Europe

Greek banks reopened today, but there isn’t much you can do at them. Capital controls and withdrawal limits remain in effect, money transfers are barred (except for tax, social security or a few other allowed domestic transactions) and new accounts or loans effectively ruled out. Greeks now will be able to deposit checks, access safety deposit boxes, and withdraw money without an ATM card. All good things, though I suspect that any political boost from the visuals relating to reopening will proved short-lived. Amidst concern that the financing needs will outstrip the three-year, €86 billion financing gap agreed last weekend, attention now turns to the €30-40 billion European rescue facility (ESM) that must be negotiated quickly. This occurs against an unsettled political backdrop—a second vote this Wednesday on justice and banking reforms should pass, but may see more defections from the government side than last week’s vote. With new elections now expected for September or October, there is a narrow window in which to get a financing agreement done. Meanwhile, industrial activity data show a continuing decline, and anecdotal evidence suggests a continuing, broad-based drop in activity. The €7.2 billion bridge loan released today will allow the government to meet ECB payments and eliminate arrears to the IMF and Greek central bank, stepping back from one cliff. But now the question of reactivating an economy that ground to a halt during the crisis moves to the fore, and the imposition of new taxes approved last week will not help in the near term. The banks will remain in this semi-frozen state pending an asset review and recapitalization (and bail in of unsecured creditors) expected by early 2016. Unrealistic expectations about a return to economic normalcy may represent the most immediate threat to the program in coming days. This is why I believe, like others (for example, here), that “Grexit” remains the most likely outcome. As the reality of the path the government has chosen sets in, the next month may prove the most difficult yet.

The Greek parliament last night passed the first package of measures required by the government’s agreement with European governments reached over the weekend, winning 229 of 300 votes in the parliament. There were a large number of Syriza defections (39) that would appear at minimum to require a cabinet reshuffling. Some local analysts predict the government could fall, though most expect that if that happened Prime Minister Tsipras would reemerge as prime minister in a new coalition government. These are only the first steps on a very long path for Greece, and the tight timeline for passage of comprehensive legislation suggests political paralysis is an unaffordable luxury. Passage of first stage measures will set the stage for a €7 billion bridge loan--likely from an EU rescue facility (EFSM) if objections from non-euro members can be overcome--that would allow Greece to meet external debt payments due Monday. More significantly in the near term, the ECB is expected to expand emergency liquidity assistance (ELA) on Thursday, which will ensure there are euros in the system. But these measures are not sufficient to reopen the banks, or reactivate an economy devastated by the crisis. To take that critical next step requires an agreement on an program with European creditors that would provide €40-50 billion in financing from the European Stability mechanism (ESM). The notional deadline for that agreement appears to be mid-August, when another round of external debt payments loom, but domestic pressures on the government to reactivate the economy ahead of the ESM disbursements is one of the most significant threats to the process and one of the central scenarios whereby the government chooses Grexit over remaining within the eurozone. The third piece of the Greek package, financial assistance from IMF, has drawn a lot of attention following release by Fund staff of a new debt sustainability assessment showing that the proposed policies, even if fully implemented and successful, would lead to debt levels close to 200 percent of GDP and gross financing needs of over 15 percent of GDP. The IMF suggests that, for a Greek program to make sense, it needs to include nominal haircuts or very long grace periods on payment (as much as 30 years). The IMF’s document has been read by some as suggesting the Fund will not lend if these levels of relief are not delivered. I’m skeptical. Ultimately the Fund will find it extremely hard to say no when its major shareholders are so committed to the program, even if the program doesn’t meet the Fund’s internal rules (including a high probability that the debt is sustainable). Nonetheless, the IMF is right to be concerned about both financing and debt, and of being pulled into a financing arrangement that it does not believe in.  