Abheek Barua & Bidisha Ganguly: The re-emergence of 'Grexit' fears

It is legitimate to wonder if the new threat of "Grexit" is, to fall back on a couple of cliche's, a case of crying wolf yet again or if things are different this time. The influential think tank, Capital Economics' Jonathan Loynes (Is a Grexit now more likely than ever? January 8, 2015) argues two things.

The relatively muted response (compared at least to similar episodes in the past) of European bond yields to the announcement of the snap elections in Greece on January 25 might reflect the fact that the markets are pricing in a lower probability of an actual exit. However, he also argues that were market pressures to intensify, with a sharp rise in bond yields, the possibility of Greece calling it quits is much higher than in 2011 and 2012.

Let's look at it from Greece's perspective. After two more years of stringent fiscal discipline, Greece is now running a primary budget surplus rather than the big deficits seen a few years ago. Even its overall budget balance is close to zero. Thus, if Greece were to suddenly wake up to the thought that the benefit of a sharply depreciated currency along with some debt restructuring outweighs the benefits of clinging on to an increasingly unpopular currency union, it might just want to leave the currency union.

From the perspective of the rest of euro zone, particularly core economies such as Germany, which do all the heavy lifting when it comes to bailouts, the case for somehow keeping Greece within its fold is lower than in 2011 and 2012. As a result of the various bailout facilities now in place, including the much-touted outright monetary transactions (OMT) or de facto large-scale quantitative easing (if, of course, it is cleared by the European Court of Justice), the knock-on effects on other peripheral economies might just be contained. In short, Grexit might not trigger the region-wide crisis that we have come to associate with it.

Political imperatives would also perhaps make a case for the core euro zone economies asking Greece to shape up or ship out. Syriza, the increasingly popular anti-austerity (but bizarrely enough, pro-single currency) party that has a high chance of getting elected in the end-January elections, is not the only "alternative" party to gain popularity. If countries such as Germany do want to send out a signal that it would not tolerate what they consider "loony left" nonsense, it might not be averse to letting Greece leave the union and not look the other way if it defaults again on its commitments.

That said, policy mandarins in Brussels and Frankfurt can hardly ignore the risk of a full-blown contagion that could engulf the bigger economies of the South, particularly Spain and Italy. If they come under pressure, the bailout programmes and even the OMT might prove inadequate to douse the conflagration. Thus, despite the hard calculus of costs and benefits, letting Greece stray from the fold will be a tough call.

The lay reader will wonder why despite years of putting together rescue packages and announcing firm resolves that the central bank will do "whatever it takes" to save the euro, the spectre of a crisis keeps surfacing. The answer might be simple. As long as the euro is relatively strong (say, higher than 1.2 to the dollar) and strict austerity results in suppressed incomes for the periphery, the southern economies will witness periodic stress. Large-scale liquidity infusion will address currency overvaluation, but whether the region can get back on its feet without fiscal stimulus remains an open question.

Tailpiece: The impact of the Reserve Bank of India's rate cut on the rupee will depend on whether the currency is predominantly a yield play (supported by debt flows) or a growth play (supported by equity flows). Rate cuts are positive for growth and we see some short-term support emerging for the rupee.

Abheek Barua is with ICRIER. Bidisha Ganguly is Principal Economist, CII