Monday, May 21, 2012

Beyond Grexit?

Fen Osler Hampson, Chancellor’s Professor and director of the Norman Paterson School of International Affairs, Carleton University, wrote an op-ed for the Ottawa Citizen, Waiting for Grexit:
Europe suffers from a new dilemma. It’s called “Grexit.” Coined by Citigroup’s Ebrahim Rahbari, the term of course combines “Greece” with “exit” to describe the prospect of Greece’s exit from the eurozone. The problem is we don’t know when this will happen. We don’t know how. And, we don’t know what consequences would follow. The suspense is literally killing us. Markets hate uncertainty. So too do investors.

Alas, like Samuel Beckett’s play Endgame, we are witnessing the last moves of a chess game where only a few pieces are left on the board and the outcome seems inevitable. Greek’s government is Beckett’s character Hamm, unable to stand and totally blind (politically that is). The eurozone is Nell, seemingly without legs and in real danger of being relegated to the dustbin. Germany’s Chancellor Angela Merkel is Nagg, who has gnawed relentlessly (or in German, nagen) on the bone of fiscal austerity and balanced budgets. Clov, the servant of Hamm, is restless and unable to sit down. Until the French electorate threw him out, that pretty much described French president Nicolas Sarkozy in this European theatre of the absurd.

But let there be no doubt, Europe’s existential crisis is no laughing matter.

Grexit dominated this weekend’s discussions among G8 leaders. As stock markets tumble and Italy, Portugal, and Spain reel from Greece’s spreading contagion, which is driving up borrowing rates and putting further pressure on Europe’s leaders, the G8 can’t put out this fire. Some countries, like Canada, want aggressive action now. But if aggressive action were possible and the answers were easy, they would have come long ago.

That is because the intractable problems are political not economic. In an ideal world, Greece would never have been admitted into the eurozone. Because it was seen as the birthplace of democracy in a Balkan cesspool, Europe did not want to leave it out in the cold. But the reality is that Greece is a clientelist state, a haven for corruption, cronyism, and widespread tax evasion. It was not ready for membership and it failed to amend its ways when it joined the euro. For a while, Greece benefited hugely from the generous dollops of cash it got from European banks, which were all too willing to look the other way and not scrutinize its poorly kept public accounts. The benefits of a strong currency allowed Greece to live far beyond its means.

Some investors and economists believe that the smart thing to do now is to let Greece default on its debts and then — or perhaps simultaneously — force it out of the eurozone. However, this would only be allowed to happen after a so-called “firewall” — i.e., massive bailout fund — was put in place to help those banks that would feel the pain on their balance sheets. Call this approach “excise the wound now in order to promote faster healing.”

However, there is no political mechanism for expelling a eurozone member. There’s the rub. If the decision is left to the Greeks themselves it is doubtful they will head for the exit. Greeks overwhelmingly favour the euro (something like 80 per cent in opinion polls) — notwithstanding the fact that they are voting in large numbers for extremist parties who are threatening to take their country out of the eurozone. No real surprise there. Like all good blackmailers, Greeks seek continued protection from their own depredations.

Greece will have to be pushed off the euroledge, because it is not going to jump. And who is going to do that? Certainly not Germany. Merkel does not want to go down in the history books as the chancellor who dismantled Europe. There is just too much history — much of it bad — there.

The other fear with Grexit is a run on the banks of other eurozone members who are in deep economic trouble like Portugal, Spain, and Italy. If investors start to lose confidence in the permanence of the euro, all bets are off. That is because investors will anticipate the zone’s breakup and act accordingly. In the doomsday, “implosion” scenario, the eurozone starts crumbling like the warming Antarctic ice cap — at first little pieces break off, then bigger ones, and then whoosh, the whole thing slides off its foundations.

The problem for Europe and the G8 is that there are no easy choices and no easy exit from the eurozone for Greece. The best we can hope for is a renewed commitment to work together while avoiding extremist solutions that would sink the eurozone ship forever.

