Will Greece Actually Default?

Executive Summary

Greece is back in the news because the government is running out of cash and is close to default. We believe Greece and its creditors will eventually reach agreement, because default would probably be in nobody’s interest. That said, the probability of Greek default and potential exit from the Eurozone, although less than 50 percent, is probably higher now than it has ever been.

There are some backstops now, which did not exist a few years ago, that should prevent contagion from spreading to other European economies. That said, nobody really knows what would happen if indeed the Hellenic Republic defaulted and exited the Eurozone. Although the probability of a “train wreck” in Europe appears to be low, it is probably more than just an insignificant tail risk that investors can blithely ignore. In our view, readers should keep a close eye on near-term developments in Europe.

Will the Greek Government and the Eurogroup Reach Agreement?

Greece has been in and out of the headlines ever since its government and the Eurogroup agreed on February 20 to a four-month extension of the country’s current (i.e., its second) bailout program.1 Thus far, the Greek government and the Eurogroup have failed to come to terms on the conditions under which the Eurogroup will release the next tranche, which is worth €7.2 billion, of the €165 billion bailout program that has been in place since 2012. Consequently, the cash balances of the Greek government are dwindling. Although the government probably has enough cash on hand to make a scheduled €768 million loan repayment to the International Monetary Fund (IMF) in May, it likely will not be able to come up with the €1.6 billion it needs to repay the IMF in June without a fresh infusion of cash (Figure 1). If not, the government of the Hellenic Republic would then be in default.

We believe the Greek government and the Eurogroup will eventually reach agreement, thereby precluding default. In our view, the Greek government will ultimately come up with enough concrete reforms to convince the Eurogroup to release the next tranche of the bailout program and to begin negotiations on the terms of a third agreement. Neither the Greek government nor the Eurogroup has an interest in a default in our view. Default, which likely would be followed by Greek exit from the Eurozone, would most likely cause the Greek economy to weaken even further. In short, in our opinion, default and exit from the Eurozone clearly is not in the interest of the Hellenic Republic.2 We believe a Greek default is also not in the interests of other European countries for a number of reasons. First, officials from other countries would be in the uncomfortable position of explaining to their voters why more than €300 billion worth of debt that Greece owes collectively to the other 18 members of the euro area could now be essentially worthless.3 Second, Greek exit from the Eurozone, should it occur, would represent the most significant setback in the process of European integration that has been in place for about 60 years. Third, an implosion of the Greek economy would likely lead to heightened social instability in Greece, a country that sits on Europe’s southern flank.

That said, there are political constraints on both sides that could preclude a deal. The Greek economy is roughly 25 percent smaller today than it was at its peak in 2007, and the unemployment rate has climbed to more than 25 percent (Figure 2). Greek politicians have blamed many of the economy’s woes on the austerity measures that have been in place for five years. The government of Prime Minister Alexis Tsipras was elected in January with the mandate to roll back some of these austerity measures, and the government may feel limited in its ability to make concessions to the Eurogroup.

Politicians in other European economies have their own political constraints as well, because many Europeans do not believe their governments should extend more aid to the Hellenic Republic. Voters could subsequently cause headaches for governments that are seen as being “soft” on Greece. A poll conducted in March found that 52 percent of Germans thought that Greece should leave the Eurozone, with only 40 percent responding that the country should remain in the euro area. As we discuss below, some officials are willing to contemplate Greek default and exit from the Eurozone because, in their view, other European economies are now largely insulated from the negative financial market effects that those events would previously have caused.

Inour view, the risk that the parties fail to reach agreement is not insignificant. The probability of a Greek default and exit from the euro area, although in our view not more than 50 percent, seems to be higher today than at any time during the 16 years that the Eurozone has been in existence.