Greece... The next Atlantis?

The turmoil around Greece started two weeks ago when ECB board member Juergen Stark said that Greece should not expect the EU to bail it out if its public deficit becomes unbearable. Since then even ECB President Jean Claude Trichet echoed similar comments on the public finances of Greece.

At the moment Greece is looking for a way out, either autonomously, or through help via the IMF. So far plans worked out by the Greece government to reduce the fiscal deficit from -12% back below the Maastricht level of - 3% by 2013, are received negatively.

This scepticism has to do with the fact that Eurostat, the statistical data centre of the European Commission (EC), found out that Greece has been manipulating the budget data towards the EC between 2005 and 2009. In this respect chances of reducing the budget deficit on its own strength are less credible.

This makes the exit via IMF advisors more likely. IMF officials arrived in Athens last week and are looking at the situation. Previous emerging market crises teach us that such kind of visits often precede a full IMF assistance programme. In the current environment, we think the announcement of such a programme would force Greek spreads significantly lower, even if the amounts being offered by the IMF are relatively small.
For the ECB and EC the IMF solution would be a clean one as well. It would be a strong signal towards other member states such as Spain, Portugal, Italy and Belgium to get their finances back under control. If not they would risk the loss of sovereign control over their finances towards the IMF. A non-intervention by the ECB and/or EC would avoid a moral hazard as we know it in the banking system.
If the ECB and/or EC would act as lender of last resort, it would be a signal towards countries such as Spain etc. to loosen their fiscal discipline as they would be bailed out somewhere in the future anyway.
We believe that the chances of a EUR break up are very small. For both the strong EUR-zone members as for the vulnerable ones such as Greece this would be a lose-lose situation. For the stronger members it would raise the risk of contagion towards other member states, and this would put significant pressure on the EUR.

In such a scenario a drop of the EUR of 20-30%, which is a similar drop if one compares this with other FX EM crises, would not be unrealistic. This is the type of volatility that EUR members want to avoid by any means. It would give them temporarily an export advantage over the US, but the credit spreads for the EUR members to issue sovereign credit would widen substantially as well.

Exiting the EUR for a country like Greece would be even more disastrous. The country would undergo an extreme devaluation of its new Greek Drachme. This would then give short term benefits from an export perspective. This is a technique Italy applied on various occasions during the 1980s. However Greece has less revenue coming from export activities compared to Italy. It would though have a small revival impact on export and growth, which would temporarily diminish the debt issues and raise employment, all this via tax revenues.

However, they would very quickly be faced with a spiralling of wage inflation and domestic prices as well. This is the phenomenon that we have seen in countries like Argentina at the beginning of this decade.

All this makes an IMF solution more probable. As a consequence credit spreads would come in slightly, but we will keep on seeing a substantial divergence of spreads between Greece and the core countries of the EUR-zone.