Fiscal figures are hostage to politics

The Greek story is based on a simple assumption: An economic turnaround, followed by strong real GDP growth rates in the next few years, fiscal discipline, more reforms and a debt relief agreement with the European Union. This assumption is clearly undermined by the increased political risk, threatening to unravel the investment case and lead to new austerity measures to close a bigger than estimated fiscal gap. This is a recipe for political havoc with unforeseen consequences if it goes unchecked.

Greece met the fiscal target in 2012 and surpassed it last year after the general government recorded a primary surplus compared to a flat outcome foreseen by the program. Moreover, some analysts argue that revenues could exceed primary expenditures by more than the program target, set at 1.5 percent of gross domestic product, this year. This is by far the biggest ever fiscal adjustment by an advanced economy in modern times, as Greece went from a primary deficit of more than 10 percent of GDP in 2009 to a primary surplus in just four years. However, it all came at a very high economic and social cost.

In addition to encouraging fiscal figures, provisional data for economic activity confirmed the recession was slowing down. Real GDP contracted by just 0.3 percent year-on-year in the second quarter on its way to having its first positive reading in the July-September period since the second quarter in 2008.

The recently released turnover index in retail trade increased by 4.5 percent year-on-year in August, with volume recording an even bigger rise at constant prices. This, along with the good tourism season, justify optimism that the economy has turned around from the third quarter.

The combination of further progress in fiscal consolidation, the tentative signs of an economic rebound and a few reforms have helped convince a number of foreign investors to buy into bonds and stocks.

Of course, other factors have played a role such as the profile of the Greek public debt with the low interest rates and the long maturities, and the risk-on trade internationally. All of these shaped the Greek investment story, which attracted hedge funds and traditional institutional investors, and boosted economic and business sentiment in the first eight months of this year.

But this story is threatened by political uncertainty and the prospect of early elections as the leftist SYRIZA party enjoys a clear lead in opinion polls. The markets have reacted in a negative way, driving the yield-to-maturity of the 10-year Greek bond yield above 8 percent and the 5-year bond above 7 percent as of last Monday. By doing so, they have made it impossible for Greece to seek a clean exit from the EU/International Monetary Fund program and even raised doubts about whether a precautionary credit line, the so-called dirty exit, would work.

At this point the risk-mitigating scenario, that is, the precautionary credit line, seems to be the government’s best card for the post-program period but things have the potential to take a turn for the worse. The government partly has itself to blame for this development, although market concerns about the so-called “SYRIZA risk” have been the driving force behind the recent sell-off.

By talking a lot about an early exit from the program but not delivering on privatizations and some key structural reforms, the government has cornered itself by alienating its closest ally, the markets. The deteriorating climate in the eurozone and the return of the risk-off trade compounded the problem.

Looking ahead, the political situation could get more complicated if the government and the troika do not agree on the reform agenda and the representatives of the lenders put off their visit to Athens again. This could accelerate political developments by upsetting the coalition government’s plan to close the current program review and focus on the day after the completion of the streamlining program, and on debt relief talks that are seen as an instrument in the quest to gather the minimum 180 votes in the Parliament to elect a new president in February.

Although most commentators are focusing on political developments, the real threat will come from the effect of politics on the economy. Protracted political uncertainty will certainly have an adverse impact on economic activity and this may become apparent as soon as the fourth quarter of 2014, affecting the real GDP growth rate for the entire year. Most estimates put economic growth between 0.4 and 0.6 percent in 2014. In addition, it could lead analysts to downgrade the GDP growth forecast for 2015, unraveling the Greek investment case and causing a massive sell-off.

The slower-than-projected growth rate could also give rise to a bigger fiscal gap which would in turn lead to new austerity measures to meet the primary surplus target of 3 percent of GDP, causing political havoc. Under these circumstances, Greece would need fresh funding from the European Union and a new adjustment program.

The scenario described above may not be the baseline but it should not be ruled out. Even if the troika comes to Athens and the review is concluded, it will be in the mind of market participants. This is more so if the government continues to give the impression that it wants to avoid reforms entailing political cost, SYRIZA’s rhetoric increases investors’ concerns and political uncertainty reigns. The potential for a big mess should not be underestimated.

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