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Strategic blind-spot

11 May 2015 By Hugo Dixon

Strategy is a word with Greek roots. But, sadly the current government led by Alexis Tsipras doesn’t seem to have a strategy for extricating the country from its parlous state.

Its government lacks a credible plan for reaching agreement with its euro zone creditors and the International Monetary Fund. It doesn’t seem to have a thought-out fallback plan of how to default while containing the damage either.

Greek financial markets have perked up in the past few weeks, largely because Yanis Varoufakis, the combative finance minister, has been sidelined from discussions with the country’s creditors.

The new composition of the negotiating team has, indeed, led to more productive talks. But there is still a mountain to climb and little to no chance of a deal when euro zone finance ministers meet on May 11.

When Tsipras took power in January, he seems to have thought he could extract more cash from his creditors as well as secure relief on Athens’ debts without undertaking serious reforms. This was pie in the sky.

The government also didn’t initially factor into its calculations how badly the economy would be damaged by months of political uncertainty and a desperate liquidity crisis. In November, the European Commission was predicting growth of 2.9 percent this year. Last week, it cut that to 0.5 percent and even that could prove optimistic.

The deteriorating economy means Athens will find it a lot harder to balance its books. Even if its creditors lower the budget target for this year, the government will have to introduce more austerity measures – and that will further damage the economy.

Athens’ cash position is desperate. All in all, Greece owes around 324 billion euros, says the Greek debt management agency. Within that it needs to repay the IMF 750 million euros on May 12 and give it a further 1.5 billion euros in June.

Tsipras hopes he can persuade his euro zone creditors to lend Greece some cash in the next few weeks to stave off bankruptcy. But that will only be possible if he crosses red lines he has said he wouldn’t – on matters such as pensions, labour law and value-added tax.

Even if Athens survives its immediate liquidity crunch, it will struggle to secure a long-term deal. Negotiations on that are scheduled to finish by the end of June but they are not supposed to start until the talks on the short-term deal are concluded.

The problem isn’t merely a matter of time. It is also a matter of money. Given Greece’s deteriorating economy, the next bailout will require more than previously estimated – perhaps over 50 billion euros. It will be hard to persuade other euro zone nations to cough up this sort of cash, not least because goodwill towards Greece has almost vanished.

Given such a gloomy prognosis, it is important to examine alternatives. There are two: default and leave the euro; or default and stay in the single currency.

The latter would be the least bad option, though far from good. To minimise the damage, the government would have to recapitalise the banks, as a default by the government would tip them into insolvency too. If the banks weren’t recapitalised, the European Central Bank would cut off liquidity, the lenders would go bust and the economy would be dragged further into the abyss.

The problem is Athens wouldn’t itself have the cash to bail the banks out and wouldn’t be able to get any money from abroad either. The only solution would be to “bail-in” depositors – converting a portion of their savings into new equity in the banks.

Although the banks are not overly exposed to the government, they would also need to be recapitalised to take account of the fact that more loans to the private sector would turn sour. The haircut suffered by depositors could be quite big. This would be a blow to the economy.

If Athens defaulted, it would also have to live within its means. Although the government would no longer need to find cash to pay its creditors, it would still have to cut salaries and pensions because tax receipts would fall in line with the deteriorating economy.

Some pundits, including The Financial Times’ Martin Wolf, suggest that Athens should instead pay salaries and pensions by issuing IOUs. This would be a bad idea because, whatever the government said, the Greek people would see these IOUs as the precursor of new drachmas and would discount them heavily.

Tax revenue would plummet – partly because the economy would be shrinking and partly because citizens would be loath to pay taxes in euros if they thought the drachma was around the corner. So the government would have to issue yet more IOUs, leading to a vicious circle in which quitting the euro might become a self-fulfilling prophecy.

That’s not a good option either. Quite apart from the fact that the Greek people don’t want to leave the single currency, the transition to the drachma would be nightmarish. Even once it was reintroduced, there is little likelihood the government would run a responsible economic policy. It would probably print money, fuelling a spiral of inflation and devaluation.

Given that even the best Plan B is dire, Tsipras should work out a realistic strategy for how he is going to come to terms with his creditors. And do so fast.

 

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