Will Greek Political Instability Renew Existential Doubts about EMU?

Many global investors limited to investment grade markets or developed markets, as defined by MSCI have no direct exposure to Greece.  Nevertheless, recent developments in Greece are worrisome to investors.  Many fear that the political challenges in Greece could lead to its ultimate exit from the monetary union and default.    

This concern has led to dramatic losses in Greek bonds and stocks.  Today's decline in Greek stocks  (10.2%) is the largest since 1987.    The 70 bp rise in the benchmark 10-year yield is among the largest of the year. 

There have been a sequence of three issues that have forced the issue to the fore.  First, over the weekend, the Greek Parliament approved the 2015 budget by 155-134 votes.  The budget was opposed by the official creditors, the Troika (the IMF, EU, ECB), which had been seeking another 1.7 bln euro in budget savings.  The government's budget went the opposite direction.  It included relief from the tax on heating oil and the income tax surcharge.  It assumed growth would be just shy of 3.0% next year. 

Second, the eurozone finance ministers blocked efforts by Greek Prime Minister Samaras to exit the assistance program.  Samaras was eager to exit and restore some of its sovereignty ahead of what will likely be elections in the early part of next year.  Instead, a two month extension of the existing program was granted, pending final approval.  This would be followed by a precautionary line of credit from the ESM.  This may force the Greek government to amend its budget before the EU grants its necessary approval. 

These two developments set the backdrop for the third.  Samaras has brought forward the selection of next Greek President.  This was expected next February.  The issue is that to select the President, a super-majority in parliament is needed.  The government commands 155 votes of the 300-seat chamber.  

The first round will be held December 17.  The presidential candidate needs to secure 200 votes.   If that fails, which is most certainly will, a second round will be held five days later on December 22.  If the candidate fails to secure 200 votes then, a third round will be held a week later.  On the third try, the candidate needs to secure 180 votes.  If this fails, general elections will be held.  The anti-austerity, and at times, anti-EMU Syriza Party is ahead in the national polls.   Hence the existential concerns. 

Samaras has very little room to maneuver.  The core opposition is divided into three parties.  Syriza itself has 71 seats.  The neo-fascist Golden Dawn has 16 seats.  The Communist Party has 12 seats.  These combined 99 seats will likely oppose the government every step of the way.  That leaves 46 seats in theory from which government needs 25 to secure the 180 votes needed for the third round.   

It is possible but the task is daunting.  Moreover, it means investors should be prepared for brinkmanship tactics.  The value of the 25 needed votes is the greatest in the third and final round of the parliamentary selection process.   Samaras has nominated former EU Commissioner and Greek foreign minister Stavros Dimas as the next president.  The merits or de-merits of the candidate are not really being discussed.  It is not a question of principles but of politics. 

The fact that Greece is running a primary budget surplus (which excluded debt servicing costs), it is a better negotiating position with its creditors.  In past, when some debtors began running a primary budget surplus they were more likely to seek debt restructuring.  Greece's situation is a bit different because debt held by private investors was already restructured.  The lion's share of Greece debt is now in official hands.   

Tspiras, the head of Syriza has indicated he seeks a restructuring of the debt held by the ECB, EU and IMF.    There are more than one way this can be delivered in a negotiated settlement.  The least likely way is debt forgiveness.  However, there is plenty of precedent for the official sector to lengthen maturities and reduce debt servicing costs.  This seems to be a more promising path and one that the EU and ECB seemed open too, provided Greece adheres to its other commitment and delivers a sustained primary budget surplus.  A unilateral default, which some observers suggest is possible or even likely, does not appear to be the most probable scenario. 

We maintain, as we did consistently during the initial Greek crisis, that as difficult as it is for Greece inside EMU,  it would be worse to drop out.  Dropping out of EMU appears to be a pre-condition for, and necessitate, default.  The new and weaker currency would make repaying euros, which the external debt would be denominated in, unbearable.  Private sector (businesses) euro obligations would also likely face default.  It would trigger an new and more severe banking crisis, as there would not be a backstop for it.  This developments would fuel high inflation and a deep economic downturn. 

While peripheral bonds yields are higher today and core bonds lower, the moves are orderly and rather modest, if one were to place much credence on the more pessimistic view of Syriza leading Greece into out of EMU and into default.   The euro itself has moved higher today, which is also not what one would expect if Greece's departure was so likely.