Abheek Barua & Bidisha Ganguly: Greece's moment of reckoning

The Greek leadership is trying to convince the people that voting "no" would not necessarily lead Greece out of the euro

Just as financial markets were getting comfortable with the fact that a last minute deal would avert a crisis in Greece, the crisis escalated sharply. The leftist anti-austerity Greek government failed to reach an agreement with its creditors before June 30, when it defaulted on a payment to the International Monetary Fund (IMF). In a move that took the stakeholders and the markets by surprise, the government called for a referendum on the bailout terms offered by the creditor institutions i.e. the IMF, the European Central Bank (ECB) and the European Union (EU). Technically, the offer from the creditors is no longer valid (as IMF Chief Christine Lagarde has been at pains to point out) after the default. The July 5 referendum is really asking people to vote on an offer that has expired. Nevertheless, the Greek leadership is keen to execute the referendum and is actively canvassing its people to vote "no".

Prime Minister Alexis Tsipras hopes that a better agreement can be arrived at by rejecting the present one. Yet, the people are bound to interpret a "no" to the bailout terms (the referendum questions are mind-bogglingly technical) as a thumbs down to the common currency or Grexit. Given the enormous cost that Greece will have to bear, if it jettisons the euro, the markets are widely expecting Greeks to be prudent and vote "yes" for staying on. The outcome will be known by the time this article appears and we find it somewhat pointless to speculate which way the vote will swing.

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Instead, we find it useful to analyse the likely scenarios and implications in either case. In case of a "yes" vote, the Tsipras government will most likely quit and creditors hope that a new government, that is easier to negotiate with, will be put in place. As this happens, the internal financial emergency situation that Greece is currently seeing will normalise with a gradual removal of restrictions on bank withdrawals. For the medium term, further negotiations are likely to result in a new and more favourable agreement with its creditors.

The EU is also praying for a "yes" vote if only to keep Greece within its fold for geopolitical reasons. Grexit could pave the way for other fiscally stretched economies to quit and usher in the collapse of the entire euro project. However, given the state of the Greek economy, a long-term solution will remain out of reach till both sides are able to make some compromises.

In case the people choose to vote "no", the consequences would be more catastrophic, as Greek banks would be cut off from ECB's emergency funding and would ultimately become insolvent. The Greek recession would deepen and Grexit would become inevitable, though perhaps not immediately. For a new currency to replace the euro, the government will have to introduce legislation to make it legal tender and all existing contracts in euro would need to be redenominated. This will certainly take a while.

The Greek leadership is trying to convince people that voting "no" would not necessarily lead Greece out of the euro or the European common market.

Finance Minister Yanis Varoufakis is a trained game theorist and seems keen to play a textbook game of chicken, in which whoever blinks first loses. At the heart of the game is the good professor's belief, that a walkout would threaten European integration and encourage other peripheral countries to take the same route.

For now, contagion has been limited with most markets holding up well and bond spreads of the peripheral markets like Portugal and Italy under control. The ECB on its part has promised to ring-fence these bonds of peripheral countries, probably through open market transactions by which the central bank buys large tranches of these bonds, to keep yields stable. Regulators in most countries have said that the risk of contagion from a Greek exit is limited. That said the long-term risks associated with Greece's collapse such as large-scale emigration from Greece to northern Europe, are somewhat difficult to fathom.

Abheek Barua is chief economist, HDFC Bank. Bidisha Ganguly is Principal Economist, CII