Greece: The necessity to choose

Philippe Waechter, Economista Jefe Natixis Asset Management - Lunes, 03 de Septiembre

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For Antonis Samaras the Greek prime minister the trip to Berlin and Paris has not changed the picture. The Greek economy has made important efforts to improve its situation and Samaras expected that to fulfill the Greek government commitment he could have a two year delay from Germany and France.

In fact he had the usual ambiguous answer from Berlin and Paris. They said that they want Greece to stay inside the Euro Zone but that it is necessary for the Greeks to fulfill their commitments without delay.This situation is a nightmare. On the one hand Greek Government has to reduce expenditures and increase taxes to try to converge to public finance equilibrium. Currently this leads to recession as this reduces the final demand to companies. To measure the effort made by Greeks keep in mind that in 2009 the Greek primary deficit was at 10.6 % of GDP and that in 2011 it was just 2.4 %. It's better than most of other European countries. In 2012 there are no large discrepancies to this trend. To be more precise, public sector wage is set to be down by 23 % this year relative to 2009. There are similar figures on spending on social benefits or on investment expenditure. That's why after a new commitment to save EUR 11.5bn Samaras asked for a 2 year delay.

 

With a low primary imbalance, public deficit will for the most part be interests paid on public debt. This debt is detained mainly by European governments and institutions. It's a kind of recycling.

On the other hand, the probability of a Greek exit from the Euro Area is still high. There are a lot of comments on the lack of progress (read above on primary deficit) on the fact that the Euro Area would be manageable with an exit (contagion would be manageable) and that in fact a Greece exit could be needed for the Euro Area to survive. All these comments have an impact on the perception of Greece. When Angela Merkel and François Hollande say, as they did last week, that they want Greece to stay, nothing is done for that.

This has a strong impact on Greeks' behavior. If they expect an exit and associated with it currency depreciation they have to put their saving elsewhere than in Athens. At the same time, as this institutional framework is not certain, a company that would like to invest in Greece will postpone its expenditures. These rational behaviors weaken the Greek economy. But it is impossible in this environment to expect a stabilization of its economic situation. As long as the probability of exit is perceived as large, nobody will invest and save in Greece.

The effort is all on Greeks' shoulders, they are in recession with a large drop on employment and Europeans expect them to stay within the Euro Area. That's the paradox. All the adjustment has to be done by Greeks and that's why this strategy is not credible in a monetary union. If nothing is done the recession will continue and they will never converge to the target designed by the troika.

If Europeans really want Greece to stay they have to change something in the scenario.

Greek public debt is large and its dynamic is not sustainable. With negative nominal growth rate, efforts to stabilize the debt are too important. (The debt dynamic is dependant on the spread between nominal interest rate and nominal GDP growth. The larger the spread, the larger is the primary surplus needed to stabilize the Public debt to GDP ratio). This means that if Europeans want to change the picture they have probably to restructure Greek debt. This would be the first step to let them being able to stabilize their economy.

Such a situation will have by-product effects. One source of uncertainty is the risk of contagion if Greece exit. If they reduce the probability of exit the risk of contagion, the premium on others countries' debt will be reduced (That could be the case for Spain).

If nothing is done to help Greece, recession will continue, constraints from the troika will be stronger and at the end people in Greece will exit by themselves. Then it will be too late.

What will be the ECB strategy?

On September the 6, Mario Draghi will present the detailed framework of the ECB intervention. On August the 2, he just presented the outlines of it. There will be 3 steps for a country in difficulties. First: commitments to fiscal targets, to structural reforms and to institutions. Then after the agreement of the EFSF (firewall) the ECB will be able to intervene.

The main question is on the ECB method for intervention. A fix explicit target (level of interest rate or a given spread with Germany) is not possible for the sake of the ECB credibility and the huge size of its balance sheet that would result from such a strategy.

It will probably be an implicit target on short bonds. That's what Draghi said at its press conference. The intervention will be only on the short part of the yield curve. Investors will not know the target but the ECB said that its communication strategy will be transparent. The amount and the kind of assets bought will be communicated rapidly. In that case, investors will be able to imagine the ECB target. But the ECB, by making its target implicit, wants to be able to manage its own strategy to intervene or not. The ECB wants to keep the possibility to adapt its strategy at each moment.

The details will be available on September the 6 but before application it will be necessary to wait the Federal Constitutional Court in Karlsruhe in Germany on the European Stability Mechanism (the other firewall).

There is another important point. At the press conference in August, Mario Draghi mentioned explicitly the Bundesbank as being reluctant to the ECB intervention (such a communication strategy has not been used yet). Last week-end, Jens Weidman the Bundesbank president said its opposition to such a strategy. The balance of strength between the two is impressive. But the ECB could win as Mario Draghi explicitly designed the person that could be responsible of a failure. This shows Mario Draghi's will to succeed and to maintain the irreversibility of the Euro Area.

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