As I wrote in my last comment on the endgame for Greece and Eurozone, the cost of a Greek exit would be crippling not only for Europe but for the rest of the world. This is exactly what Alexis Tsipras, the leader of the left-wing SYRIZA party is banking on as he plays the game of "Who will blink first?":

The jury is still out on how Greece could actually leave the eurozone. But it seems that Syriza leader Alexis Tsipras is hedging his bets that the euro area will be extremely reluctant to pull the plug on Greece for fear of a catastrophic contagion to the rest of the eurozone. And thus the country’s lenders will be forced to renegotiate a new scheme that would give a much-needed breather to those who have been hardest hit by the harsh austerity dictated by the memorandum.

The idea is that if the Greek electorate rejects the bailout in next month’s elections, the ball will return to German Chancellor Angela Merkel’s court and she will have to decide whether it’s worth risking the destruction of the eurozone project by halting Greece’s bailout loans or be forced to accept a negotiation of a new, more lenient, approach towards the loan-dependent nation. Tsipras’ strategy hinges on the anticipation that Merkel will blink first.

In an interview this week to the BBC, the Syriza leader accused Merkel of playing a poker game and gambling with people’s lives with what her critics describe as a stubborn insistence on Teutonic-style austerity. That could indeed be the case. But by the same token, Tsipras is also gambling with the lives of the Greeks by his strong belief that Germany will buckle and be forced to renegotiate a new deal if a newly-formed left government cancels the memorandum. The billion-euro question is whether he will be dealt a good hand and whether he has the right to take such a risk in the name of an increasingly desperate nation.
But it isn't Merkel who is playing a poker game, it's Tsipras because he thinks that Germans and the rest of Europe owe Greece something, even though it's clear Greece failed to implement the bulk of the structural reforms in the public sector that its creditors have been asking for.

Importantly, austerity measures in Greece have disproportionately impacted the private sector, not the public sector (look at where job losses are concentrated). Greece's bloated public sector is an absolute travesty and no Greek political leader from any party has the guts to make drastic cuts to an inefficient, bloated and corrupt public sector that is the real cancer of the Greek economy.

I agree with German Finance Minister Wolfgang Schaeuble, European solidarity is "not a one-way street" but the problem is Germany is dealing with a foolish demagogue called Alexis Tsipras who panders to the powerful Greek public sector unions, promising them that he alone will save Greece from the jaws of austerity that the evil Angela Merkel is imposing on them. Most who work in the Greek public sector have severe entitlement issues and think that they deserve to have jobs and benefits for life.

Having said this, Germany needs to change tactics too. Austerity without growth initiatives is what led to this political mess in Greece and it threatens to do the same thing in Spain. Moreover, Germany's reluctance to back a eurobond market is sending out the wrong message, namely, that Germany is not willing to back a European bond market that will address Europe's debt woes in a forceful manner, one that will make it much harder for speculators to gang up on peripheral countries, wreaking havoc on the global financial system.

As far as markets are concerned, some think Grexit will be worse than Lehman, which is why for them good old bonds are still the safest asset class. But as I explained in the Mother of all risks in 2012, in my opinion, investors are overestimating the risks in risk assets and underestimating the risks in risk-free assets like bonds.

Later this week, I will show you where top funds are placing their bets in this market and how they're looking beyond Grexit, positioning their portfolio for the next major upswing in risk assets.

I want all of you who are reading this comment to also start thinking beyond Grexit. While the media loves covering bank runs in Greece, fearing contagion in the rest of peripheral economies, Andreas Koutras has written an excellent analysis on why such fears are way overblown.

Finally, Patrick Allen of CNBC reports, Forget a ‘Grexit.’ Watch for a ‘Grashall Plan’:
“Very little of the bail-out money so far has gone to the Greeks. It has all gone to the bankers,” one analyst tells CNBC.