On the financing side, the gap is set at around €85 billion, and could well be higher with normal slippages and hidden losses in the banking system.  With only around half the financing coming from the ESM program, and seemingly unrealistic assumptions including €50 billion from privatization, there would seem to be substantial risks of a unfilled gap that the IMF would be pressed to fill. In the IMF’s current Greek program, there is €16.4 billion that is undisbursed and available between now and March 2016. But a new program now looks likely adding materially to their exposure, and in the absence of adequate financing and debt relief, risks making the IMF a de facto lender of last resort. On the debt side, the IMF has been pressing Europe for a number of years for a more realistic policy on debt.  After all, there are well-defined policies for dealing with excessive private debt (private sector involvement, or PSI, can be a condition for Fund lending as in Ukraine recently) and for the official debt of developing countries (through the Paris Club, an informal grouping of official creditors). But European creditors, for a range of economic, legal and precedential reasons, have been deeply resistant to setting such rules in place for Greece and other heavily indebted periphery countries (although granting substantial relief on an ad hoc basis). The Greek crisis now has made the debate urgent, and U.S. Treasury Secretary Jack Lew in meeting with European leaders today will lend his support to this position (though U.S. leverage on the issue appears limited).  Actual cuts to principal appear unlikely, though long-term grace periods seem achievable. If indeed debt relief falls short of the Fund’s target, I would still expect there to be a program. That might require the Fund to adopt an optimistic (if unrealistic) assessment that the program has a high chance of success, as was done for the 2014 Ukraine program.  Alternatively, it could invoke the so-called systemic exception, a 2010 rule devised originally for Greece that would allow it to waive the debt sustainability test. The IMF would be loath to use this rule, in part because it does not see this crisis as necessarily systemic, but some of the major creditor countries may see this as a realistic acknowledgment of the geopolitical importance of  the effort to keep Greece in the eurozone. A better way to look at the IMF’s analysis (and their unusual decision to release the documents) is that battles among official creditors are becoming an increasingly common feature of the a rapidly growing international financial system. Consequently, the needs of countries in crisis are growing faster than the resources of the Fund (creating large financing gaps), and swings in capital flows can leave sovereigns with high levels of debt. From this perspective, the failure of Congress to pass IMF quota reform, and broader constraints on increasing quotas, leads to an inherent tension for the Fund, whose rules were drawn up in simpler times.  Greece represents an important, but by no means unique, test of their capacity to adapt.

European leaders, meeting tonight in Brussels, appear to have given Greece something close to a take-it-or-leave-it offer.  If the Greek government can pass far-reaching reforms by Wednesday, creditors will provide bridge financing to meet near-term debt payments and cash to reopen the banks.  These steps also would allow a rebuilding of trust and allow negotiations on a third bailout that could total €86 billion to proceed. It is unclear as of now whether the Greek government will take this deal, or end negotiations knowing that a failure tonight could signal Greece’s exit from the eurozone. Even if Prime Minister Tsipras does agree to these measures, the risk of failure is high, and deteriorating economic and financial conditions will further stress the government.  Already there are reports of significant fissures within the ruling Syriza party, which could result in a political realignment (and possibly an unaffordable delay) if the government is forced to rely on substantial opposition support to pass these measures. At this stage, it is hard to have much confidence that this route will lead to a Greece that is competitive and growing sustainably within the eurozone. What creditors are offering The proposal, as reported by various news agencies, requires the Greek government to pass a broad range of reforms by Wednesday, July 15. These include: substantial VAT and pension reforms; a new code of civil procedure as part of judicial overhaul; full implementation of past EU laws, including procedures for automatic fiscal cuts when targets are not met; and, implementation of bank recovery and resolution directive as first step towards fixing the banks. Many