swedbank analysis post-election greece: 10 questions and answers

Swedbank Analysis No. 6 18 June 2012

Economic Research Department, Swedbank AB (publ), SE-105 34 Stockholm, tel +46 (0)8-5859 7740 e-mail: [email protected] Internet: www.swedbank.com Responsible publisher: Cecilia Hermansson +46 (0)8-5859 7720.

Magnus Alvesson +46 (0)8-5859 3341, Jörgen Kennemar +46 (0)8-5859 7730 ISSN 1103-4897

Post-election Greece: 10 questions and answers

Although New Democracy has won the Greek election by a slight majority, there is still considerable uncertainty how a government will be formed. New Democracy and Pasok together would have a majority, but it is unclear how the reform package will be implemented considering that these parties didn't previously take ownership of it.

Signals that the euro countries are willing to ease the reform package should be seen largely as a symbolic gesture to improve negotiations with the new government and strike a softer balance between austerity and growth. For the most part, the package remains unchanged, though the timetable to meet the terms could be expanded. It would be positive if the deadline to decide on 11 billion euros in cutbacks were delayed slightly.

Initially positive market reactions are a sign of relief that Syriza didn’t win the election, which would have increased the risk of a Greek default and exit from the euro cooperation. Given the uncertainty still swirling around the government, the fact that parliament is in no position to decide on cutbacks and that a payment default still can’t be ruled out, market concerns are likely to increase once again. There is also a risk that the government won’t last and a new election will have to be called after the summer. Even if Greece manages to reverse its slide, it will take years to turn the economy around.

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Question 1: What do the election results show? New Democracy has won the Greek election by a slight margin. With practically all the votes counted (99.86%), it took 129 seats in parliament, with the leftist coalition Syriza winning 71 and Pasok 33. Syriza’s leader, Alexis Tsipras, has congratulated his New Democracy counterpart, Antonis Samaras, on the victory. In all likelihood, Samaras will be named the new prime minister of a coalition government, though there is still considerable uncertainty how a government will be formed.

According to Greek law, the party that wins the most votes receives an additional 50 seats in parliament, so the difference between New Democracy and Syriza was actually much smaller, 29.7% vs. 26.9%, or 79 seats vs. 71 seats without the extra 50. Pasok received 12.3% of the votes, down from the May election. The extreme right Golden Dawn party received about the same share of votes as the May 6 election, 6.9%, and 18 seats. This gives it a place in parliament and underscores a widespread displeasure with the established parties.

The young – many urban and without work – voted more for the leftist alternative, Syriza, while more older and wealthier voters chose the New Democracy center-right alternative. It's worth noting that a majority of the population didn’t vote for either of the two parties that are expected to form a government.

Question 2: What do the results mean for Greece? It is unclear how the government will turn out. New Democracy didn’t receive a majority and has to form a coalition. Pasok announced early on that unless Syriza was part of the government it wouldn’t join, but Syriza prefers to be in opposition (with the possibility of gaining greater support if the new government fails).

If New Democracy manages to persuade Pasok, the traditional parties will have a majority and regain power (162 of 300 seats in parliament). These two parties have signed the loan agreement with the so-called troika (the IMF, EU Commission and European Central Bank, ECB). While they intend to fight for less onerous terms, there has been no mention of tearing up the entire package as with Syriza. This increases the likelihood that Greece will accept austerity and remain in the euro zone.

Pasok and New Democracy haven't previously shown a willingness to comply with the reform package. Many of the terms haven’t been met and the measures have been delayed. This includes liberalizing the guild system and product markets, privatizing state enterprises and improving tax collection. Although the major decline in the Greek stock exchange complicates privatizations, a slightly faster pace of government sell-offs is possible.

New Democracy has won, but what the government will look like is unclear

New Democracy and Pasok may eventually govern, but haven’t previously taken responsibility for the reform process

Swedbank Analysis No. 6 • 18 June 2012 3

The question is how the new government will reform the country and whether it will be able to stay in power for any length of time considering the many challenges and the differing opinions between New Democracy (with a right-leaning ideology) and Pasok (more leftist) about what has to be done.

Even if a new government is formed, there are still several challenges before it is certain whether a euro zone exit can be avoided. A decision first has to be made about 11 billion euro in austerity before the euro zone will release its next payment. If this doesn't happen, there is a risk Greece will default on its payments on July 20, when it says it will run out of money. Until then bank withdrawals will continue, which could eventually result in an exit from the currency union if it isn't stopped.

