Risk of Greek default remains high

Last week, Greece repaid a €750m loan to the International Monetary Fund (IMF), ending weeks of uncertainty over whether it would become the first developed economy to default on a loan from the IMF.

The unconventional mechanism Greece used to finance the repayment testifies to the increasingly desperate state of the nation's finances. Greece took the highly unusual step of using its deposit with the IMF, the so-called Special Drawing Right, to make its repayment to the Fund.

Greece avoided a default, but it faces a huge challenge in making far larger debt repayments over the coming months.

Perhaps surprisingly, the problem is not Greece's deficit. Years of austerity have dramatically reduced Greece's budget deficit. The IMF forecasts that the Greek government will register a surplus in 2016, the strongest position of any euro area economy.

So, why is Greece on the brink of default?

The Greek government is now generating enough revenue to finance public spending, but not to meet interest payments and repay maturing debt. Following two bailouts in 2010 and 2012, Greece has a mountain of outstanding debt to pay back to creditors, €20bn of which is to be repaid over the rest of this year.

Greece will have to secure a third bailout package if it is to meet its commitments to creditors. This is a tricky task for the governing Syriza Party which was elected in January on the promise that it would renegotiate Greece's earlier bailouts and slow the pace of austerity.

Progress so far has been minimal. Other euro area member states are wary of bailing Greece out again partly because of the precedent it sets. They fear it could bolster anti-austerity movements in other peripheral-European countries, particularly Spain, where bailouts have required recipients to cut public spending, improve revenue collection and reform of the economy.

So, how could this play out over the next few months? We see three possible scenarios:

The most favourable outcome for Greece would be an agreement to restructure its debt, easing the burden of debt repayments. This might include giving Greece longer to pay the money back, reducing the interest rate or, most radically, simply writing off a portion of the stock of debt.

Yet Greece's creditors seem unlikely to agree to such a deal given that, three years ago, they signed off on a deal which enabled Greece to undertake the biggest debt restructuring in history. Negotiations for that restructuring were easier than today as much of the outstanding debt at the time was distributed among several private investors.

Following the last bailout almost two-thirds of Greece's €317bn in outstanding debt is owned by the European Union (EU) and nearly half the remaining is shared between the IMF and the European Central Bank (ECB). These three negotiators have far more clout and influence with Greece than the private investors involved in the previous bailout.

The second option for Greece is to default on its debt. But that would not solve all of Greece's problems. The Greek government cannot fund its banking system which is dependent on emergency assistance from the ECB. If Greece were to default on its existing commitments, the ECB would probably reduce funding for Greek banks, pushing many into insolvency.

Denied funding for its debt and its banks Greece might decide that euro membership was no longer worthwhile and elect to leave. Under such circumstances Greece would need to create its own, independent central bank and a new national currency.

The rest of the EU, which has lent money to other peripheral-European nations, would have an incentive to facilitate Greek exit to make clear to other bailout recipients the consequences of breaking the rules.

Yet an outright default followed by departure from the euro zone would go down badly with Greek voters, three quarters of whom want to retain the euro.

The final, and least disruptive, option for Greece would be to agree on a third loan or bailout.

Whilst negotiations are already underway between Syriza and European policy makers, there are a number of sticking points to be resolved before any agreement is reached. Above all, Syriza is strongly opposed to EU proposals to cut Greek pensions and reduce the minimum wage.

The debate on pensions illustrates the challenges faced by the negotiators. About three million Greeks, more than a quarter of the population, are formally retired, even though one million of them are less than 65. For Syriza, climbing down on pensions could alienate a significant portion of the Greek electorate. For the Eurogroup, a failure to reduce what many outside observers see as an unaffordable entitlement would set back the cause of reform.

The German finance minister, Wolfgang Schauble, has recently suggested that Greece could hold a referendum on the European proposals for a bailout. This would get Syriza off the hook of agreeing to cuts it opposed during the election campaign. And a referendum would enable the Eurogroup to make clear to the Greek electorate the stark choice between sticking with austerity and the euro – or defaulting and leaving the Single Currency.

Our sense is that the most likely of these options is that a third bailout is put to, and accepted by, Greek voters, with Greece's creditors making some concessions on proposed cuts to pensions and the minimum wage. This would let Greece avoid a default and keep it in the euro.

But we would emphasise that such a happy ending is far from assured. It may well prove impossible for the two sides to reach a compromise. The risk of Greek default and of a Greek exit from the euro remains significant.

What is clear is that European businesses want to see more reform in the euro area. Today sees the release of a new report, the European CFO Survey, aggregating findings from Deloitte's national surveys of Chief Financial Officers across Europe. In their responses to questions on the euro debt crisis, European CFOs say that structural reforms would improve competitiveness with 93% suggesting they would be effective or very effective in supporting growth. Only a small fraction of CFOs, just 8%, favour dissolving the euro