of these proposals had been floated in earlier rounds of negotiations, but the requirement that they all be passed by Wednesday is daunting. Conditional on above, negotiations will be launched on a third bailout package and would include further reforms including: (i) Eliminating the pension deficit (that now stands at 10 percent of GDP); (ii) Adoption of ambitious product market reforms; (iii) Privatization of the electricity transmission network (ADMIE); (iv) A comprehensive labor market review including collective bargaining, industrial action and collective dismissals and a commitment to European best practice; (v) Large-scale privatization, including the possibility that €50 billion of assets would be turned over to an EU-controlled facility; and (vi) Broad-based administrative reform. The financing program would be between €82 and €86 billion. Most of the funding would come from the European rescue facility (ESM), but IMF monitoring and financing is a precondition for a new ESM arrangement. Financial support would include a near-term bridge of around €7 billion by July 20 and another €5 billion by mid-August that would allow it to meet upcoming debt payments and clear arrears with the IMF, but fiscal support for the reactivation of the economy would appear to wait for the approval of the larger program later this summer. I assume that a possibly significant expansion of emergency liquidity (ELA) by the ECB would be part of the package. There is no explicit commitment to debt relief in the proposal, meeting German concerns about setting new precedent but denying Greece political cover that they had sought for the reform package. Longer grace and repayment periods would be considered conditional on full implementation of measures and after a positive first review of a new program, so around end year. Finally, there has been discussion that Greece would take a "time out" from the eurozone if a deal can’t be agreed, with the promise of a return at some future date.  This is clearly provocative and probably not essential to a deal. Ambitious but likely to fail This is an extraordinary ambitious package, and includes an intrusive continuing role for the Troika (IMF, ECB, and EU). Further, as difficult as passage of the July 15th measures will be, the requirements for a third bailout looks to be an even more substantial ask of the Greek government, which raises the prospect that the stage one agreement is a bridge to another confrontation and crisis. As I mentioned earlier today, the massive financing need is a problem.  There are hints in the document that that financing could fall short, which would then require additional fiscal adjustment or privatization measures. (Greece has already strongly objected to turning over privatization assets to a EU-controlled institution.) It also is unclear whether a buffer fund of €10-25 billion for recapitalization and resolution costs is included in the gap or additional, but in either case the banking costs are substantial and growing by the day. The IMF cannot be thrilled by the proposal. The IMF has been wary about committing financing to a package that doesn’t have debt relief, which is not explicit here, and should worry that they will be asked to pick up the residual if financing falls short. Their exposure is already high and exceptional access would be difficult to justify in these conditions under their rules.  Meanwhile, the Greeks would far prefer to not have a new IMF arrangement. Both sides look like they will be disappointed on this point. In sum, a very tough and risky choice for Greece. Negotiations are continuing, but aside from some hot button issues (e.g., privatization) and some smaller issues on the margins, there would appear to be little appetite for additional concessions from creditors.  We should learn soon which direction Greece will take.

European finance ministers are meeting this morning amidst deep divides over whether, and on what terms, to provide a lifeline to Greece. Finance Ministers will not agree to a deal, with Germany (and other skeptical governments) resisting pressure from France and Italy for concessions to Greece. Leaders will have to decide. As of this writing, it looks likely that there could be some broad agreement to negotiate a deal, but not a deal itself. Greece will be asked to take a number of tough upfront measures, actions that will politically and economically stress the country beyond anything we have seen to date. If this is too much to ask, and it may well be, Greece’s exit from the Eurozone could quickly follow. The gridlock in Brussels reflects three basic forces at work. The need is massive. The Greek request was for €53.5 billion (around $59 billion) over three years, but the actual need is much greater. Factoring in a realistic assessment of the damage caused