Question 3: What would have happened if Syriza had formed a government? If Syriza had won the election, received the extra 50 seats and found willing coalition partners to form a government, the situation would have been quite different. Those who voted for Syriza wanted to see politicians who hadn't previously been responsible for the country’s mismanagement and neglect. They had also hoped that the country could keep the euro, but without taking the measures associated with budget discipline and improved competitiveness. Syriza campaigned on keeping the euro, the emergency loans and the write-offs, but wants to tear up the austerity package, which they feel is unrealistic. Instead Syriza would have introduced a national reconstruction program based on its left-leaning policies.

Had the austerity program been torn up as Syriza promised, lenders would have probably frozen the emergency loans and Greece would default on its payments – first in the form of domestic payments for salaries and pensions and then to foreign lenders. Syriza had planned to use the interest payments on the foreign loans to invest in growth.

With even more bank withdrawals, capital flight and bank panic, Greece would have had to transition back to its old currency, the drachma, which would probably be valued at 40-50% of the euro. This would help exports but make imports that much more expensive. The Greek central bank would have had to print a lot of money to capitalize the nationalized banks and finance the government budget, which isn’t yet generating a primary surplus, i.e., excluding interest payments. With higher import prices and overheated printing presses, inflation would have risen to double digits and interest rates would have skyrocketed.

Syriza, which had promised not to trim the state apparatus, has at the same time announced that it would raise tax revenues. The question is whether it would have succeeded in markedly changing taxpayer behavior in the short term. It is more likely that little would have come of the party’s election promises.

Syriza promised voters they could keep the euro – but without meeting the terms of the reform package


Turbulence in the financial markets, capital flight and significantly lower asset values would have also led to corporate bankruptcies, higher unemployment and the risk of political instability.

Because the new currency would have cut the wealth of Greek citizens (and GDP) in half after a euro exit, at the same time that foreign debt in euro wouldn't have changed in value, a payment default would have been necessary and led to increased isolation from investors, lenders and even the EU and IMF. There would have also been a risk that Greece would have had to leave the EU.

Geopolitically, Greece’s new friends would have probably included Russia, China and Venezuela. Tension with Turkey still exists, and huge cuts in the military budget (from very high levels) would have increased in the dependence on alliance partners outside NATO.

Question 4: If the parties don’t manage to form a government, what will happen? The parties have already declared that it is crucial a government is formed fairly quickly, so there is probably room for compromise.

There is still a possibility, however, that the parties will fail to form a government. For example, there is a risk that Pasok will not want to govern with New Democracy, since it could be hurt by supporting policies that go against its core beliefs. Syriza has already taken over many of Pasok’s supporters. That makes a new election a possibility. Until then a caretaker government could be formed, which would delay any difficult decisions and increase uncertainty and turbulence in the financial markets.

A new election is also a possibility if a new government fails to last, one of the parties drops out and a majority is no longer in place to execute the policy. There are fears this could happen as soon as after the summer.

Question 5: How likely is it that lenders will accept renegotiated terms? Even before the election results were finalized, Germany’s Foreign Minister, Guido Westerwelle, suggested that the austerity could be eased. It is likely, however, that the troika and the euro countries would have handled a Syriza-led government differently. If Syriza had won, it would have been harder to see the troika meet the new government halfway due to Syriza’s populist rhetoric and the policies it wants to implement, including nationalizing formerly public institutions and maintaining the relatively large public sector – contrary to the bailout package.

A new election after the summer can't be ruled out

It is reasonable to expect that lenders will ease some of their terms


On the other hand, if New Democracy succeeds in forming a government with Pasok, there is the possibility that the troika and the heads of the euro zone will agree to ease their demands. This could include extending the deadline for meeting the terms (a delay in deciding on 11 billion euros in spending cuts would be welcome), as well as investments that facilitate a transition to economic growth.

It is also important that Germany shows empathy for the difficulties faced by the Greek people now that unemployment has risen to over 22% and where measures are needed to assist the many young unemployed in particular. The troika and euro countries also have to convince the financial markets that austerity is realistic. Otherwise concerns will continue to spread to other crisis countries.

Question 6: What do the election results mean for the euro zone? The election results increase the likelihood that Greece will abide by the terms of the bailout package and not exit the euro zone. This is provided that the new government supports the package and we don't see a government crisis in the near term. It is also important that the wave of recent withdrawals in the banking sector can be stopped. The ECB has to support the Greek central bank and facilitate a capitalization, so that the bank panic doesn't worsen and spread to other crisis countries.

