A summit of European Union leaders begins tonight in the capital of Latvia, Riga, and while the official schedule contains talks about Eastern Europe and Russia, Greece and its bailout will be sure to figure prominently.
European markets have been incredibly sanguine -- or perhaps complacent -- about Greece even when it surfaced that the country was very close to running out of cash before making a big payment to the International Monetary Fund (IMF). But will investors regret not selling Europe in May?
To be fair, some of them did sell. The week that ended on May 13 recorded the first coordinated outflows of capital from both European bonds and stocks since the 2013 "taper tantrum." But appetite for European assets is still running strong, with eurozone equities the preferred asset class for fund managers in a recent survey.
Hopes are high for a solution to the Greek debt talks that have been dragging on since leftist Syriza won the elections in January on a promise that it will renegotiate the country's bailout. The party's mission was to force the eurozone creditors, the IMF and the European Central Bank (ECB), to give up their requests for reforms and continued austerity for Greece.
Lately, the Greek position seems to be shifting towards accepting some reforms, while the Europeans seem to be opting once more for what they do best: kicking the can down the road. The Riga summit could play an important role in reaching a compromise that would allow Greece to get cash for now in exchange for reforms for... well, later.
Scenarios about how this will come about abound. The latest was reported by German newspaper Süddeutsche Zeitung, which said that eurozone officials are considering extending the current bailout until the autumn. This would allow Greece access to up to 4 billion euros ($4.45 billion), in exchange for which the government should find additional savings of 5 billion euros and reform its value-added tax system.
The country would be allowed to postpone controversial reforms of its pension system and labor market to the autumn, with a third bailout being negotiated over the summer, according to the report.
The details of the proposal are similar to the ones leaked on Monday to a Greek newspaper, and this bodes well for the talks -- it means a compromise may be reached relatively soon, although not necessarily tomorrow as some points will still need to be ironed out.
Uncertainty is still very high on this; a European Commission official denied Thursday afternoon that such talks were talking place.
For the short term, Greece can still survive without a deal. Alberto Gallo, head of macro credit research at RBS, notes that the ECB raised the emergency liquidity assistance (ELA) limit for Greek banks again yesterday, by around 200 million euros to 80.2 billion euros and refrained from increasing haircuts on collateral from Greek banks. "This again in our view shows that the central bank wants to distance itself from all the political disputes, and is likely to maintain liquidity to Greek banks for now," says Gallo.
So, the signs show that investors hoping for a short-term resolution for the protracted dispute may be in luck. But those with a longer-term view understand that kicking the can along the road, although it's a precious skill that European negotiators have turned into an art, does not resolve problems.
"Even if Greece's bond redemptions are deferred, the renewed slump in the economy means that it will need to finance a continued budget deficit alongside further IMF repayments," Jonathan Loynes, chief European economist at London-based think tank Capital Economic, warns.
Source: Capital Economics
Greece has no chance of gaining access to the markets again with a public sector debt to GDP ratio of over 170%, Loynes adds.
Long-Term Danger
It will therefore have to reach a compromise with its debtors for the longer term, too. But that will be very difficult, not in the least because the positions are so radically different.
In a recent working paper, Richmond Fed senior economist Robert L. Hetzel argues that, while Greeks blame the depression their country is in on austerity and Germans blame profligate fiscal spending before 2009 for the crisis in Greece, both sides are wrong.
"The depression comes from the deflation required in order to achieve depreciation in Greece's eurozone terms of trade. That depreciation in turn is required in order to turn a current account deficit into a current account surplus," writes Hetzel.
Some analysts say that because the Greek crisis was caused by the fact that it has a currency that is too strong compared to its needs, and cannot devalue it in order to make its exports more competitive, the only long-term solution would be for the country to leave the single currency.
Interestingly, Hetzel disagrees with this view. He says that even if the government re-introduces the drachma, which will then devalue, citizens will continue to use the more credible euro as medium of exchange for high-value transactions, store of value and unit of account (in essence, for all three roles of money). This would defeat the purpose of Greece having its own currency.
Greece's only real chance to lessen the amount of deflation that it needs in order to correct the external trade imbalance is structural reform, because it would alter the real terms of trade without deflation, he argues.
Structural reforms -- such as deregulating access to around 500 professions making up one-third of employment, forcing businesses and individuals to pay taxes and reducing corruption -- would make Greece more attractive to foreign investors and would make its companies more competitive and innovative, boosting exports.
But, Hetzel says, structural reforms are slow to happen in Greece. "All an economist can do is to make the case for free-market reforms and to point out that such reforms will only produce significant foreign direct investment if they are perceived as permanent. For that to happen, the Greek populace must accept them," he writes.
It looks like Grexit is still very much in the cards, then. Not that it would help.