by the standoff, as well as a rapidly rising cost to recapitalize the banks, and the bill soars to over $80 billion for the three years. While more than half reflects debt service (total amortization over the period equals €30 billion and interest payments another €17 billion, the majority of which is owed to European creditor governments) the commitment of new money, after so many failed efforts, is proving to be a huge impediment to action. The financing gap also forces the IMF back to the table, as their money will now be needed. The dire state of the Greek economy has forced realism, making kick-the-can solutions harder to justify. Trust is missing. The standoff of the last several months has destroyed trust between the sides, making it far more difficult for some governments (Germany importantly, but they are not alone) to accept the political and financial costs of a multi-year financing package when so much depends on implementation by the Greek government. In an odd way, the decision by the Greek government to do a U-turn on Thursday and in essence fully accept creditor proposals that it had previously railed against validated skeptics’ view that their commitment to implement reform is weak. The program is likely to fail. To paraphrase a popular commercial, finance ministers negotiate deals: that’s what they do. But getting a deal done isn’t success unless it charts a course for Greece to become competitive and generate sustainable growth within the eurozone. Otherwise, any deal—even if Europe bends on debt relief so that the numbers add up—is a bridge to nowhere. I still believe there is a path forward for Greece—a “grand bargain” that combines a massive reform effort with massive financing and debt relief—but the window is narrow and there is no doubt that the events of the past month have raised significant doubts among European leaders as to whether Greece—economically and politically, can manage a transition where previous Greek governments have failed. Even the best designed program begins with a high probability of failure. At the same time, it is hard to see how Greece can survive much longer without an up-front infusion of cash that keeps euros in the ATMs and supports private activity. This will require forbearance on the part of the ECB, and that in turn requires backing from leaders.  As I have argued from the start of this crisis, ultimately it is domestic economic and financial conditions, and the stress caused by arrears and a breakdown of the Greek financial system, that will determine the timing of the Grexit decision. From caterpillar to butterfly Slovak Finance Minister Peter Kazimir on Saturday summarized his skepticism in a tweet: Following latest developments, listening to #Greece govt officials one can wonder how quickly can caterpillar turn into butterfly #Eurozone — Peter Kažimír (@KazimirPeter) July 10, 2015 To do that in the first instance means quickly implementing a number of early actions that show a commitment to reform, and agree on a number of additional actions. According to leaks this morning, those additional actions include: (i) Ambitious pension reforms to fully eliminate the pension deficit (currently, the drain on the budget from pensions stands at around 10 percent of GDP); (ii) More ambitious product market reforms ; (iii) Privatization of the electricity transmission network operator (ADMIE); (iv) On labor markets, best practice on collective bargaining, pay and labor practices inconsistent with Syriza election promises; and, (v) Aggressive actions to clean up the banking system. Finland already has made clear its opposition to any deal, and finance ministers from a few other small countries have signaled their concerns. Under the EU’s emergency procedures, a deal can be agreed with support of 85 percent, so that small-country opposition cannot stop an agreement, but it raises the political hurdle for leaders already under pressure from legislatures back home. A further impediment at this point is Germany’s steadfast refusal to accept a nominal haircut on the debt, which it sees as a violation of EU rules and a dangerous precedent. While very substantial debt relief can be provided through a further extension of maturities and low interest rates, the IMF has already made it clear that it thinks that nominal haircuts will eventually be needed. And, given the significant austerity that is being asked of it, it will be difficult for the Greek government to sign a deal that doesn’t contain at least a nod in this direction. In the first post on this blog, I called for a Paris Club for Europe, an idea Germany has for the first time yesterday hinted at in a non-paper circulating at the meeting. Something along these lines will need to be part of any long-term solution if indeed we are to see a butterfly take flight.

