financing agreement involving the issue of 10 billion euros of short-term treasury bills to provide room to reach a more comprehensive accord by June. The ECB has indicated it is unwilling to agree to this. For its part, the Greek government has said it is committed to running a primary budget surplus, one of the conditions demanded by the creditors, but the size of that surplus will be a matter for negotiation. And so the negotiation process begins.

We will not go into the many dimensions of these negotiations which address Greece’s €303 billion debt. Of this amount, bonds account for less than a third, some €82.445 billion. Loans are the greater financial challenge. Eight outstanding loans account for more than €221 billion. They are from the European Commission, the EU stabilization fund, the ESFS program, and the IMF. The largest of Greece’s obligations this year is €8.7 billion due to the IMF. The creditor countries with the largest exposure to Greek payments due this year are the United States, Germany, France, Italy, and Spain. They, along with the ECB and the IMF, will seek strong structural reform conditions as part of an agreement. The Greeks will seek relaxed austerity conditions to give the Greek economy a chance to recover. They may also threaten to turn to Russia and China for assistance, a move the Europeans and the United States would strongly oppose. The difficulties that lie ahead for these negotiations are suggested by the initial moves of the new Greek government to reverse austerity measures that were conditions of Greece’s bailouts: they proposed ending the sale of public assets (including Greece’s largest port and its dominant utility), ending public sector firing, and pledging instead to rehire public sector workers and raise the minimum wage significantly.

Greece will likely find some sympathy among its Eurozone partners for an agreement that provides some prospect for continuing the fragile economic recovery that began last year after one of the largest and most painful adjustments ever experienced under an IMF assistance program. That program began in 2010. Under successive rescue packages, output dropped more than 20% in real terms. The unemployment rate soared to 27.5% in 2013, improving a bit to 26.4% last year.

The economy has finally stopped declining and posted instead a small 1.1% advance from a very depressed base in 2014. Growth of about 2.5% this year looked likely to forecasters before the change of government created great uncertainty about the outlook. An accord on debt that permits the recovery to continue, including conditions that consist of market-friendly economic reforms, could improve the growth outlook. An accord that adds to restrictive austerity conditions would likely check the fragile recovery. And a failure to reach an accord, followed by default, would be very harmful for Greece, for its major creditors, and for Europe. That is why we expect that an accord will eventually be reached. There could be a lot of volatility in European markets as the negotiations proceed.

It is likely that the negotiations on Greece will feed into a broader discussion in Europe on the future of austerity measures, which are encountering increasing political resistance across the continent. Even the ECB is calling on governments to do their part to encourage economic growth and counter deflationary pressure through increased fiscal stimulus. The recent massive leftist demonstrations in Spain were a demonstration of the pressures many governments are experiencing. Growth in Europe does appear likely to pick up this year, with both a cheaper euro and lower oil prices providing a modest tailwind. However, the demands for reduced austerity will remain strong.

The small Greek equity market has begun to attract some investors looking for gains following the decline of 46% in euro terms and 55% in US dollar terms over the past 12 months. The sole Greek ETF, the Global X FTSE Greece 20 ETF, GREK, rose 13.2% Tuesday. This surge followed an 11.7% increase Monday and a 5.7% decline last Friday. It is still below the year-end 2014 price. This kind of volatility is likely to continue. Cumberland Advisors does not hold Greek debt in any of our International or Global Equity ETF Portfolios.

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