To receive the next payment, parliament has to find 11 billion euros in spending cuts, which could prove difficult and create concerns about a default despite the formation of a new government. Moreover, it is unclear how the new government will follow the program, i.e., how quickly reforms can be implemented and in what way. Without a willingness to reform, there is a risk that the package will fall apart and spark renewed uncertainty about Greece’s place in the currency union.

We cannot rule out, therefore, that Greece’s fate will remain uncertain despite the outcome of the election. In a Greek exit, the euro zone’s taxpayers would lose over 100 billion euros that the Greek central bank owes the other central banks through the Target2 system. Without an exit, it’s more of an accounting question how the funds will be adjusted between euro countries within the central banking system, but if Greece is no longer part of this system the other euro countries (mainly Germany, which is responsible for about a third) will have to pay the cost.

Lenders will also lose money if Greece exits the currency union. The ECB has purchased Greek bonds valued at 56 billion euro. The euro countries have lent Greece 161 billion euros and the IMF 22 billion. European banks have receivables from Greece through government bonds they purchased for 55 billion (after write-offs). International banks still have receivables from Greek businesses and households worth 69 billion, of which French banks (37 billion) are most at risk, while British (8 billion) and

The euro countries are likely to ease terms somewhat, but there is still a risk of a Greek exit


German banks (6 billion) are slightly less exposed. This doesn't include the insurance companies and pension funds that have purchased Greek corporate bonds.

Another important factor if Greece exits the euro zone is whether the contagion will spread. The first to be affected would probably be Cyprus, which has awaited the election results before formally requesting emergency loans from the EU, ECB and IMF. It’s possible that the country will need emergency loans of up to 50% of GDP to capitalize its banks, or about 9 billion euros. Foreign banks have an exposure of 36 billion euros.

There would also be expectations that Portugal and Ireland would have to give up the euro, creating further turbulence and raising risk premiums and financing costs for these two countries. Even worse is the possibility that this would then spread to larger countries such as Spain, which already faces problems in its banking sector, and Italy, whose high debt and weak competitiveness are worrying markets. Withdrawals from Greek banks are a problem, but would be even more so if the contagion spreads to Spanish and Italian banks.

It is equally important how a Greek exit would affect the euro collaboration in general. A country cannot officially leave the currency union, but if one or more did so nonetheless, confidence in the currency would wane. To date the euro has lost fairly little against other currencies, although its slide has accelerated of late. If Greece exits, confidence in the euro would be affected. On the one hand, the currency union would be hurt by its increased fragility. On the other, it could be helped by having a weak member drop out and the stronger ones remain.

Integration in the euro zone would probably be affected as well. The crisis has accelerated changes in its institutions, and the pace of reform could slow if instability is reduced. If more countries exit the euro zone, however, there is a risk that the EU will also be affected, which could mean less integration in a number of areas.

Question 7: What kind of market reaction can we expect? The outcome of the Greek collection on June 17 should please the financial markets. Asian stock markets have risen and the euro has strengthened slightly. The results have to be seen as a relief, since the party that wanted to tear up the austerity program didn't win. The risk of an exit from the currency union has temporarily declined, and the new government will provide a counterparty for the troika to negotiate with. The pace of reform should increase compared with the caretaker government and former technocratic government that led the country in recent months.

The equity and currency markets have initially reacted positively, but their joy could be short lived


The focus of the financial markets has already shifted to Spain and Italy and eventually will turn to France. The serious situation facing Spanish banks is also affecting French banks, and by extension the budgets of both countries. The financial market is carefully monitoring what the euro zone is doing to strengthen its institutions and to form a banking union with a single regulator, a deposit guarantee and resolution practices. Another priority is how support can be transferred directly from the structural funds to the banks without raising national debts, as happened in Ireland and now most recently Spain.

Question 8: How serious is the situation in the Greek economy? The situation in the Greek economy is grave. The onslaught of withdrawals from banks shows a lack of confidence that a euro exit will be prevented. Hospitals and energy companies cannot pay their bills, and without new emergency loans the state will default by the end of next month. Greece is in its fifth year of recession. Between 2007 and 2011 the economy shrunk by just over 13%, and an additional loss of 5-6% is expected this year. It would seem that Greece is actually experiencing a depression considering its lost production, high unemployment and collapse of its economic system.

Greece’s GDP growth (%)

Unemployment exceeds 22% for the population as a whole, but is around 50% for young adults. One in five people work in tourism, which is being hurt by uncertainty. The election results could all generate more last-minute travelers if a government can be formed and stability is achieved.

