The relief rally following last week’s EU summit is well and truly over. Greece’s planned referendum on the latest bailout, announced as polls show its citizens reject it, has thrown the whole pack of cards up into the air. Bank runs, disorderly default, a Greek exit from the euro and vicious contagion elsewhere no longer look like wild scenarios.
Quite what George Papandreou thought he was doing by calling a referendum is unclear. The Greek prime minister seems to have taken his European partners by surprise. The relentless criticism at home about how he has handled the crisis and the pressure from the rest of Europe for permanent monitoring of the government’s actions may have caused him to snap.
Last week’s planned debt restructuring and bailout isn’t ideal for Greece. Even in 2020, the country’s debt is projected to be 120 per cent of GDP. The people will also have to endure continuing austerity. But, the package did come with the promise of euro130 billion of new loans from Athens’ European partners, of which euro30 billion was earmarked for recapitalising the country’s banks.
If the Greeks vote ‘No’ in a referendum likely to take place in January, that aid may also disappear. Given that Athens only has enough money to pay its bills until early next year, it could then be forced into a disorderly default. The country’s banks would then go bust, as they hold huge sums of Greek government debt, causing the economy to plunge further into the abyss. Greece would have little choice but to quit the euro. But, that would bring with it mayhem, not least because Athens is still running a primary budget deficit. With nobody willing to provide it with funding, the government would have to embark on even more severe austerity.
Papandreou may hope such a nightmarish scenario would shock the citizens into voting ‘Yes’. But, such scare tactics could actually trigger problems before the Greeks even have a chance to vote. Depositors have been gradually taking their money out of Greek banks.
Faced with the possibility of a ‘No’ vote, an exit from the euro and the bankruptcy of their banks, a bank run could accelerate. As of August, there was still euro189 billion of deposits in Greek banks. The European Central Bank would then have to decide whether to allow the Greek central bank to continue making emergency loans to the country’s banks or force their bankruptcy even before the referendum.
Contagion to the rest of the euro zone would be far more vicious than anything seen so far. Italy is the weakest point. Rome’s own political shenanigans have already rattled the markets. The country’s 10-year bond yields have risen to 6.2 per cent, a rate probably unsustainable in the long run.
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Last week’s package came up with a plan to leverage the European Financial Stability Facility (EFSF), the euro zone’s bailout fund, with the idea that it would then be big enough to provide some sort of safety net for Italy, if needed. The snag is that this is based on untested financial engineering, including raising money from China. After Greece’s bombshell, EFSF could face a tougher job to sell its own bonds.
Now, of course, there are other scenarios and possible contingency plans. Papandreou hasn’t said what the Greek people would be asked to vote on. It is possible he will come up with a crafty question that secures a ‘Yes’. It’s also conceivable that his government will fall before the referendum, allowing another prime minister to take over.
Meanwhile, the rest of Europe may look into their own abyss and decide they are prepared to continue supporting Greece both through its referendum process and even after a ‘No’ vote, in order to avoid a disorderly default. They may decide to regroup and force a steeper haircut on Athens’ creditors to bring its debt load down to a more sustainable level. Finally, the ECB still hasn’t turned on its big bazooka. It could theoretically stem the rot, for example, by itself lending to EFSF, although this would involve swallowing all its principles.
However, one thing is clear. Papandreou’s bombshell has tipped the euro crisis back to square one — or worse.