Grexit stage left: Is Greece taking a final bow on the euro stage?
Waddell & Reed Advisors Market Perspective – June 2012
"Grexit" stage left: Is Greece taking a final bow on the euro stage?
After it appeared European officials made strides toward Addressing the debt crisis there, Greece’s may election ushered in another round of uncertainty. With the vote leaving no political party or coalition with enough support to implement its platform to either reject or accept austerity measures in exchange for a European Union (EU) bailout, Greece has been left in a state of paralysis that is likely to remain until new elections can take place June 17. It will take even longer to resolve the lingering questions about the future of the eurozone, which the Organisation for Economic Co-operation Development (OECD) labeled the “biggest downside risk” facing the global economy.
A European tragedy?
Earlier this year, Greek officials agreed to a new package of austerity measures in exchange for a 130 billion euro bailout from the European Union (EU) and International Monetary Fund (IMF). As a condition of that agreement, Greece is supposed to implement 11 billion euros in spending cuts this summer in exchange for a 31 billion euro bailout payment. The Greek side of that agreement, however, came into question when voters fled the parties that had supported the pact and instead backed the Coalition of the Radical Left, also known as Syriza. The coalition, which finished second in the election and is growing in popularity, is against any agreement that exchanges austerity measures for a bailout and also refuses to form a government with any party that feels otherwise.
As a result, the upcoming election is shaping up as a national referendum on Greece’s future as a eurozone member, although there may be some room for negotiation. Some EU officials, have recently hinted that they might be willing to alter some of the terms of the bailout package – accepting less austerity, for example. Additionally, shortly after the announcement of the second Greek election, German Chancellor Angela Merkel and new French President Francois Hollande said during a joint press conference that the EU would, in fact, consider proposals designed to spur Greece’s economic growth as long as voters there committed to austerity measures.
Greek voters, however, were not willing to make that commitment in May and it is not clear that they will make it in June, setting the stage for what some are calling a “Grexit.”
While there is currently no procedure for a nation leaving the currency union the International Monetary Fund has already warned European leaders to prepare for such an event and said it will do what it can to make the transition as orderly as possible.
Meanwhile, former Greece Prime Minister Lucas Papademos has been quoted in media reports as saying the country is considering preparations for a eurozone exit.
Although the EU can incent Greece to remain in the eurozone, perhaps through measures hinted at during the Merkel/Hollande press conference, it cannot force Greece to stay if the country’s leaders decide to break away. An argument might be made that a Grexit could potentially offer the upside of a resolution. However, those benefits – if there are any – will depend on the political and policy response, as well as how the markets react. Certainly, there will be significant challenges and pain, including potential turmoil related to the default on outstanding Greek debt and problems for European banks.
Looking beyond Greece, the bigger concern, of course, is that Greece may be only the first in a series of dominos to fall, leaving other European countries, primarily those in the south, vulnerable. Protecting the region from markets driven either by fearful investors or those seeking to capitalize on the instability, could force the remaining EU members to more closely align economic and fiscal policies. EU officials at a May 23 meeting did agree to begin crafting proposals for closer fiscal coordination, a Europe-wide deposit guarantee and, longer term, euro bonds. Although those proposals are scheduled to be ready in time for a June meeting, officials cautioned that they would only be “building blocks” and not specific proposals.
There are also other options. For example, the European Commission said on May 30 that it would consider giving Spain more time to meet EU deficit targets if the country presented a clear budget plan that tightens spending. Spain may carry more leverage with EU officials because its economy is among the eurozone’s largest and far bigger than that of Greece.
Meanwhile, as officials were meeting on May 23 reports were being prepared for release that showed the European economy contracted at the fastest pace in almost three years in May, while numerous surveys also showed the instability was having an impact on the overall eurozone economy. Beyond Europe, the OECD’s May 22 report said that a failure to resolve the worsening European crisis and spillovers beyond Europe risk “serious consequences” for the global economy.
“The question here is not if the euro zone will experience a recession, but how big of a recession will Europe experience?” said Hank Herrmann, chairman of the Investment Policy Committee, and CEO of parent firm Waddell & Reed Financial, Inc. “While not positive, we believe the financial situation ultimately to be manageable. We may see, approximately, a 1 percent GDP decline in Europe. There are observers who foresee up to a 2.5 decline in euro zone growth, which would result in some collateral damage to the U.S. economy. We are not of that view at this point.”
Greek voters were only the latest group to reflect the continent’s divided views on how to move ahead. Similar views are also embodied by Hollande, a socialist who campaigned successfully on the idea of growth over austerity and calling for a renegotiation of existing economic treaties. Meanwhile, Merkel, backed by the powerful German economy, has demanded austerity from Greece and the other European nations facing similar debt problems. Merkel has also remained opposed to the creation of euro bonds that some favor as a way of dealing with the debt crisis. The German chancellor has argued that combining eurozone debt would remove any incentive for troubled European economies to adopt reforms.
Some European press has been especially positive about the initial Merkel and Hollande meeting in Berlin, which came only 12 hours after the new French leader was administered the oath of office. As the leaders of the continent’s largest economies, their cooperation could be critical to the eurozone’s future. However, it is important to keep in mind that, despite whatever goodwill might have appeared at the media event, Merkel and Hollande still hold drastically different views. Hollande, for example, has supported the creation of eurozone bonds.
While post-meeting headlines might have focused on the idea that both recognize a European turnaround requires not only austerity, but also programs for growth, Germany had previously held that view.
The bigger issue is that their opinions vary widely on exactly what a growth pact entails and what appears to be emerging support across the continent for additional stimulus over austerity. Our investment team continues to analyze the fluid situation. We believe that additional stimulus, both fiscal and monetary, is likely and will be beneficial to growth. The terms of a solution, however will be crucial to determining whether it is more “kicking the can down the road,” or it effectively addresses the challenges of Europe’s southern zone.
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