As the world waits to see if Greece will reject the austerity imposed upon it by the European Union and International Monetary Fund, and even leave the euro, one analyst is warning investors that Germany will not stand by and allow a Greek exit from the euro zone—a so-called “Grexit”—as more and more market-watchers now seem to expect.

“It’s not hard to understand why. The Greeks won’t accept austerity anymore. The Germans won’t give them any more money if they don’t take the harsh medicine that is being prescribed. Game over. The exit signs are flashing red,” Matthew Lynn, the founder of Strategy Economics in London told CNBC.com on Wednesday.

“There’s just one snag with that analysis. It isn’t going to happen. Germany will realize the risks involved, eat its words and come up with a mega bail-out. Instead of a ‘Grexit,’ we’ll see a ‘Grashall Plan’—as a Marshall Plan for Greece will quickly be dubbed—to reflate its economy and keep the euro staggering on for a couple more years at least,” said Lynn.

A growing number of market-watchers believe that a Greek exit from the single-currency zone is now a very real prospect, and that Greece risks losing funds from the EU and IMF bailout unless it sticks to the terms imposed upon it.

“The cash to pay bondholders isn’t going to be there. The police and soldiers and public servants are not going to get their wages. Without the next slug of bail-out money, Greece is going to quite literally shut down,” said Lynn, who expects Greek voters to reject austerity for a second time in elections next month.

The message from Berlin is fairly clear, with senior officials saying that everything is under control. But the German government will not allow Greece to leave the euro, according to Lynn.

“A ‘Grexit’ is far from certain. The Germans are talking tough. When it comes to the crunch, however, they will blink, and deliver a Marshall Aid-style package to keep Greece in the euro.”

“There is absolutely no way of knowing whether contagion to other countries can be contained,” he added.

“You can line up a few emergency summits to solemnly declare that even though the Greeks might be out, there is no way the Portuguese or the Irish are going to follow them—and certainly not the Italians or the Spanish,” he said.

“The trouble is, you can’t really know how it will play out. No one has tried breaking up a single currency before. Money may start to flee out of every country at risk of coming out of the euro,” Lynn warned.

With Europe on the brink yet again, Lynn predicted Germany will act.

“The Greeks can’t carry on with the austerity being imposed on them. No country can be expected to endure annualized falls in GDP of 7 percent or more,” he said, “and 50 percent youth unemployment for years on end”.

“On Tuesday we learned that the Greek economy shrank by another 6.2 percent in the latest quarter. It simply isn’t acceptable” Lynn said.

“But Germany and the rest of the EU could come up with a Marshall Aid-style package for Greece. Very little of the bail-out money so far has gone to the Greeks. It has all gone to the bankers.”

“Forget talk of a ‘Grexit’. There will be a mega-bail-out—a ‘Grashall Plan’—instead.
And when it happens, the markets will rally on the news.”

Back in November, I explained why the Greek bailout was nothing more than a corporate handout. The gig is up, austerity without growth is a recipe for disaster. Germany has to step up to the plate and start investing in real projects in peripheral economies and back the creation of a solid eurobond market.

Importantly, this will demonstrate true European solidarity and send the right signal to growing number of desperate Europeans in peripheral economies stuck in the dark hell of unemployment.

But Greeks also have to recognize that enough is enough. They can't keep growing their monstrous public sector and ask the private sector to shoulder the brunt of austerity measures. Nobody owes Greece anything and it's up to Greeks to elect leaders who will make the tough decisions to get them out this economic quagmire and lead them to recovery. I am confident they will make the right choice in the follow-up elections on June 17th.

Below, Michael A. Gayed, chief investment strategist at Pension Partners LLC, talked about the blowout in credit markets late last week. He spoke with Adam Johnson on Bloomberg Television's "Street Smart." I think that fears are way overblown and that those betting on a credit event in the U.S. or elsewhere are going to get hosed.

Forget 'Grexit', buy the dips on risk assets. The biggest risk remains a market melt-up unlike anything you've seen before.

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