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Squeezing Greece's Cash Flow

David Malpass | May 21, 2012

Greece’s political impasse and the risk of contagion to euro deposits in Spain pushed markets down last week. We think those developments are serious but not necessarily fatal to the euro-zone. The downward pressure from the Facebook IPO and the disclosure of big, vulnerable JP Morgan long positions on corporate credit should fade, leaving U.S. and Chinese growth as key variables along with Greece and euro developments. We don’t think the June 30 wind down of the Fed’s operation twist (which was ineffective) or the fiscal cliff (open to compromise) are as important.

We expect the Greek government’s cash to be squeezed hard in coming days. The question is how that plays politically in Greece. Running short before the June 17 election might be helpful to reformers. Greece’s government has been sustaining itself (meeting payroll) by hollowing out the Greek banking sector (as discussed in previous pieces), but the government is at the limit of this resource. The banks are nearly drained and the withdrawal of bank deposits hastens this endpoint (because it uses up any remaining assets). The ECB is reducing Greece’s access to the discount window. It could restrain currency transfers or stop the “emergency lending” that the Bank of Greece has been allowed to make even as its capitalization goes more deeply into the red.

Despite the U.S. push at the G8 meeting for more European government spending, there hasn’t been any indication that there will be extra aid for Greece. We think there will be more funding for the European Investment Bank and more French-German discussion of growth policies, but not steps that help Greece.

Germany has made clear that it has some flexibility but needs Greece to move first. It would support pro-growth structural reforms (like labor reform and government spending cuts) and would allow Greece to substitute new conditions for existing ones. We’re not fans of Greece’s current IMF program – too much of the austerity was placed on the private sector where austerity hurts growth and not enough on excess parliamentary and military spending where cuts would have been pro-growth.

Setting the tone from the Greek side, however, last week Greek officials suspended work on the sale of government assets, one of the more important pro-growth conditions in the IMF program. Asset sales would raise cash, show government interest in reform, and allow more competitiveness as government monopolies are liberalized. In addition, it was one of the easier conditions for Greece to at least pretend to honor because most of the sales wouldn’t have been completed for years. Greek leftist leader Alexis Tsipras claimed in a detailed Wall Street Journal interview on Friday that: 1) Europe should give Greece more aid with no conditions because otherwise Greece will drag Europe down; and 2) Greece could manage without new aid by not paying its debt. This crystallizes the confrontation with the rest of Europe. We don’t think either view is correct – Europe is unlikely to give more aid; and stopping debt payments wouldn’t be enough to allow the Greek government to manage because the government is running big deficits apart from the debt payments.

From the beginning of the European debt crisis, Germany has had the view that brinksmanship was the likely path. Senior German and ECB officials are explicit in their view that politicians in the periphery will not undertake structural reforms unless pressed to the edge of the cliff.

A key issue is where does compromise lie between Germany and Greece. In stepping back from the brink in late 2011, Germany got new governments in Spain, Italy and Greece and the fiscal compact. In return, it allowed what we called forbearance – an acquiescence that the European bank regulators and the ECB could look the other way as weaker banks and central banks hollowed out their assets and stronger banks met capital adequacy standards without raising new capital -- for example, by reclassifying senior debt as equity.

The grounds for compromise this time draw on: 1) The euro-zone, including Greece, strongly support the continuation of the euro; 2) there are reforms Greece’s government could undertake that would be pro-growth and also deficit reducing; 3) the EC, EFSF and ECB have sizeable resources that could be directed to Greece if it shows interest. Germany and most of the euro-zone are at a point where they want to push the cash flow issues with Greece now in the hope that the June 17 election will create a coalition that will work on structural reforms.

This piece originally appeared at Encima Global.

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