It’s Greek economy suicide watch day 700; the decision to call a referendum on its draconian austerity program is surprising to say the least and it takes a Panglossian investment bank to put a positive spin on this decision. The Prime Minister’s bolt from the blue Aegean has shocked financial markets out of their complacent assumption that last week’s confidence trick from the €urozone politicians to leverage up the European Financial Stability Fund would find willing buyers for its PIIGS in a poke. We had not expected this fiction to last long, but the unravelling has been remarkably quick. The referendum call represents the final throw of the dice for Papandreou, he has a of just two seats in parliament (with one MP resigning in reaction to the referendum announcement), down from five in the summer and this lead is slipping away as the country buckles under severe austerity, excess debt and substantial contraction of GDP. This is a vicious cycle in which the economy lacks the competitiveness or material export industries to escape this cycle. Quite simply, it is impossible for this majority to survive until scheduled elections in 2013. The Prime Minister has called a vote of confidence as well as his intention to call a referendum. The vote of confidence will take place this Friday and defeat would supersede the referendum.
However, a general election would inevitably force defeat upon Papandreou’s Pasok party and provide opposition with the mandate to renegotiate the terms of the second bailout, which in turn would be met with opposition from creditor nations within the €urozone such as Germany, Netherlands, Finland and Austria. Consequently a referendum represents Papandreou’s best prospect for clinging onto power and maintaining his credentials as a good European. However, being a good European in a failing peripheral state inevitably means surrendering sovereignty for the greater good of the single currency. Papandreou does not want to be the Prime Minister who surrendered sovereignty without the support of the electorate.
The extend of this loss of sovereignty will not become apparent until December when European leaders are scheduled to have a summit on changes to treaty legislation, but this is clearly a sensitive issue in Greece and other peripheral economies. The surprise referendum call can be seen as a means of trying to constrain German moves to greater political union and control from the centre. The stunned silence from European capitals suggests that they were not forewarned about Papandreou’s intentions.
The key risks to Papandreou’s cunning plan in the short-term are the implacable opposition to the referendum from the opposition parties. Their resignation on mass would force early elections. Mass resignations are a common ploy in Greek politics and normally forces early elections should the government refuse to resign. The second risk factor is within Papandreou’s own party if three more deputies resign or vote against the referendum. Press reports suggest that at least six Pasok deputies have threatened to vote against the government in Friday’s vote. The main uncertainty arising from immediate threat to Papandreou’s cunning plan is that the opposition New Democracy’s party share of parliament was decimated in the 2009 elections and they only have 80 seats, requiring an equally dramatic shift back in just two short years of Lazarus proportions to gain an outright majority. If it does achieve an outright majority and fulfil their promise to renegotiate the second bailout, then the option of hard default will be considered. However, the most likely outcome of any new elections is likely to be inconclusive with New Democracy as the largest party but no overall majority. The resulting government of national unity is likely to be highly unstable and resist further austerity that will inevitably be imposed once it becomes clear that the PSI haircuts implied by the second bailout are inadequate and that Greece requires another 50% haircut, the prospects of a hard default will once again become active.
If we assume that the government maintains sufficient cohesion to win the confidence vote, attention will turn to the referendum. The referendum will take place in January. The opposition to the referendum suggests that the government will not be able to achieve the super-majority of 180 votes necessary for a referendum on specific legislation. Instead if it comes to pass, the referendum vote will be as a “national emergency”, which requires a simple majority of 151 votes and a minimum participation of 50% of the electorate to be binding. The basis of the decision to call a referendum, which apparently was not communicated to the Finance Minister until after the announcement, have been public opinion polls suggesting that 60% of the electorate is opposed to the terms of the second bailout plan and in particular the private sector haircuts, which effectively defaults on the banks, pension funds and the private sector. However, opinion polls also indicate that a large majority remains in favour of membership of the single currency. It appears to be based on the threat that if the electorate refuse to accept European imposed austerity then the threat of ejection from the EU will force the recalcitrant electorate to accept austerity.
There is no legal mechanism to force a country to leave the single currency, the politicians believed that to allow this provision would be to incite speculation that membership was not irrevocable. Article 50 of the Lisbon Treaty allows a country to negotiate an exit from European Union and in effect membership of the single currency, but this negotiation is likely to involve a complex legal and technical process that would require the nationalisation of the banking system and imposition of capital controls. Exit from the EU would involve loss of structural funds as well as substantial corporate and household default since the devaluation of the new drachma is likely to be at least 50%. However, a country cannot be ejected from the EU without a change of treaty, but all 27 members of the Union must agree any treaty changes and, pardon the expression, “turkeys don’t vote for Christmas”. The Netherlands and Finland would like any prospective changes to the Lisbon Treaty to improve economic governance within the €urozone to include such a provision, but the current crisis over the Greek referendum highlights how difficult it will be to achieve contentious changes and explicit loss of sovereignty necessary to provide the appropriate checks and balances necessary for Germany and other rich economies to fund the transfer union required for the smooth functioning.
