Investment Note

21 January 2015

Greek election: A ‘Choose Your Own Adventure’ story1

At the end of this week, will hold national elections. With the far-left party, Syriza, leading the polls, economic and political commentators are once again predicting that a Syriza victory could raise the specter of Greece exiting the eurozone. Megan Greene, Manulife Asset Management‘s chief economist, who has just returned from Athens, provides insight into the possible election outcomes and what they mean for Greece and the wider eurozone.

Investors and economists are sick of hearing about a ―Grexit‖, or a potential Greek exit from the eurozone. But ignore the recent talk of instability in Greece at your peril. A Greek exit from the common currency is not our base case scenario, but it has become a much bigger risk as a result of the upcoming Greek general election. Even in the absence of a ―Grexit‖, instability in Greece could impact the region economically, financially and politically.

Greece is set to go to the polls to elect a new parliament on 25 January, and all opinion polls suggest the far- left party Syriza will win. Syriza nearly won in the general election in 2012, a prospect that sent deposits and capital flying out of Greece then. In the past two years, however, the party leadership has toned down its rhetoric and become more moderate. Still, Syriza‘s leader is demanding a renegotiation of both the country‘s publicly held debt and the measures Greece must implement as a condition of its bailout loans. In 2012, investors worried that with Tsipras at the helm, Greece would unilaterally default on its debt. Recently, Tsipras has assured investors that Greece will not act unilaterally, but this does not mean there is nothing to worry about. Scenario 1: A second election called

One scenario for the Greek election is that Syriza fails to form a government and Greece is pushed into a second round of elections—just as occurred in 2012, but with far more serious implications this time around.

Syriza will likely fail to receive enough support to win an absolute majority in parliament on 25 January and will have to find at least one coalition partner. The three main contenders are the social democratic party Pasok, a small centrist party, To Potami and a new party launched by former Prime Minister . The problem is that Tsipras has repeatedly said that he will never partner with anyone who supported the austerity measures Greece had to implement. The leader of Pasok (Evangelos Venizelos) and George Papandreou were previously finance minister and prime minister, respectively, and are widely considered to be the grandfathers of austerity in Greece. Tsipras has also ruled out partnering with To Potami, arguing that it has supported the so-called troika (the European Central Bank, European Commission and International Monetary Fund).

If Tsipras sticks to his word, then it is possible no government will be formed and a second election will be called. By the time a second election is held and a new government is formed, Greece could already be out of money.

1 ‗Choose Your Own Adventure‘ refers to a series of children‘s books that gives the reader a variety of different endings from which to choose. Greek elections – A ‘Choose Your Own Adventure’ story

21 January 2015

The country has received an extension of its bailout program until the end of February. If there is no government in place at that stage, the country will automatically exit the bailout program. Greece has been shut out of the bond markets since late 2014, however. While the country does not have any significant bonds to roll over until July 2015, it will have to roll over a number of Treasury bills (T-bills) over the next few months.

If Greece is ejected from the bailout and there is no government in place to negotiate a credit line for the country with official creditors, then Greece may be unable to roll over those T-bills and could default on them. Capital and deposits likely will flee the country as well. The government already faces a significant budget gap in 2015 even without being cut off from funding from the troika. If Greece exited the bailout without access to a credit line this gap would only grow. Eventually the government could blow through the small primary surplus (budget surplus not including debt servicing costs) it has amassed and the only way to fund day-to-day operations could be for Greece to abandon the euro and issue its own currency.

Fortunately, we think this nightmare scenario will be avoided in any number of ways. Neither Greece nor its creditors want to see Greece tumbling out of the euro, and particularly not in a disorderly fashion. The troika could give Greece an additional extension of its bailout. It is also possible a technocratic government could be instated in order to negotiate a credit line for Greece before the bailout expires. Scenario 2: Government rises…and falls

A second scenario is that Syriza succeeds in forming a government, either by winning an absolute majority or by negotiating a coalition. Tsipras has changed his tune a lot in the past two years, and it is possible he will go back on his promise not to partner with those who supported austerity. In getting Pasok, To Potami and/or Papandreou‘s party on board, Syriza would have to moderate a number of its demands before it is even in charge. The party will also have to go back on some of its campaign promises in subsequent negotiations with the troika.

The problem with Syriza moderating its demands is that the party struggles with cohesion. Syriza is actually a coalition itself consisting of a number of different political movements. The wide array of views within the party can be witnessed by following Syriza‘s electoral campaign thus far; a number of party officials have contradicted one another on significant issues. There is therefore a chance that the more radical wing of the party will rebel and Syriza will splinter and fall apart, triggering yet another election.

We believe the current prime minister and leader of the right-wing New Democracy (ND) party, , is hoping for this outcome. If his party were not to win the general election, it would potentially be in a close second position and poised to take over should Syriza fail and fall apart.

If Syriza does fall apart, the timing of it is crucial. If it is immediate, Greece will face the same funding pressures as in the first scenario as the country goes to a new election. If Syriza manages to hold onto power long enough to negotiate a credit line with the troika, then a new election could pose less of a threat to the country.

However, if ND does poorly in the general election and Syriza falls apart, it is very difficult to see where voters would turn in the ensuing election. With Greek voters fed up with the two centrist parties and an opposition having imploded, the Greek political scene would be incredibly fragmented. A government of national unity could emerge, but would have little chance of lasting for any significant period of time. Political instability would undermine the Greek economic recovery and we could expect to see significant capital and deposit outflows.

Instability in Greece might not impact the rest of the region given ECB president Mario Draghi‘s promise to ―do whatever it takes‖ to support the eurozone. In the face of severe economic, political and financial stress, however, Greece might fail to qualify for support from the ECB as the central bank seeks to minimize its exposure to potential losses. Greek elections – A ‘Choose Your Own Adventure’ story

21 January 2015

Scenario 3: Greece muddles along

A third scenario is that Syriza forms a government, agrees to concessions with its coalition partners and the troika and the new Greek government manages to stay together for more than a year. This scenario poses the smallest threat to Greece‘s economic recovery, but still paints a grim picture for the country.

A number of structural reforms have been legislated over the past few years in Greece but have yet to be implemented. While Greece has made a huge fiscal adjustment since the beginning of the crisis, it has a lot of work left to do in terms of opening up labour and product markets to find sustainable growth. These structural reforms will support growth in the medium to long term, but in the short term they could undermine it.

The greatest impact of this scenario on the rest of the region is political. Greece‘s election is the first of a number of elections in Europe in 2015. Already there are scheduled elections in Spain, Portugal, (local), Germany (local) and the United Kingdom. In all of these countries but Portugal, there is an anti- European opposition party that has gained significant support over the past year. A Syriza-led government in Greece could give credibility to these parties and see them brought into government as well. Conclusion

In our view, a ―Grexit‖ remains unlikely, but the risk has certainly increased as a result of the snap elections called in Greece. Whatever the outcome, Greece is likely to face continued political, economic and financial instability. While contagion in the eurozone has been mitigated since the ECB vowed to support the euro, such instability in Greece will still impact the rest of the region.

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