The large victory of the Syriza party in Greece, with Prime Minister Alexis Tsipras one or two seat below absolute majority (see graph below) raises the questions: ‘What will happen now in the Eurozone? Is a Grexit scenario possible?’
My take here is that not much is likely to happen, except some tough bargain between the new government and the Troika. Let's consider the following:
- No one, neither the new government of Greece nor the Troika, can credibly threat to ‘overturn the table’, abandon negotiations and let Greece exit the Euro.
This outside option would be too costly for both parties.
Greece has needs financing of about €28 billion over the next two years and has no access to capital markets. A disorderly default on official debt would cut off Greek banks from collateralized lending from the ECB, and would likely result in a dangerous banking and currency crisis. On the other hand, a Grexit would send shock waves through the Eurozone. Markets may once again price exchange rate and default risks in peripheral countries' (e.g. Italy) sovereign debt, jeopardising the financial stability of the area as a whole.
If negotiations must take place, the question is: What will they cover?
It is unlikely that a consistent debt restructuring can be agreed upon, for three reasons.
- First, after PSI in 2012, official creditors who now hold about 83% of Greek debt have already granted large extensions of debt maturity (the average is 16.5 years, compared to about seven in Italy) and have considerably reduced interest rates.
With a debt to GDP ratio above 175%, Greece pays about 4.5% of GDP in interest, less than Italy does, with 134%.
- Second, a restructuring would prompt similar requests from other peripheral EU debtor countries, opening up a Pandora's Box.
- Finally, the German electorate does not want to hear about debt forgiveness.
It is more likely that negotiations will concern giving more time for fiscal adjustment. Although the new guidelines for the Stability and Growth pact, similarly to Draghi’s QE, do not apply to Greece, some leeway could be made invoking the ‘cyclical clause’ that reduces fiscal adjustment when the (negative) output gap is very large. Considering that Greece has made an unprecedented fiscal adjustment in recent years (see graph below), with a primary structural balance moving from -13.6% of GDP in 2011 to +5.4 % today, such concessions may be easier to justify.
How much would Greece get from the Troika?
Now assume that Prime Minister Tsipras and the Troika bargain on the size of the discount on the fiscal adjustment. How much is Tsipras going to get? A simple back-of-the envelope calculation may help here.
If we use a Rubinstein (1982) bargaining approach, with Greece and the Troika making alternative offers and deciding to accept or reject, the answer depends how patient are the two sides. It turns out that each side's gets a larger share of the pie the more ‘patient’ he is and the more ‘impatient’ is his opponent. One can make a lower offer to an impatient opponent.
The table below plots Tsipras' equilibrium pay-off, the reduction in required fiscal adjustment as a percentage of output, for different value of the discount factors of the two sides. As the Troika becomes more impatient, its discount factor (d2) falls, by moving from left to right in the table. Greece becomes more impatient (d1 falls) moving downwards.
Table 1. Greece’s percentage reduction in adjustment as a function of discount rates
Since Greece faces a higher interest rate and political pressure than Germany, the solution is likely to lie below the principal diagonal of the pay-off matrix. My best guess is that the bargaining solution will be a number close to 25%, which means that rather than running a structural primary surplus of the order of 5 % of potential output, as envisaged in the IMF projection (see above), Greece could get away with a number close to 3.75% . Just some breathing space.