Another cliff in the never-ending Greek drama, as European leaders set a Sunday deadline for a deal. It’s easy to be cynical, but Europe could look very different next week. I now think that “Grexit” is very likely, and it could happen soon. Later today or tomorrow, the Greek government will unveil its financing and policy proposals, launching what is expected to be an intense set of negotiations over the next several days. In a telling move, it was announced that all twenty-eight European Union leaders plan to meet on Sunday to discuss contingency plans for a Greek exit from the euro, but not the European Union. If there is an agreement in principal by then, the meeting can be cancelled (and presumably replaced by a meeting of the nineteen euro area members to approve a Greek deal). Statements from the European Central Bank also signaled that if there were no deal by Sunday, it would be forced to end its emergency assistance to the Greek banking system, which would precipitate the immediate and full failure of the banks. In a further setback, a scheduled meeting of finance ministers was cancelled this morning and it was announced that the Greek proposals would be dealt with in a working group.  There is a lot of work to do and not much time. After months of false showdowns, there are a number of reasons to treat Sunday’s deadline more seriously. Conditions in Greece are deteriorating rapidly. ATMs are close to running out of euros, which will cause severe problems for pensioners and others dependent on the banking system and cash. Further, the lack of finance and imports is increasingly disruptive to private activity—supply chains are breaking down, critical inputs running short. These conditions will put immense pressure on the Greek government to issue IOUs and change laws to put purchasing power in the hands of those most in need. That means a new currency in practice, if not in law. These measures quickly will become hard (but not impossible) to reverse. On the creditor side, we should not underestimate the role of rising parliamentary and public opposition to another bailout for Greece (and not solely in Germany). This limits the willingness and ability of leaders to compromise (more than finance ministers, leaders feel this pressure). There was a strong expectation among leaders that the Greek government would present a concrete proposal yesterday. When they did not—their informal ideas on a two stage approach with bridge financing for reforms setting the stage for a bigger deal later represents a step backwards in some respects—a perception that Greece does not want a deal became further entrenched. There were some small bits of good news from yesterday’s meetings. The cross-party statement of support Prime Minister Tsipras received over the weekend and the statement by the new finance minister yesterday called only for initiation of a meaningful discussion on the necessary restructuring of the debt. That was a softening of their earlier demand for a hard commitment to debt relief, and seems more feasible. Further, though a reported French-led effort to generate some concessions to Greece through a two-stage approach flopped, there does seem to be momentum (backed by EU bureaucratic machinery) for continued, serious negotiations in coming days. Sunday is not a final deadline. There are creative ways to find bridge financing (including addressing a large July 20 payment due to the ECB) so that even without a deal, it will still be possible to pull Greece back from the brink in coming weeks. The primary impediment to a deal at this stage is policy, not financing.  A combination of frustrated creditors and growing pressures on the Greek government mean that dramatic policy reforms are needed for Greece to survive within the eurozone, and I sense little room for compromise on the part of creditors. There seems to be a belated understanding that populism and fixed exchange rate regimes make poor bedfellows. The Tsipras government will need to commit to tough reforms, crossing many if not all of their red lines on pensions, taxes, and labor markets.  It is time for Greece to decide.

Now that Greek voters have voted “no” in the referendum, the government is engaged in a last-ditch effort to reach agreement with its creditors on policies and financing; if an agreement is not reached soon, a rapid move to a new currency appears likely. Among those who hope for or predict an agreement between Greece and its creditors that would keep it in the eurozone, there is a widely held belief that introduction of a new currency will be difficult, perhaps prohibitively so. Amid crisis and chaos, efforts by a discredited Greek government to reintroduce the drachma (or some new currency with a different name) would lead to further economic chaos, rapid depreciation, and hyperinflation, the story goes. Some have argued that a currency reform would fail, leaving Greece euroized like Montenegro—without an effective currency and operating on the euro but outside of the eurozone. In fact, the opposite is the case—introducing a new currency is the easy part; much harder is the task of building a social consensus—inside or outside of the euro—for sustainable and growth-promoting economic policies in Greece. Drachma or Euro: The Pressure to Decide Much of the discussion about whether Greece should remain in the euro has focused on whether it is truly a part of Europe’s optimal currency area, and whether there is a path for Greece within the eurozone where it can be competitive and grow. Even those who believe the answer is “yes”—including the IMF—acknowledge that the path for success is narrow. There is likely one last chance to reach agreement on a comprehensive agreement that combines significant policy reform with up-front debt reduction and adequate financial support. As of this writing, Greek banks