Political Uncertainty Threatens Greece's Eurozone Future

The Greek crisis took another turn for the worse following the inconclusive election earlier this month (see Greece: 8 May 2012: Election 2012: Struggle to Form New Greek Government Raises Prospect of Repeat Poll). The results showed that, although the majority of Greeks seem to be in favour of staying in the Eurozone, a large proportion of voters are not in favour of the austerity policies the country has pledged to follow in return for financial support from the "troika" of lenders—the EU, the European Central Bank (ECB), and the IMF.

Political Environment Extremely Uncertain

The political gridlock resulting from this month's election has made a very bad situation even worse. Given that the economy is in the doldrums, the precipitous fall in support for the parties supporting the bailout programme was not particularly surprising. However, the strong performance of the left-wing Coalition of the Radical Left (SYRIZA)—which received 16.8% of the vote—certainly was. SYRIZA insists on the renegotiation of the economic programme agreed with the official creditors, although it maintains that it wants to see Greece remain a member of the Eurozone. The latest polls suggest that support for SYRIZA has actually increased in recent weeks, raising the probability of a left-wing anti-bailout coalition government emerging from next month's repeat election.

The economy is certainly in a vicious circle of austerity and recession. More austerity, without the introduction of measures aimed at giving the economy some breathing space in the short run, would probably be self-defeating. However, how realistic is a renegotiation of the bailout programme? In IHS Global Insight's opinion, Greece's negotiating position is not particularly strong. Greece has a poor track record on the implementation of the measures agreed with the troika. The virtual vacuum of power in place until at least mid-June threatens to derail Greece's compliance with the objectives agreed with the troika even further. As opposed to the other two countries receiving support from the troika (Ireland and Portugal), there is a sense among European policy-makers that Greece is not trying hard enough.

Moreover, there also seems to be a growing view among policy-makers that a Greek exit from the Eurozone now would not have the catastrophic consequences that it would have had a year ago (even though, in our view, this belief may prove to be very optimistic). Indeed, the Eurozone's exposure to Greek sovereign debt has diminished significantly following March's debt restructuring. Europe now has a firewall in place in order to deal with contagion. The European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM)—scheduled to become operational in July this year—will have a combined lending ceiling of EUR700 billion (USD887 billion), although the new lending capacity (i.e., excluding funds already committed) will be around EUR500 billion. Limiting contagion has been one of the main concerns of Eurozone policy-makers since the start of the crisis. Greece represents less than 2% of Eurozone GDP. As a small country, the direct consequences of its collapse should not represent a systemic risk to the Eurozone as a whole. However, should the impact of a Greek collapse extend to larger countries—such as Spain or Italy—the future of the entire Eurozone project would be in tatters.

There is also the "moral hazard" issue. If the EU continues to fund a country that has not been delivering on its promises and, additionally, now has a government that is not committed to austerity and reforms, the incentive for other countries to implement the painful policies they are requested to put in place will diminish.

A Greek exit from the Eurozone is no longer a taboo topic. When former prime minister George Papandreou surprisingly called for a referendum on austerity measures in November 2011, Germany and France made it clear that the vote—which ultimately never took place—was in practice a referendum on Greece's Eurozone membership. Only earlier this week, German finance minister Wolfgang Schäuble said that if Greece wants to stay in the Eurozone "then they have to accept the conditions" agreed as part of the bailout programme. SYRIZA's leader, Alexis Tsipras, has repeatedly said that these statements are no more than "bluffing" and Europe will not cut its support for Greece. Although he might prove to be correct, this is a highly dangerous strategy to follow.

Indeed, all the aforementioned factors lead us to believe that, should an "anti-bailout" coalition emerge from June's election, Greece will be in real danger of having its external funding cut.

Why This Is Important: Economy on Life Support

Despite the economy being in recession since 2008, Greece is still running a current-account deficit of more than 9% of GDP. Moreover, the austerity measures put in place since the start of the crisis have not prevented the fiscal deficit from standing at a still high 9.1% of GDP last year. With international markets closed, Greece is completely reliant on its official creditors—the EU, the ECB, and the IMF—to fund these deficits. Without external support, Greece would face a choice between two evils: become a cash economy in which the government could pay only what it collects; or leave the Eurozone.

Outlook and Implications

Even if a "pro-bailout" government emerges in June—probably comprising a coalition of New Democracy (ND) and the Panhellenic Socialist Movement (PASOK)—it is very uncertain whether Greece will be able to implement the reforms the country so badly needs in order to ensure its long-term survival in the Eurozone.

A dire economic situation does not help. The economy is expected to contract for the fifth consecutive year in 2012 and unemployment currently sits at a record-high 21.7%. Concerns about the country's future in the Eurozone are also having a devastating impact on the banking sector. A report from Reuters highlights that depositors have withdrawn EUR3 billion from banks since the results of the election became known. Falling deposits and asset prices are having a major impact on banks' capital levels. As a result of banks running out of collateral from the ECB's funding operations, banks are now being supported by the more expensive Emergency Liquidity Assistance (ELA) programme. Although banks are expected to qualify again for ECB funding by next week following a capital injection from the Hellenic Financial Stability Fund (HFSF), this situation illustrates the extremely fragile position of Greece's financial sector.

With the economic situation likely to get worse before it gets better, political and social support for austerity and reforms is unlikely to rise over the coming months. A dire economic situation, combined with extreme uncertainty on the political front, suggests that the probability of a Greek exit from the Eurozone has increased dramatically. Indeed, IHS Global Insight is set to increase the probability of this outcome from the current 49% to 75% in our next interim round.