Where Will Greece Go From Here? How Will It Affect India?

There may be no Greek Tragedy for India, but it should safeguard its stability.

– Cost of a Grexit: €245 billion i.e the cost of Greek bankruptcy to which the Euro Zone countries and the ECB are exposed.

– A “moral hazard” issue for the EU – What if high indebted countries like Spain, Portugal and Italy are tempted to follow the example of Greece?

– From the perspective of foreign trade, there is nothing much to fear for India: its trade and economic relationship with Greece is of a very modest dimension

– In the event of the cascading impact of Grexit on the EU/global economy the impact on India would be somewhat more severe.

Emotionally charged Greek citizens have voted a resounding “no” to more austerity in the July 5 referendum, thereby rejecting the offer of a “humiliating” bailout proposal from the country’s principal creditors, namely, the troika of the International Monetary Fund [IMF], the European Central Bank [ECB] and the European Commission [EC].

This outcome is perceived as a great political victory for Greek Prime Minister Alexis Tsipras, but the moot question is at what cost and consequences to Greece, the European Union and the global economy. How would it impact the future of the Greek economy? Would it ease the hardships of its citizens and change their way of economic life? And the most important question, which remains open, is: will Greece still continue to be a part of the Euro Area arrangement with its single currency shared by 19 EU member states or will it have to eventually exit – popularly called the Grexit?

Before reflecting on these issues, it is worthwhile to highlight some serious immediate challenges confronting the Greek government. Greece has already defaulted on the payment US$1.7 billion due to the IMF (the deadline was June 30), thus acquiring a dubious distinction of becoming the first developed economy to do so. Immediately after the results of a referendum, Tsipras promised that he would return to the negotiation table, and obviously bargain hard.

There is also a change of guard in the finance ministry, perhaps indicative of a likely conciliatory approach. But those on the other side of the table – all the principal creditors – are unlikely to soften their stance. In the meantime, the international credit rating agency Fitch believes that it will be “difficult” to reach a deal before July 20 when Greece has to repay about US$3.9 billion to the ECB.

Moreover, the ECB’s governing council is not expected to provide more liquidity assistance to Greek banks, which is maintained at about Euro 90 billion for past many days, leaving the country’s financial system in a stranglehold. Without any increase in such support, it would be difficult for the government to withdraw the newly imposed capital controls. Like-wise, Greeks may not be able to withdraw from their bank accounts even the meagre US$67 allocated per day.

Greek’s Secular Economic Drift

Such immediate problems apart, Greece is now staggering deeper into the economic unknown. Virtually nothing seems to have worked well with Greece ever since the 2008 global economic crisis. The World Bank data shows that its GDP [at current prices] has contracted by almost one-third from US$354.6 billion to US$237.6 billion between 2008 and 2014.

Its short-term growth outlook is now highly uncertain, albeit the Economic Intelligence Unit, London, has, in its recent forecast, projected zero growth in 2015 and a gradual recovery towards 2 per cent to 2.8 per cent growth rate in the subsequent two years.

In the meantime, the government debt to GDP ratio of Greece has risen from 146 percent in 2010 to 177 per cent at present. The current size of Greece’s total debt is Euro 323 billion, which is predominantly owned by the Euro Zone countries and the ECB. Although its fiscal deficit ratio improved from a high 11.1 percent in 2010 to 3.5 percent in 2014, it has to sustain this effort to make some visible reversal in government’s indebtedness. This would only be possible with tough austerity measures or equally painful structural reforms.

Its external sector has turned around – current account deficit to GDP ratio was 9.9 percent for two consecutive years (2010 and 2011) but turned into a surplus of 0.9 percent by 2014. But its crucial unemployment ratio remains persistently as high as 26.5 per cent at present, thereby stoking continuing social unrest.

In substance, the Greek citizens have not only suffered massive erosion in their standards of living since 2008, but also a large proportion of the labor force is without jobs. The share of youth among the unemployed is staggeringly high. This is despite two massive bailouts in all amounting to Euro245.6 billion [over US$270 billion] during the last five years, which have brought in their wake severity of fiscal austerity. Indeed, several experts right in the beginning were skeptical about the efficacy of the austerity programme imposed on Greece.

For example, Dr. Arvind Virmani, India’s then Executive Director in the IMF, prophetically pointed out

“the scale of the fiscal reduction without any monetary policy offset is unprecedented …[it] is a mammoth burden that the economy could hardly bear. Even if, arguably, the programme is successfully implemented, it could trigger a deflationary spiral of falling prices, falling employment, falling fiscal revenues that could eventually undermine the programme itself. In this context, it is also necessary to ask if the magnitude of adjustment – is building in a risk of programme failure and consequent payment standstill … there is concern that default/ restructuring is inevitable”.

In substance, fiscal austerity per se has become part of the problem, not the solution.

Incidentally, Greece joined the EU in 1981 and adopted the Euro in 2001. At that time, several experts were doubtful about the sincerity of Greece to abide by the rules of the game of the Maastricht Treaty, which prescribed for the aspiring EU members very tough norms of [a] inflation rate; [b] fiscal deficit to GDP ratio; [c] public debt to GDP ratio; [d] interest rate on 10-year government security; and so on.

Being an integral part of the EU, Greece certainly gained significantly from its membership during the period 2002-07 in terms of capital inflows and investments in key areas of infrastructure, real estate and tourism. In turn, this brought about a great deal of comfort and complacency among its citizens at large, as well as among the policy makers and the government. But the global economic crisis of 2008 exploded its vulnerability and crucial gaps in its official data of key fiscal parameters.

And the rest is now the recent history of huge imbalances in its fiscal management and massive accumulation of sovereign indebtedness, and consequent growing needs of bailout programmes for it to remain in float, and as part of the Euro Zone.

