TELEGRAPH SPECIAL: Greek Drama Puts Eurozone at Risk

Global equity markets ended the week on a positive note, buoyed by signs of progress on EU debt talks with Greece and a glimmer of East-West rapprochement at the Minsk summit. Stocks rallied on both Thursday and Friday, with investors’ risk appetite rising as German Chancellor Angela Merkel shook hands with, and then smiled at, Greek Finance Minister and Negotiator-in-Chief Yanis Varoufakis. That came alongside a Ukraine ceasefire deal – again, brokered by Merkel – which pushed European shares and bonds higher, amid hopes of easing tensions between Russia and the West.

Then we had news of better than expected eurozone growth during the fourth quarter of 2014. The combined economy of the 19-country currency bloc expanded 0.3pc during the final three months of last year, reported Eurostat, with GDP rising at an annual rate of 0.9pc. This improvement was led by a 0.7pc increase in German national income, compared to just a 0.1pc expansion the quarter before. There were also indications of stronger growth in some “periphery” member-states, with Spain and Portugal notching-up figures of 0.7pc and 0.5pc respectively.

Many eurozone exporters are clearly benefitting from a cheaper currency, the euro having fallen 10pc in trade-weighted terms since last March. As a major energy importer, the region has also gained from the halving of oil prices during the second half of 2014. With the European Central Bank having announced a quantitative easing programme to buy over a trillion euros of bonds during an 18-month period from March, eurozone shares have gained 12pc since their mid-January lows, when this latest Greek crisis erupted. Preliminary survey data indicate a further growth upturn last month, so the rise in equity prices looks set to continue – as long as the Greek debt negotiations keep progressing and there’s no renewed escalation of violence in Eastern Ukraine.

While last week’s market upswing felt good, this sudden improvement in investor sentiment, an almost effervescent return to “risk-on”, could be built on precarious presumptions. Across the world, geo-political risks remain legion – not just Russia-Ukraine, but also in the Middle East, where the IS terrorist group is trying to return the region to its pre-1914 borders. Oil prices, having quietly risen by around 25pc over the last month, as cheap crude limits supply, could be in for prolonged volatility. The Western world’s multi-trillion dollar sovereign debt markets, meanwhile, remain propped up by printed money.

All of these issues – not least a renewed oil price spike – have the capacity seriously to dent emerging investor optimism. The main determinant of global market sentiment, though, the keystone now propping up the tower of confidence, is Greece. For a fully-blown crisis, involving a near-default or even Greece crashing out of the Eurozone, could spark a “Minsky moment”, dealing a shattering Lehman-style blow to global markets.

So, ahead of the next round of talks between eurozone finance ministers tomorrow, followed by Thursday’s session of the ECB’s governing council, what are the prospects for Greece? Will there be a resolution that avoids disaster? Or will these EU-Athens negotiations tear the single currency, and the entire “European project” apart?

Two massive bail-outs in 2010 and 2012 kept Greece afloat, and within the eurozone, but sent the national debt soaring to 170pc of GDP. While Athens has so far met most “austerity” measures imposed by international creditors, one in four workers are now unemployed, with national income now some 25pc below pre-crisis levels – a downturn as long and deep as the 1930s Great Depression that so traumatised America.

That’s why Syriza emerged from relative political obscurity to win last month’s Greek election on a vow of abandoning the bail-out terms, hiking public spending and raising state wages and pensions. The trouble is that this democratically-expressed Greek desire is anathema to electorates not just in Germany, which has bank-rolled almost a third of the €240bn Greek bail-out, but other eurozone countries too. Spain and Portugal have also received bail-out assistance contingent on tough reforms, conditions they’ve largely fulfilled. In those nations, in particular, there’s rising anger at the prospect of a Greek sweetheart deal.

Although the mood music emanating from the EU-Greece talks has been positive, the reality is rather different. Yes, the radical-left Greek government met their creditors last Thursday, and agreed to discuss a restructuring of the country’s debt – a shift from Syriza’s campaigning cry of ignoring the obligations completely.

While that was an important first step towards, other members of the Greek delegation later appeared to reverse that agreement, rejecting a statement committing Greece to exploring the “possibilities for extending and successfully concluding the present [bail-out] program”.

Germany had offered “new contractual arrangements”, a euphemism for easier bail-out conditions. The possibility of “bridging finance” was also raised – which is vital to Athens. Greece, after all, must pay its creditors (mainly eurozone governments and the International Monetary Fund) more than €20bn over the next 12 months, if it is to avoid default. The government, at the same time, needs to prop up three “systemic” banks in which it now holds majority-stakes – or otherwise endure a catastrophic bank-run. Syriza also needs money to keep an enraged electorate, now with sky-high expectations, relatively calm.