remain closed and ATMs are about to run out of euros. This means that the formal payments system consists of electronic transfers between Greek citizens into accounts whose balances cannot be converted into cash. The economy, to the extent that it is operating, relies almost exclusively on barter. In this environment, Greece shows three characteristics common to many countries that have chosen to reform or change their currencies: (i) a government that was unable to finance essential services (i.e., a fiscal crisis); (ii) a government that sees politically unacceptable distributional consequences to remaining fully reliant on barter; and (iii) a government that has sufficient legal and political control to enforce the currency used in commerce within its borders. The government could begin to issue IOUs to address the fiscal issue, but not the distributional costs of the bank closures. There is a broad group of Greeks, including pensioners, who rely on cash from ATMs to survive. An IOU, unless it can be easily bartered for goods and services, will not address their concerns. In some cases—for example Argentina before it exited its currency board in 2002—a market for such IOUs developed that allowed cash to circulate within the economy. The deep discount on those IOUs then became a proxy for the value of the new currency that ultimately replaced them. Here, however, without a credible bank-based payments system, it is hard to see such a market surviving in Greece. In this environment, the pressure to change currency policy is substantial and immediate. The critical question from this perspective is not whether such a move meets the test of an optimal currency area. That question is usually answered with an assessment of whether the geographic and policy situation makes the currency an effective store of value, unit of account, and medium of exchange—the well-established purposes economists look to in assessing the efficiency of money. Rather, it’s whether the state has the authority to implement the move—that is, can it force citizens to accept the new currency within the country’s borders. And from this perspective, even amidst the chaos, the answer in Greece is a “yes”. This idea, that decisions on currency are ultimately driven by questions of state power, is what Charles Goodhart has called the “cartelist” theory of money. As Goodhart and others have pointed out, there is a strand running through cases as diverse as the Roman’s use of a cow (or “pecus”) standard for its currency, the U.S. confederacy’s rapid introduction of a new currency after the Civil War began, or the break-up of the former Soviet Union: the evolution of money is linked to the needs of the state to increase its power to command resources through monetization of its spending and taxing power. Currency Reform Lessons A successful currency reform requires a number of conditions be met over the medium term, including implementing legislation, issuance of new notes and coins, and measures to recapitalize and reopen the banking system. (Joe Gagnon has a very nice discussion of what is needed.) But there is a rich diversity of experience with the introduction of a new currency, which reminds us that this rarely happens by the book, particularly when the change is driven by an economic crisis. In the extreme, introduction of a new currency can be as easy as the government stamping the existing notes with a mark as a transitional measure until the new currency is designed and printed. Brazil’s transition from the cruzeiro to the real began by establishing “units of real value” as market-based units of account, and gradually adding other functions as the currency moved to have status as a legal tender. These moves were back by fiscal consolidation.  The Real Plan showed that a gradual transition can soften concerns about weak monetary institutions. Analysts also often point to the breakup of the former Soviet Union for examples of countries that moved to introduce their own currency only after detailed planning and preparation. But, of course, that was not always the case. In June 1992, months before the total collapse of the ruble-zone was a certainty, Estonia was the first of fourteen countries to break from the currency union. Over a long summer weekend, Estonia abandoned the monetary union and relaunched the kroon as the sole legal tender. The Bank of Estonia, which a year earlier had had only twenty-five employees, had neither the experience nor institutional capacity that the Bank of Greece has today; and tensions with Russia/CIS made it difficult to discuss settlement arrangements for a currency transition. As a result, the currency fluctuated wildly at first, though it eventually stabilized and provided support for the subsequent economic transition. Tight fiscal policy and structural reforms complemented the rigidity of the currency board, and eased Estonia into a market economy. There are costs to these types of transitions, notably in a reduced credibility of the new currency. A rapid introduction of a new currency raises the risk of counterfeiting, fraud, or abuse. But, in the end, it is overall macroeconomic and structural policies that are most important to determining the success of the new currency, rather than logistic or legal questions. Currency transitions must be accompanied by simultaneous structural reforms that enhance the credibility of the new currency and support the transformation of the economy. I have argued elsewhere that there is one last chance to get a deal that keeps Greece within the eurozone, and if that fails an exit makes most sense for Greece and for Europe.  But absent a better policy mix than has been seen so far, depreciation and default will not provide the basis for long-term growth. Today, achieving these structural reforms appears a hard task for any Greek government.