An Uncertain Way Forward!

While getting the popular mandate against the austerity conditions of a fresh bailout has been relatively easy, the Greek government now has a more formidable task – to chart out a new decisive policy direction of either remaining in the EU or finally moving out. The immediate priority is obviously to restore the normal functioning of the banking system and the restoration of economic stability. But even for that, some calibrated programme with the troika of creditors will have to be worked out.

Many commentators have eloquently argued that the outcome of referendum marks a dramatic increase in the risk of Greece sliding towards a disorderly exit from the Euro Zone. But at this stage, everything seems to be in a state of flux, and the definitive response of the EU, the ECB and the IMF are as much anxiously awaited as that of the Greek government.

What is, however, clear is that either of the options would be dreadful for the Greek economy and its various stakeholders! But from the overall perspective of EU, the future of the Euro and the relative global financial stability, working out some format of compromise would perhaps be a far more desirable option.

Grexit would obviously have immense cost – the cost of bankruptcy to which the Euro Zone countries and the ECB together are exposed to the tune of about Euro 245 billion. So also its contagion effect – and the “moral hazard” issue – with other high indebted countries like Spain, Portugal and Italy, who may be tempted to follow the example. Undoubtedly, the risk factors of financial turmoil in the EU and its global fallout are now considerably enhanced.

For the Greek government, the exit process would inevitably involve, as a first step, the introduction of a parallel currency – effectively going back to the drachma, the Greek currency before it joined the Euro, which was officially phased out in 2002. Presumably, all of the money in Greek banks would be converted back to the drachma.

Apart from the difficulties of doing this, the big worry is that the new currency would be found to be of much less worth than the existing scarce Euros, which would still be hoarded by Greek citizens. This would lead to the parallel currency depreciating substantially versus the Euro, pushing up domestic inflation through the imported goods channel, especially that from the Euro Zone countries.

There are also apprehensions that Greek banks, falling short of capital, might be nationalized. During the transitional period, the lending activity would be likely to come to a halt. There would be an investment collapse and erosion of private consumption demand. All this would push Greece into a deep recession. Besides, there would be legal problems relating to the conversion of private liabilities in Euro vis-à-vis foreign creditors.

There would be a further immediate increase in the unemployment rate. Given the very weak export sector, any positive export push through depreciation of its currency would probably take time to materialize. According to an IMF estimate, the Greek exit would cause an 8 percent decline in Greek GDP.

Thus, Greek citizens would be worse off with a Grexit, suffering from an enormous drop in purchasing power, higher unemployment and even more fiscal discipline. Moreover, structural and institutional reforms are likely to remain key ingredients under the new dispensation. The government would also be constrained to enforce best practices in the public administration and manage efficiently public resources.

From the EU perspective, the Greek economy is doubtless of a modest size – just about 2 percent of its aggregate GDP. Hence, Greek’s exit from the EU would not cause a much immediate dent in its overall economic activities. But the problem is about the financial implications of exposure of the governments of the Euro Zone and of European banks to the massive size of Greek sovereign debt – a large part of which may have to be written off.

There are already pressures on the exchange rate of the Euro vis-à-vis the US dollar. Also, there are concerns about how to keep the rest of the Euro Zone together – that is its long-term credibility and sustainability. Questions also will be raised about the existing framework and structure of the EU arrangement and the imperatives of reforming the same.

Implications for India

How is the Indian economy going to be affected by the on-going Greek tragedy? Specifically, from the perspective of foreign trade, there is nothing much to fear. India’s trade and economic relationship with Greece is of a very modest dimension. The two-way trade is just about half a billion US$ – Greece’s exports to India of $73 million are not even 0.02 percent of our overall imports, and India’s exports to Greece are about $428 million or less than 0.2 percent of our overall exports. There is, thus, not much direct impact of Grexit on India’s trade.

However, the EU happens to be India’s major trading partner, accounting for over 10 percent of our two-way trade. If the EU comes under some intense pressure due to the Grexit, there would be an inevitable setback to India’s exports.

Also, in the event of the cascading impact of Grexit on the EU’s banking and financial sector, and its fallout on the rest of the global economy, the impact on India in terms of trade, capital flows and exchange rate behaviour of the rupee would be somewhat more severe. The general perception is that India will clearly be affected if the global economy suffers widespread contagion. It is, however, too early to speculate on this aspect.

Far more important for us is to feel reassured by the strength and quality of our macro fundamentals.

First, the growth recovery of 2014-15 – the GDP growth rate of 7.3 percent – would be followed by its further momentum in the current fiscal year.

Second, the inflation rate looks within the RBI’s comfort zone, and the consumer price index (CPI) inflation of around 5 percent at present is unlikely to cross the threshold level of 6 percent.

Third, fiscal consolidation is reasonably well-anchored with more positive news on the buoyancy of non-tax revenues and potential reduction in oil subsidies.

Fourth, the external sector is in a comfortable balance – the key measure of current account deficit to GDP ratio is likely to be beyond 1.1 per cent – perhaps one of the lowest in recent years.

Fifth, forex reserves are well entrenched at around US$355 billion at present and could combat speculative capital flight.

Sixth, the banking system is well-capitalized and adequately geared to handle the changing risk profile.

Finally, there is a stronger sense of political stability with the government moving forward with the implementation of key policy reforms.

All in all, there is a messy economic and financial situation around the on-going Greek Tragedy. Everything is still in a state of flux – the dilemma of to be or not to be part of the EU would continue to haunt the Greek government till it takes a final plunge. Consequently, the global economy in general, and the EU, in particular, would be on the tenterhooks. India, of course, cannot remain a silent spectator in such a milieu, and must proactively decide what it needs to do to safeguard its growth ambition as well as its fiscal and financial stability.