I probably don’t need to tell you that Greece has a debt problem. Actually, it’s better to call it a crisis. It now faces two very large and imminent debt payments: 2 billion euros due to the International Monetary Fund (“IMF”) within 30 days and by the July 20 it has to pay 3.5 billion euros to the European Central Bank (“ECB”). If Greece somehow manages to negotiate a refinancing or restructuring for these amounts it “kicks the can down the road” but a failure to do so will likely drive it into default.

Why is a deal elusive?

The two main points of disagreement between the creditors (IMF and ECB) and the Greek Government are the public budgets and pensions. The creditors want to make sure Greece is moving it’s restructuring to the point where they can actually repay the loans. Greece, on the other hand, wants to limit the amount of austerity they conduct so as to limit the continued negative effect on the economy.

The negotiations are revolving around what surplus Greece needs to run on its government budget and how much their very generous pensions need to be cut. Politics, of course, is also playing a role. The Greek government insists that the voters have had enough of austerity while the creditors remind them that they need to abide by the rules of the currency union.

What would happen if a deal isn’t reached?

Without a conclusive agreement, Athens will likely default on its creditors. It will still have some money to pay for its salaries and pensions at home, but Greek banks will most likely no longer receive liquidity from the ECB. Of course the next question for the Greeks is whether to leave the European Monetary Union and/or the European Union. If they choose to leave, they could immediately repudiate their crushing debt load.

The exchange rate of the new drachma would undoubtedly fall precipitously. In turn, the costs of Greek goods abroad would regain competitiveness, and exports and cheap tourism could drive a large part of job growth. Currency devaluation has long been the salve for declining competitiveness of less disciplined countries.

In the short run, however, prospects would be dim. Banks would fail, capital controls would be imposed, and the cost of imports would soar. Greek unemployment would likely jump far above today’s already appalling 25 per cent rate. Hyperinflation and economic depression could lock Greece out of the international capital markets for years. In the long run, Greece could begin the long road to recovery but the European Union’s resolve may falter.

The end game

The amount of debt Greece has racked up is staggering and insuperable — 177.1 per cent of GDP (as of December 31, 2014). The choices to deal with its Herculean obligations are limited. There are three essential paths to deal with this:

1. Increase tax collections through economic growth.

2. Continue cutting existing programmes to service its debt obligations.

3. Debt restructuring or outright default.

Options one and two don’t seem plausible given Greece’s anaemic growth prospects and lack of political appetite to enact further cuts. Let’s let Chris Brightman and Shane Shepard from Research Affiliates run the math:

“A simple calculation on a bar room napkin defines the scope of the problem. With the current account positive for the first time in more than 35 years … let’s assume a relatively rosy scenario: Greece sustains the 3 per cent primary budget surplus demanded by the troika. In addition, the government brings the real GDP growth rate to a level equivalent to the real interest rate on its debt through a combination of current account surpluses and slower cuts in government spending. This is not an easy task. If, however, this scenario plays out, it would still take 30 years to bring Greek’s debt levels down to a more reasonable — and perhaps still unsustainable — 85 per cent of GDP. This is a big task for a country that voted for political upheaval following just three years of austerity policies.”

So let’s not mince words. It is basically a mathematical certainty that Greece will default at some point. All the money shuffling is just a series of aid packages to keep the “game going”.

Greece is not new news. Everyone in the financial industry is aware of the story and the risk. This isn’t likely to result in a Lehman scenario. Beside the private sector, European banks have over the last few years essentially reduced their exposure to Greece in order to help insulate themselves from any dramatic fallout. The good news for the investor (not for the European tax payer) is that most of the obligations are held by the troika and that most private institutions have retreated from Greece by now.

In the longer-term it may send a good moral message for other European countries to stick to their programs and remain prudent with spending. But there could also be near term consequences.

One potential risk would be that of contagious spikes in yield of other periphery countries as a result of the failure on fears of “who’s next?” European bond and stock markets could become very volatile in the near future. One should have less fear that Spain or Portugal may follow in Greece’s wake, given that both have made great efforts to reform, and more concern about Italy and smaller central and eastern European economies which have never effectively reformed.

If the contagion becomes more pronounced, it is likely that the ECB would step in with even more liquidity injections for the entire European system. This may push the euro down even further, possibly to parity with the US dollar. In this case rate hikes in the US may be delayed even further.

A Grexit would also damage the integrity of the entire European Union project. At this current point, the Euro is only 16 years old, and has never had any nation leave it. If Greece leaves, it calls the permanence of the Euro project into question, consequently leading to lower levels of certainty in investors for what could be decades (until the crisis is distant enough to forget).

By preventing Greece from leaving, the European leaders are asserting their faith in the permanence of the European system.

Ultimately a default would be messy. It’s unclear how things for Greece would ultimately be unwound. There really is no historic precedent for this scenario. The Greek drama continues and this is one play that is long past due to end.

Nathan Kowalski CPA, CA, CFA, CIM is the chief financial officer of Anchor Investment Management Ltd and can be reached at nkowalski@anchor.bm

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