Commitment to euro not in question

Greece will have to rely on a significant increase in investments and exports of goods and services while pursuing fiscal consolidation to revive its economy and cope with tough labor market conditions. Political risk is bound to play a bigger role than before in this period, however, contrary to conventional wisdom and the markets’ interpretation, this is unlikely to undermine the country’s future in the eurozone.

Political risk has assumed an even bigger role following the recent decision by the modest Democratic Left party (DIMAR) to withdraw its ministers from the government, leading to a reshuffle. Conservative Prime Minister Antonis Samaras was pragmatic enough to give up his pre-election pledge last year that New Democracy (ND) will never co-govern with center-left PASOK and form a new government with more ministers from its old-time ideological rival. The new administration has a small majority in the 300-seat Parliament as ND and PASOK control 153 seats, but it may also count on a few independent deputies on specific issues.

In this context, it was natural for markets to react negatively to the news of the breakdown in the tripartite coalition and re-rate the country’s political risk. The Athens bourse benchmark index fell sharply while yields on the new state bonds rose to new multi-month highs before receding. The index fell close to 800 points from about 1,000 points in early June while the yield of the 10-year bond jumped to 11.6 percent from near 8 percent in mid-May.

Part of the price move in both cases was due to international developments, especially Fed’s tapering of bond purchases later this year, yet the main driver was concerns about political uncertainty, leading to policy inaction and strains in the country’s relationship with its international creditors that may affect the release of future bailout tranches. Although some of these concerns have eased, doubts about the longevity and effectiveness of the new government still linger. The prospect of triple elections – local, for the European parliament and maybe even general elections – in May-June 2014 does not make things easier.

Some think market participants may take a wait-and-see attitude toward the new coalition in the next few weeks and months. They will continue evaluating the situation as they receive more data on Greece’s twin deficits – fiscal and the current account – the performance of real economy in the second quarter, the implementation of the sell-off program and efforts to downsize the public sector.

Undoubtedly, OPAP’s privatization and the signing of the 12-year concession of state lotteries could help boost market sentiment. This would add to the recent good news of the Trans Adriatic Pipeline (TAP) being selected to transport Azeri natural gas to Western Europe via Greece and the privatization of the gas transmission operator DESFA.

Nevertheless, good news is not likely to change the perception of elevated political risk held by the investment community, which constitutes a significant hurdle for productive investments at a time when Greece needs them most. It is reminded that investment spending is estimated around 13.2 percent of GDP this year compared to 17.5 percent in 2010 when the country entered the bailout program and 26.7 percent of GDP in 2007. So, the country has a lot of catching up to do with its average – no matter how one calculates it. This could help pull the economy out of recession if combined with some decent export growth and a neutral fiscal stance or at least a less tight one.

In the eyes of many investors, especially abroad, political risk is linked to the country’s euro membership. So, the perceived elevated risk leads to an upward revision of the likelihood, however small, of the infamous Grexit. But many market participants and others may be mistaken in the way that they approach political risk. Although no one denies it exists and may lead to short periods of uncertainty and the stifling of some reforms, there are three quantitative elements which have to be taken into account.

First, no mainstream political party, including left-wing SYRIZA, advocates the country’s exit from the eurozone. Ultra-right Golden Dawn and the Communist KKE are the only parties represented in Parliament calling for an exit – the position of the right-wing Independent Greeks is somewhat ambiguous. This means that any likely coalition that may arise in the future would not pursue this course of action.

Second, there is no political party, movement or personality that has convincingly made the case for a better alternative outside the euro. Therefore, popular support for the euro remains strong, albeit weaker than a year ago due to the negative effects on incomes and employment from the protracted recession.

Third, kicking Greece out of the euro is not in the best interest of its eurozone partners, as it would mean the country defaulting and them sustaining huge losses in the loans extended to Greece. Moreover, the indirect cost of potential contagion is hard to estimate, while the damage to the euro project would be irrevocable. Of course, there will always be politicians and others in core countries like Germany advocating a Grexit, but the costs far exceed the benefits in the eyes of most policymakers. This is more so given how close Greece is to delivering a primary surplus and almost balancing its current account deficit while having made progress in structural reforms and regaining most of its competitiveness since its euro entry.

Undoubtedly, estimates of political risk may vary over time. This is more so in Greece, which lacks a tradition in coalition governments and is feeling the pinch of austerity, resulting in huge output and employment losses. But periods of increased political uncertainty should not be confused with a change in the political elite’s commitment to keep the country in the euro. Changing this perception may prove catalytic for Greece’s efforts to attract productive investments and get out of the economic slump.

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