Greece is not in recession – it's more of a depression


Unemployment in several euro countries, % of workforce

The Greek economy has been weak for several years. Competitiveness is clearly trending lower with rising unit labor costs due to low productivity growth and rapidly rising labor costs.

Unit labor costs in manufacturing, index 2000 = 100

The low interest rates in connection with the nominal convergence of the money and bond markets drove real estate prices higher, which in turn raised consumer prices and reduced real interest rates. Imports grew substantially, while exports developed more modestly. The result was a large current account deficit, which is now being reduced by the slowdown in the economy and collapse in imports. The key, however, is to implement reforms that raise competitiveness, not only by cutting wages and pensions but by improving productivity.

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Current account balance in several EU countries, % of GDP

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Question 9: What does Greece have to do to turn around? It is important that the new government implements reforms that improve competitiveness in the economy as a whole and budget discipline in the state apparatus. According to question 8, competitiveness has declined throughout the 2000’s, while Greece was unable to devalue and costs rose faster than in competing countries. Budget discipline was worse than first reported when Greece entered the euro zone, which means that the budget deficit was larger and government debt had increased more. The key now is to balance revenue and spending, which means a downsizing of the public sector as well as better tax collection and taxpayer ethics.

Competition in product markets is being held in check by the guilds that protect various professional groups. Liberalization would benefit consumers and stimulate growth. State-owned enterprises have to be privatized in order to increase productivity and efficiency. To date the pace of reform has been slow, but it is critical that the austerity package agreed to is followed at the same time that weak groups are better protected.

Greece’s politicians haven't supported the reform package yet, which creates a risk that it will fail. The new government has to take responsibility and ownership for the economy. This will be

Greece has to implement extensive structural reforms – a necessity with any currency system


the most important element in the negotiations between the troika and the government, which means that the troika has to agree to concessions and the government has to take over the program. It is uncertain whether this will happen considering that the parties – the same ones that signed the agreement – haven’t taken responsibility so far.

Question 10: What do developments in Greece mean for the Nordic and Baltic regions? Only Finland and Estonia, as euro members, are affected by the negotiations with the Greek government on terms and loan programs. Although it is unlikely that more money will be given to Greece, an extended deadline to meet the terms could make the program more expensive.

If a government is successfully formed and an exit from the currency union is avoided, the election results could mean a slight improvement in the euro zone’s situation thanks to increased stability. This would benefit exports and investment in the Nordic and Baltic region as well. Less uncertainty would also help the economy by encouraging households and businesses to spend and invest.

Many questions still remain, however, and concerns about Spain and Italy have grown. Greece has taken a small step in the right direction, but there is still a risk that it may default on its payments and exit the euro zone – a risk that continues to create concerns about the euro zone, but also for Europe, including the Nordic and Baltic regions. It will take many years to strengthen the institutions in the euro zone, improve conditions in the crisis countries and create stability and growth. Until then northern Europe will see its key export markets grow below their potential. Creating increased political stability is imperative if the countries are also going to tackle their economic challenges.

Cecilia Hermansson

The Nordic and Baltic countries are mainly being affected through export and investment markets


Economic Research Department

Sweden

Cecilia Hermansson +46 8 5859 7720 [email protected] Group Chief Economist Chief Economist, Sweden

Magnus Alvesson +46 8 5859 3341 [email protected] Head of Economic Forecasting

Jörgen Kennemar +46 8 5859 7730 [email protected] Senior Economist

Anna Ibegbulem +46 8 5859 7740 [email protected] Assistant

Estonia

Annika Paabut +372 888 5440 [email protected] Chief Economist, Estonia

Elina Allikalt +372 888 1989 [email protected] Senior Economist

Latvia

Mārtiņš Kazāks +371 67 445 859 [email protected] Deputy Group Chief Economist Chief Economist, Latvia

Dainis Stikuts +371 67 445 844 [email protected] Senior Economist

Lija Strašuna +371 67 445 875 [email protected] Senior Economist

Lithuania

Nerijus Mačiulis +370 5 258 2237 [email protected] Chief Economist, Lithuania

Lina Vrubliauskienė +370 5 258 2275 [email protected] Senior Economist

Vaiva Šečkutė +370 5 258 2156 [email protected] Senior Economist

Economic Research Department SE-105 34 Stockholm Telephone +46-(0)8-5859 7740 [email protected] www.swedbank.se

Legally responsible publisher Cecilia Hermansson, +46-8-5859 7720.

ISSN 1103-4897

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swedbank analysis post-election greece: 10 questions and answers

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