The darkest hour is always just before dawn

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Over the last few quarters, the provision of liquidity by central banks and bouts of risk aversion (i.e. abrupt switches between “risk on and risk off” regimes) have been important factors influencing events in financial markets.

In line with this environment, the two events dominating global financial and economic news currently are speculation about the Federal Reserve’s monetary policy and the outcome of the Greek crisis.

1 / “Chi va piano va sano*”: the US Federal Reserve’s monetary policy

Between now and the end of 2015, barring an unforeseen accident, the Fed will bring an end to a period of over eight years of abnormally low interest rates. Investors have now taken note that an accelerating rate of economic growth in the US, a decline in unemployment and a fading of the “plummeting-oil-prices-in-2014” effect on price indices, will lead the Fed to raise its policy rate. Janet Yellen’s approach to monetary policy is characterised by pragmatism:

The normalisation of monetary policy will be very gradual: the Fed prefers to remain “behind the curve”, i.e. will not risk hiking rates too soon in a context of a fragile recovery (the potential growth rate in the US has been revised downwards significantly by the Fed to 2%) and an absence of inflationary pressures;

– This rate hike will come either in September or December, the timing depending on economic data; The known unknowns with regard to this event reside mainly in the impact on the dollar and on emerging markets (EMs). The expectation is that the greenback will appreciate while EMs will be hit by a triple whammy: repatriation of capital toward the US, an aggravation of their debt burden via a stronger dollar and a rise in interest rates. While the way ahead for US monetary policy seems predictable, the outcome of the Greek crisis remains uncertain … this has mechanically led to flows of capital out of Europe by investors who prefer to be positioned in non-eurozone assets or simply prefer to sit things out!

2 / “The darkest hour is always just before dawn”

In Europe’s Greek crisis each side is right but all stand to lose!

It is obvious that the Greek population has gone through an extremely difficult period. They have made remarkable and painful sacrifices – Greece’s GDP has fallen by 25% in five years, jobs in the public sector have been cut by 30%, fiscal balances and the current account have improved by 20 and 16% respectively over the same period…! But despite these efforts Greece remains in the rut which the incompetence of Greece’s ruling class in recent decades has left the country…

A key lesson to draw from the debt crisis that the world is going through is that without economic growth there will be no happy endings…

It is also incontestable that European solidarity has not wavered during this period: the restructuring of private debt in 2010, coupled with injections of liquidity and credit made available since then represent the equivalent of EUR 200 billion!

The factors to be resolved are:

 – Greece is unable to repay loans due to the IMF (EUR 1.5 billion on 30/06) and the ECB (EUR 3.5 billion on 20/07);

– The Greek government refuses to raise VAT and/or reduce pensions;

– The European partners reject the idea of a debt restructuring;

– Greek debt is now exclusively in hands of states which in 2010 rejected the imposition of a debt restructuring on private investors (mainly banks);

There are two potential solutions to the problems:

– A Greek default (and therefore a writing-off of Greece’s debt);

– An agreement between creditors and the debtor; A Greek default does not automatically result in a Grexit. Note, however, that since the Lisbon Treaty in 2009, it’s possible – under multiple conditions – to leave the European Union, which would de facto mean exiting the Euro too… I have held the same view for months on Greece: An agreement will be reached: the current disagreement is only over a sum of some EUR 2 billion.

The Greek government will have to make concessions on the issue of pensions and the European partners will accept a restructuring of Greece’s debt (extending the term and lowering the interest rates) and an increase in their own debt/GDP ratios (a full Greek default would mechanically result in a rise of two precentage points in the debt/GDP ratios of the eurozone countries). France’s total debt would increase from EUR 2200 billion to EUR 2260 billion…

Everyone knows that Greece cannot repay its debt (322 billion or 175% of GDP). Default and restructuring strategies would both mean non-repayment but in the second case, creditors would, at least, receive interest..!

An agreement remains the preferred outcome in my view because even if the financial and economic cost today of a default followed by a Grexit would be lower than in 2010 (the Greek GDP represents only 2% of European GDP, the eurozone is now equipped with powerful protective measures – The EUR 700 billion European Stability Mechanism (ESM), the ECB’s OMT programme, quantitative easing, no European bank exposure, …), the jump into the unknown which the challenge to the irreversibility of the euro constitutes would set a serious precedent and go down as a historic failure that would surely permanently weaken the project of European construction.

In geopolitical terms there is a lot at stake: history teaches us that the Balkans are “flammable” in Europe (the Greek proverb “freedom or death” is symptomatic of this). At a time when the borders of the Ukraine are being redefined with violence, where Turkey wavers in its choice of the way ahead, Greece remains strategically important: both the US and Russian administrations understand that what is happening currently in Athens goes beyond a purely economic/financial framework. 

Although the risk of an accidental Grexit cannot be completely ruled out common sense suggests an agreement will be forthcoming. But whatever the outcome of this ordeal and particularly in the case of an agreement, future European governments will have to demonstrate that they can address the original incoherencies of the European project without the tumult of a crisis to drive them on! A Europe of variable geometry is probably the European project to be built in order to ensure that, beyond the current vicissitudes, Europe can evolve to retain the most successful balance between economic competitiveness and well-being in the world.

* “chi va piano va sano e va lontano” is the Italian translation of a latin proverb better known in English as “more haste less speed”

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