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Last week, a journalist began our conversation by saying, “Whatever is on your mind, promise me we’re not going to talk about Greece.” After more than five years of a Greek drama that would have made Sophocles proud, most of us have become fatigued with hearing and reading about Greece’s debt problems, the one issue that just won’t go away.
But unfortunately, despite our fatigue, the Greek saga continues to influence investor behavior. Over the past several weeks, each development in Greece’s ongoing negotiations with its creditors precipitated a significant rally (last week) or precipitous drop (this week). Greece’s government added to the uncertainty over the weekend by scheduling a referendum on July 5th, after their financial support program has ended. Greece has now had to introduce capital controls and a bank holiday, and will be in technical default on its 1.5 billion euro payment due to the IMF Tuesday.
Looking forward, Greece will likely continue to be a source of headline risk. My short- and long-term outlook for Greece helps explain why
Short-term outlook: A deal is still the most likely scenario, but there’s no easy path to get there
Market expectations for an imminent resolution took a nosedive over the weekend. Greek prime minister Alex Tsipras’s announcement of a referendum, a public vote on the creditors’ proposal, was swiftly followed by the Eurogroup announcing that the program of financial support due to expire on June 30th wouldn’t be extended. Following that decision, the European Central Bank (ECB) announced that it will not increase the lifeline emergency funding that has largely funded depositors withdrawals from Greek banks. In response, Greece declared a bank holiday.
The next key milestone will be the July 5th referendum. The most likely outcome is a “Yes” vote, although the significance remains unclear. At best, the vote will lead to another round of negotiations between Greece and its creditors. However, while events have clearly taken a turn for the worse, our base case remains that the European authorities will make every effort to minimize contagion and there will be limited impact on European financial markets beyond short-term sentiment driven mark downs.
Long-term outlook: The real issue isn’t debt sustainability, it’s growth
Even if Greece and its creditors are able to arrive at a short-term deal, this is unlikely to solve Greece’s main problem: No country can grow out of a large debt burden when it’s no longer growing. Investors have focused on the Greek government’s Olympian-sized debt burden, roughly 180 percent of gross domestic product (GDP). While this is well into the danger zone, the near-term implications are less dire than you would expect. Almost all of this debt is held by public sector creditors, not private investors. From Greece’s perspective, financing the debt has been made much easier by numerous maturity extensions and rate cuts. The end result is that the debt doesn’t create a particularly burdensome obligation, at least not in the near term.
The bigger problem is a lack of growth. Greece suffered through a brutal depression. While growth rebounded last year, recent uncertainty has extinguished the recovery. Making matters worse, Greece’s current list of proposals is heavy on taxation and light on reform. While a short-term compromise is still possible, given the present government’s agenda, any deal is likely to be temporary and do little to address the country’s long-term structural problems.
In the near-term an exit from the euro wouldn’t be catastrophic thanks to ECB bond buying, better capitalized banks and new mechanisms to help ring-fence contagion. But over the longer-term, the implications are less clear. Membership in the euro was not supposed to come with an exit clause.
Sources: Bloomberg, BlackRock Research