Greece on its way for a third bailout

Long term issues not solved but, for now, risk-on is justified

A radical political change
Greek PM Tsipras has seemingly bitten the austerity bullet in order to demonstrate his political commitment to keeping his country in the euro area, when facing his peers on Monday night (22 June). Until then, there had been a distinct possibility that Greece’s plan was to miss the end-of-June payment due to the IMF and push their brinkmanship strategy to the very edge of the cliff, that is until the payment of bonds due to the ECB (20 July), in order to get a better deal. There was also a darker possibility, namely that the new cabinet was comfortable with the alternative of a Grexit, even perhaps with the idea of leaving the EU itself. By handing a list of reforms that crossed three of the red lines previously presented as non-negotiable, the Greek PM has changed the whole negotiation dynamic and opened the door to an extension of the second bailout, debt relief, and a third bailout.

This does not mean that all obstacles have been removed but, in our view, implies that the main case scenario is now that Greece will remain in the euro area and that the prospect of capital and deposit controls is a remote one. Will Greece’s economic flaws be solved before yet another liquidity crisis happens? Will the Greek government become solvent in a sustainable way? This is far from certain and, because the deal in the making will solve only short term issues, it is unlikely to answer these questions. The conditions for a third bailout –there will be conditions, of course– may help, but this cannot be taken for granted, especially if the IMF is no longer involved in negotiations.

A significant and seemingly credible fiscal tightening
Greek proposals put forward on Monday night include, among others, a widening base and higher rates for the VAT, restrictions to early retirement and cuts in net pensions, all measures that would cut the Greek ‘red lines’. On pensions, for instance, the proposal includes increases in the health contribution paid by pensioners from 4% to 5% for the main scheme (and from 0% to 5% for supplementary schemes), which implies a close to 2% cut in net pensions and thus in their budgetary cost. Most of the proposed measures look credible, inasmuch as they are verifiable. The darker side of these measures is that they imply significant fiscal tightening, pro-cyclical policy and, in the case of some measures, an increase in the cost of labour (increases in social contributions). After a lot of wrangling about privatisations (the Greek government has important assets, especially the properties of the Greek Orthodox Church) and reforms of a very dysfunctional labour market, not even mentioning corruption and tax evasion, the negotiation seems to have focused on ‘pure’ fiscal and budgetary matters. Yet, it is likely that, in exchange, Greece will get a debt relief, although not as a part of the current agreement, and a strong commitment from the EU to channel and fund more foreign investment in Greece, within and perhaps beyond the scope of the Juncker plan.

What’s next?
The Greek proposal was favourably received by euro area heads of state. The Eurogroup meeting on 24 June night will probably iron out the differences between the Greek and the
creditors’ positions and present its recommendation to the EU Council on 25-26 June, which may result in a draft deal. Obstacles remain, starting with the approval of the Greek Parliament. The probability of the bill being turned down looks very thin: either Mr. Tsipras is supported by his own coalition (Syriza and Independent Greeks) or he needs the support of other parties, in case of dissenting votes in his own coalition. In the latter case, a new coalition would emerge, which might lead to snap elections. Also, to get the formal approval of the lending countries, the agreement will pass through some Parliaments, starting with the Bundestag. Yet, if Greece’s partners consider that the new proposal is serious and credible, this does not look like a significant hurdle. Eventually, Greece will benefit from an extension of the second bailout (ending on 30 June) by perhaps six or even nine months, and should be able to meet its payment to the IMF, thanks to an emergency release of some of the funds that have been earmarked for Greece (the remainder of the second bailout, €7.2 or around 4bn, if the IMF can’t disburse immediately its share) or its banks (€10.5bn).

The next phases of the negotiation will focus on a restructuring of the Greek debt (nicknamed OSI, for official sector involvement), which might start with the bonds held by the ECB. Note in this regard, that a detailed agreement on a debt relief cannot be part of the current deal for a very simple reason: since it will have an impact on other countries taxpayers, a debt relief (which doesn’t imply a haircut) will have to go through Parliaments separately.

In the event, even if Greece receives all the funds that were promised under the conditions of the second bailout, the current situation of the economy is so disastrous that the country will be unable to meet its funding needs in the capital markets and will probably need to inject more than previously thought to recapitalise a banking system badly hit by the recession and capital flight. Therefore, a third bailout of at least €50bn, will have to be discussed and it is possible that the debt relief will come with it. Whether the IMF will remain involved or not is an open question. As a lender, it looks unlikely but as a technical advisor, this is possible.

In the end, Greece is certainly not out of the woods and it is possible that European policy makers have just agreed to kick the Greek problem down the road once again, although this will depend on the negotiation of the third bailout. But the systemic risk generated by the standoff has been removed and this has been very quickly perceived by the financial markets. This will not change the ECB’s QE policy –why would it?– but this is removing one of the potential roadblocks to a US Federal Reserve hike in the coming months. Foreign exchange markets have taken notice.

Eric Chaney, Research & Investment Strategy team – AXA Investment Managers