The precise wording of the referendum will be important if it goes ahead, but it is possible for the electorate to vote against the draconian bailout provisions forcing new elections to provide the next government with a mandate to renegotiate the second bailout package. We doubt whether the will of the Greek people will significantly alter the demands of the EU/IMF given that the former sinews are stiffened by opposition to transfer unions in the triple AAA core economies, then once again we face the prospect of a hard default. Indeed, the only positive outcome after a prolonged period of uncertainty would be a referendum victory for Papandreou, which would provide a mandate for additional austerity and keep him in power at least until the end of 2012 and within the next three years a second 50% haircut on government debt. In the meantime, the next instalment of the first bailout on November 8th is likely to proceed. Europe’s share of €5.8bn has already been agreed and this is sufficient to meet the country’s obligations of €2.9bn in the remainder of the year, even if the IMF delays its share of €2.2bn.
When Harold MacMillan was asked under what circumstances government policy would change he replied laconically; “events dear boy, events”. These words have returned to haunt European politicians. The political risk inherent in the €urozone will materially reduce the willingness of external government, particularly sovereign wealth funds tasked with maintaining the value of their reserves, to provide funds to leverage the SPIV. This suggests that governments will have agreed to increased guarantees of the European Financial Stability Fund re-visiting the difficult process of endorsement by national parliaments.
It has been abundantly clear over the past two years that none of the peripheral economies are risk free and important members of the core economies, namely Belgium and France are not or unlikely to retain triple AAA ratings. These credits have too much debt to be sustainable and consequently, we believe that the ultimate solution to the European Sovereign Debt crisis is debt devaluations across a whole swathe of countries. The desire of the Greek people for easier austerity terms is likely to be matched by Portugal, Ireland and Spain, where we expect haircuts of 50%, 40% and after further substantial bank bailouts 30%, while debt in Italy and Belgium is too high to allow these economies to grow their way out of austerity and will require debt devaluations of 20-30%. Belgium has been the first European economy to publish preliminary third quarter GDP and found no growth in activity during the period, while the second quarter rate was revised down to 0.4% from the original preliminary rate of 0.7%. We expect Belgium activity to contract during 2012. We also expect recessions in Greece, Portugal, Ireland, Spain, Italy, Austria and France. The recession in France is likely to be the catalyst for a downgrade of its sovereign credit rating from triple AAA to AA+, which in turn will cause the EFSF to lose its guarantee.
The bookmakers, William Hill have slashed the odds on one or more countries leaving the €urozone by the end of 2012 from 5-2 to 11-10. We believe that this process will take considerably longer but it is a dead cert that one or more countries will leave the single currency by 2020 with or without debt devaluations. We continue to view the single currency as a political construct and as Enoch Powell noted; “all political lives, unless they are cut off in midstream at happy juncture, end in failure”. Failure will be a prolonged process punctuated by infrequent moments of euphoria. The biggest potential source of euphoria would be the commitment of the ECB to monetise peripheral government debt through an open-ended and unlimited commitment to buy Italian and Spanish government debt. Germany inserted a clause into last week’s agreement that maintained the presumption that the ECB would end its securities market program once the second Greek bailout had been agreed and the leveraging of the EFSF had been achieved, which was expected to take some time in December after the German Constitutional Court had ruled on its injunction to determine whether a special budget sub-committee could agree to EFSF purchases without recourse to a full parliamentary vote. We expect the Constitutional Court to rule in favour of the parliament in line with their recent ruling on the first Greek bailout.
German opposition to monetisation of the debt is driven by its history, and while monetisation of the debt would not be inflationary because it would be offsetting the deleveraging of government, consumer and banking systems in the periphery, this opposition is supported by the Netherlands, Austria and Finland. Consequently, we expect Mario Draghi to maintain his predecessor’s stance that modest purchases of peripheral government bonds will continue until the EFSF is operational and that this is necessary to help the transition of monetary policy, but that the central bank will maintain its independence of fiscal policy and will not monetise the debt nor materially increase the size of purchases. The EFSF current size of €440bn is likely to be deployed by the end of December and even without the additional leverage will be able to purchase substantial amounts of peripheral government debt over the first quarter of next year even if it will become abundantly clear that this is not a solution. Monetisation is probably in 2013, but it will require debt devaluations in Portugal, Ireland and even Spain before Germany is willing to abandon its history and sovereignty.
Prior to the Greek bombshell we had expected the press conference to utilise the familiar traffic light procedure to signal a 50bps rate cut in December as well as maintaining unlimited liquidity to the banking system through term repo facilities. However, there is a very strong probability that the latest twist in the crisis will encourage the central bank to bring forward this rate cut to November. A reversal of the inexplicable rate hikes in the second and third quarters is long overdue but its economic impact is limited and we believe that the ECB will be forced to lower its benchmark two week repurchase rate further to 0.5% during the first quarter of 2012. These interest rate cuts will weaken the €uro.
The flight to quality into bunds, gilts and treasuries once again highlights the shortage of safe haven asset in a world of manipulated exchange rates and excess savings. Ultimately, these savings will have to be expropriated through debt or currency devaluations, but in this prolonged economic conflict between creditor and debtor nations, recessions in Europe and growth-recessions in the rest of the world will help drive down spot benchmark yields in the UK, Germany and the US to less than 1%. The best returns in this environment will be driven by the bull flattening of forward interest rate curves.
Chief Economist, Co-Fund Manager
Nov 2, 2011 at 9:27am