As such, without additional finance, the Greek economy will collapse, while failure to agree a long-term renegotiation of terms could see the ECB cut off its credit-line to Greek banks, as it did to Cyprus in 2013. Yet, despite all that, Varoufakis, having previously agreed on Thursday’s statement to renegotiate the bail-out in principle, later withdrew Greek support. So negotiations on Monday will start again from square one.

The likelihood is that we will eventually see a new deal for Greece – one that cuts Athens’ obligations significantly, while extending additional finance – with Germany being the first side to blink. Such “extend and pretend” measures will happen as long as the settlement is complicated enough for Berlin and Brussels to claim it amounts to something other than “debt-forgiveness” or a so-called creditor “haircut”.

For all her steely resolve, Merkel has given way in every previous eurozone crisis – and that’s why Varoufakis, despite his public intransigence, is tentatively floating schemes involving easier terms for Greece rapped in obscure language most eurozone voters won’t grasp. As such, we can expect to see swaps of creditor government loans for long-dated GDP-linked bonds that pay interest as the Greek economy expands. The ECB, meanwhile, is likely to likely end up with interest-bearing perpetual bonds with no repayment deadline in return for its tranches of Greek debt.

Before all this happens, though, there is still likely to be a series of almighty public rows, and a return to full-blooded threats and counter-threats, regardless of their impact on financial markets. In order to quell opprobrium towards Greece at home, various eurozone governments, going beyond Germany, could say “so be it” if Greece looks like crashing out of the single currency. The political and financial stakes are so high, that everyone involved needs to be seen being as tough as possible. Syriza, for its part, might even threaten to take direct control of Greek lenders and write-off billions of euros in household loans, destroying bank balance sheets in a frenzy of populist contractual vandalism.

So while there will almost certainly be a deal, with Greece staying in the euro for now, the diplomatic situation will probably get a lot worse before it gets better. And that will generate significant financial volatility, reversing the heightened investor optimism of last week.

The greater danger, though, is that rather than resolving the eurozone’s systemic and diplomatic woes, a Greek deal merely provokes even greater intra-regional tensions. For even if the current imbroglio is resolved, we’re set for a year of political turmoil across Western Europe, with ever more doubts being raised about the future of the single currency.

Elections are due in Italy – the real GDP of which remains 10pc down on 2008, in part due to being being trapped in a high-currency straitjacket. The eurozone’s third-largest economy, Italy’s three main opposition parties are now all campaigning on a platform to leave the euro. Spain and Portugal will also hold elections in 2015 – and, again, anti-euro parties are set to make significant gains.

That’s why, even if the Greeks and Germans end up behaving rationally, and an immediate Grexit is averted, speculation about eurozone break-up could well continue – as other “peripheral” nations enduring austerity programmes then demand similarly less onerous terms. Why wouldn’t they, having just seen the success of the tactics employed by Greece? Such prolonged tension and diplomatic angst, to say nothing of the costs, could ultimately end Germany’s patience, but not before sending eurozone bond markets haywire.

While remaining circumspect with regards to Greece, it may also be wise to be cautious about Ukraine. At least 5,300 people have been killed in East Ukraine – as a result of shelling by Kiev and the activities of resistance fighters. Some estimates put the victim numbers in the tens of thousands, most of them civilians. So the Minsk II agreement is to be welcomed, as long as it doesn’t turn out like the previous ceasefire, which lasted just a few short weeks.

Again, though, investors should be cautious. The agreement calls for a ceasefire from this weekend, a pullback of heavy weapons from the front-line of fighting to create a demilitarized zone. There will then be elections in rebel-held regions under Ukrainian law, leading to a “decentralization” of Kiev’s powers in Eastern Ukraine.

While presented as a compromise, Russian Foreign Minister Sergei Lavrov was heard to quip that the deal was “better than super”. That’s a major reason why Minsk II may not hold. An outcome that is seen to favour Russia is far more likely to raise the ire of the US, fuelling on-going calls for Washington to send weapons to Kiev – rapidly increasing the risk of an escalating conflict on the edge of Europe. For all Merkel’s diplomatic energy and brio, the view of Germany and many other EU countries is very different from that of America, not only because EU trade with Russia is 12-times that of America, but because this conflict is right on Europe’s border.

While the Minsk II agreement is a start, then, there could be a lot more drama before we reach a durable East-West resolution over Ukraine, not least because of the fundamental rift now been exposed between the EU and US. As such, despite better news last week, the West’s conflict with Russia, just like the issue of Greek eurozone membership, remain geopolitical dangers that could yet upend improving investor sentiment.

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