Paola Subacchi
Research Director, International Economics
Once a Grexit is actually on the table, the negotiations between Greece and its creditors are likely to take a dramatic new turn.
A man passes by Greek and European Union flags on 3 June 2015, in Athens. Photo by Milos Bicanski/Getty Images.A man passes by Greek and European Union flags on 3 June 2015, in Athens. Photo by Milos Bicanski/Getty Images.

Greece is virtually bankrupt. Time (as well as creditors’ patience) is running out. And yet, looking at eurozone countries today, there seems to be little sense that Greece’s default, or even its exit from the euro, might spell deep trouble for Europe’s monetary union.

Approximately 52 per cent of Germans polled would like Greece to depart the eurozone, according to a March survey. Sentix’s Greek Euro Break-up Index, a monthly poll of investors conducted by the German research group, indicates that 41 per cent of the investors surveyed in May expect Greece to leave in the next 12 months, but only 24 per cent believe that if Greece did leave, the eurozone would be at risk of contagion. Is this another case of 'Greece is too small to matter' — as it was in the early 2000s, when the country was admitted into the monetary union despite falling short of debt and deficit requirements? Or, is this all because the rest of Europe, already on the road to recovery, is no longer prepared to put up with the Greek saga?

Forthcoming payments

The latest chapter in this saga began in January, when the anti-austerity party Syriza won the general election on two conflicting promises: to stop austerity and to stay in the eurozone. To achieve the former, the government has to repeal some measures that are part of the bailout programme, such as labour market and pension reforms. But this raises the question of how Greece can remain on the euro. Creditors require adherence to this programme, including these unpopular reforms, in order for the Greeks to secure bailout funds. Without these, Greece will struggle to meet its upcoming financial obligations. In particular, on 5 June Athens has to return to the International Monetary Fund €300 million  — a chunk of the total €1.6 billion that need to be paid by 19 June. Large redemptions of Greek bonds held by the European Central Bank (ECB) are due in July and August. Together, these payments add up to the current expenditure on pensions, social security, and public-sector salaries.

Having begun with a good deal of sympathy, the Greek government has only itself to blame. Since Syriza took power in February, the government has managed to burn a great deal of political capital and goodwill, perhaps due to lack of experience or hubris (or both), with no tangible progress.

As Greece’s liquidity situation deteriorates day by day and pressure on domestic financial obligations such as pensions and salaries mounts, it becomes increasingly likely that the government in Athens will miss a payment to the IMF in June unless a credible and comprehensive agreement is reached. But nobody seems to believe that this is in reach. Although the odds are currently low, even IMF Managing Director Christine Lagarde has acknowledged the possibility of a Grexit.

Wake-up call

Perhaps Lagarde deliberately chose to overcharacterize the situation in order to send her Greek interlocutors the message that the time for talks is over and concrete action is now required. Missing a payment would not mean default yet, nor would it surely push Greece out of the monetary union. But it would act as a wake-up call.

Complacence is widespread — among commentators, investors and even policymakers — about the fact that a deal between the Greek government and creditors ­could be reached, even at the last minute. This has been reinforced by the belief that the risk of contagion to the rest of the eurozone is limited compared with the 2011-12 period, mainly due to the ECB’s willingness to absorb sovereign bonds if demand weakens and due to the reduced exposure of European banks to Greece (from €180 billion in 2010 to just over €30 billion at the end of 2014). The improvement in the economic outlook of the eurozone’s periphery countries, like Spain and Italy, also helps ease concerns.

The reality of Grexit

In the coming weeks, Greece’s debt saga will firmly shift into a more political territory. The official creditors, as well as the eurozone governments, will be forced to contemplate a series of ugly scenarios. First, being unable to repay the IMF will make evident that there are high costs to keeping Greece in the eurozone. For example, the government will need to introduce capital controls to avoid (further) outflows, calling into question the very notion of monetary union. And there will be a significant impact on market confidence, with a possible increase in the risk premium of the eurozone-periphery bonds — the correlation between Greek bonds and those of Italy, Spain and Portugal has increased since March, despite the ECB’s quantitative-easing bond buying.

Second, and linked to the previous scenario, the other eurozone members will begin to consider the trade-off between living with a eurozone member that is unable to play by the rules and breaking the golden rule that there is no exit from the monetary union. In other words, what are the limits of the rules of engagement and of fiscal coordination within the eurozone? Greece’s attempts to redefine these rules have been rebuffed not so much by the troika, but by other member states that oppose an easy leeway to Greece.

By refusing to do whatever it takes to keep Greece within the monetary union, these countries are considering the possibility — inconceivable until very recently — that countries will be able to leave without breaking up the whole structure. How that will be done remains unknown, but once a Grexit is actually on the table, the negotiations between Greece and its creditors are likely to take a dramatic new turn.

This article was originally published in Foreign Policy.

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