Why Greece Might Very Well Say “Goodbye To All That”

Submitted by Karl Weber of KW-invest AG (pdf)

Has anybody noticed the changes in the macro picture?

If GDP statistics are anything to go by, this move in the right direction is noteworthy: in 2014, the Greek economy has shown signs of stabilising or even growing a tad. It looks as if the Greek GDP growth trend was even better than that for the Eurozone. Greece also appears no longer be lagging to the other Southern European nations.

Analysts, in general, expect the Greek economy to improve in the foreseeable future. Their estimates for 2014 had to be revised upwards (E +0.9%); and their forecasts allow for a bit of optimism (2015 E +1.7%, 2016 E +2.4%) even if we anticipate continued moderate deflation.

While industrial production is still shrinking, there are tangible indications of improvement: the steady increase in the capacity utilisation rate in manufacturing, moderate growth in domestic demand and better external trade data in goods and services.

And yet, these signs of "recovery" may easily be subject to the “too little, too late” argument in reference to the labour market. Since 2013, the unemployment rate in Greece has slightly fallen, as it did in Portugal and Spain (but not in Italy). However, at around 26%, this rate still marks a painful depression. The jobless rate for under 25-year olds is, now as before, dreadfully high (50%).

Euroland: youth unemployment (jobless rate for under 25-year olds) in Southern Europe + Ireland

Deflation is aggravating the economic plight; consumer prices are now down 2.5% from a year-ago. This is the worst picture in the eurozone.

Consequently, the market turned its back on Greek government bonds. Fears grew again that under these conditions the nation has no chance to produce sufficient growth and tax income to service the outstanding debt. (In stark contrast, yields on other Southern European government bonds kept falling rapidly.)

The Hellenic Republic bond I looked at six months ago (and decided not to buy), with a life until 2024 and a coupon of 2%, had a redemption yield of 4.0%. Today it shows a yield of 8% and a bid price of 59% (down from 83%)... Clearly, I would have incurred a marked loss, had I bought the "deflation is good for bonds" thesis.

The synopsis of all this: any betterment related to overall domestic demand is fenced by the huge debt burden and the resultant complete loss of manoeuvering room for fiscal policy.

To state again the patently obvious: Greece's government debt mountain looks now as before insurmountable.

In the current political negotiations between the Eurogroup and the new Greek government, the latter wants to deal with the heart of the problem and do away with this debt burden. Greece has obtained the critical mass of political clout by threatening to walk away from the monetary union.

It would be no easy taks for the Eurogroup to create a template for an orderly eurozone exit (for more than one country). Some form of asset destruction in the balance sheets of the large European banks would be inevitable. And for the export locomotive Germany, a stronger (!) euro would be costlier than a few billion Euros sent as bridge money to Greece.

There are two facts which put the new government in a credible position should it want to play the gambit of Grexit:

Firstly, there is a current account surplus, overall exports were higher than imports in 2014. This would give a newborn Drachma some support.

Secondly, Greek achieved a primary fiscal surplus (before interest cost on borrowings).

This is a favourable starting position for a nation who envisages a default and a start from scratch.

I assume that the overall costs (and risks) of Greece saying "Goodbye To All That" are considered too high by both the Eurogroup and the new Greek government. (In practice: a 5- day bank holiday, issuance of Drachmas, the conversion of euro assets into Drachmas and the announcement that 90% of outstanding debt will no longer be honoured.)

Eventually, there will be a compromise aimed primarily at gaining time. The Eurogroup will continue to allow the minimum financing of the Greek state ("extension") and say that they will need time to think how a "debt restructuring" could like like.

Mr Tsipras and Mr Varoufakis will be content having secured "bridge funds" for another 6-9 months while still in possession of the trump card "Grexit".

Finally, I would like to share a thought about Greek banks. Since 2011, their share prices have slumped 80%-99% (!). They are more like options now. An investment in Greece bank shares cannot be recommended to the faint-hearted. But for an investor who bets against the political wild card "Grexit", this could be a rewarding deal since valuations are very low (allowing for the blurred visibility).