This is a guest post by Amanda Roth, a former intern for the Council on Foreign Relations Africa Program. She is a recent graduate from the Columbia School of International and Public Affairs, where she studied international security policy.  According to the International Organization for Migration, 23 percent of the 170,100 refugees that arrived in Italy by sea last year were from Eritrea. In a country of only 6.3 million, the United Nations estimates that approximately five thousand people flee every month. Eritrea has been largely ignored internationally, but increasing numbers of refugees, a growing diaspora community, and the regime’s involvement in instability in the Horn of Africa may mean that it is time to take a closer look at the police state that has been called the “North Korea of Africa.” Earlier this month, the UN released a report illuminating the country’s horrific conditions and accusing the Eritrean government of “systematic, widespread, and gross human rights violations.” The report is only the latest to condemn the government of President Isaias Afwerki, who has ruled the country without elections for more than twenty years and exerts control over nearly every aspect of daily life. One of the primary reasons that Eritreans are fleeing is the forced national service that all Eritrean men and women must complete. Citing the country’s violent conflicts with Ethiopia (from whom it gained independence in 1993) and other neighboring countries, the government maintains one of the largest armies in sub-Saharan Africa. Men and women are forced to serve indefinitely with little or no pay. One study found that the average length of service among former conscripts was six and a half years, although some served twice as long. Entire families go hungry because potential breadwinners must choose between forced conscription and fleeing the country. The UN report also outlined “widespread use of torture” and “ubiquitous” arbitrary detention. There is no free press, and Afwerki’s government operates a system of mass surveillance, with government informants everywhere. There is a severe shortage of food and basic goods. Because so much money and manpower is devoted to the military, there is very little internal capacity to meet people’s needs. Given these conditions, it is not surprising that the UN High Commission for Refugees counts more than 400,000 refugees and asylum seekers from Eritrea, approximately 6 percent of the country’s population. Even the Afwerki regime’s alleged "shoot to kill" policy on the border does not dissuade thousands from fleeing. However, even if individuals do manage to escape, they are not safe from the government’s reach. There have been reports that Afwerki supporters working as translators in Europe inform the Eritrean government about the private statements migrants make during asylum hearings. Eritrea uses extortion and threats of violence to exact an involuntary tax from the diaspora. The government also allegedly tortures and punishes deserters’ families that remain behind. As Europe continues to debate how to respond to the migrant crisis along the Mediterranean, there are repeated calls for the European Union to attempt to address the “root causes” that lead tens of thousands of migrants to flee. The UN report, which states that the Eritrean government may be guilty of crimes against humanity, casts a harsh light on some of these root causes in one of the world’s most brutal dictatorships. Countries and international organizations seeking to address Mediterranean migration should take notice.

There are reports this morning that the Greek government has made a new proposal (PDF) to break the deadlock, involving a two-year bailout program to be funded from European facilities (e.g., ESM) and with explicit debt relief, but without the IMF financial involvement. Eurozone finance ministers will review the proposal in a call tonight. Details are still limited, and I do not expect any agreement today (i.e., the IMF payment will be missed).  But a few initial thoughts. For this to be acceptable to creditors, the Greek government would need to accept the policy proposal tabled by creditors on Friday, with very minor modifications. This would represent an extraordinary U-turn by the Greek government, and breach all their previously stated red lines. Initial reports on the proposal do not mention policies, only the request for an extension of financing that on its own would be rejected.  I have no sense of the government’s motives, but it is possible that the significant distortions associated with the banks closing were a factor in the decision to make a new proposal. If agreement can be reached on policies and there is a commitment to renewed negotiations on financing/debt relief (the German government has said actual financing negotiations must come after the referendum), the government could then campaign for a yes vote in this weekend’s referendum, relieving pressure on the government to step down if the yes side wins. Agreement on policies would potentially allow the ECB to increase emergency liquidity under its ELA program, a necessary condition for banks to reopen.  This is a very narrow path to navigate. Because the previous bailout program expires tonight, entirely new financing arrangements would need to be devised. On the negative side, this is a much heavier lift because a new financial program would need fresh approval from parliaments already exhausted by the Greek saga. On the positive side, an underappreciated point is that by starting with a clean sheet of paper it gives parity to debt relief proposals that had been ruled out previously because they were not in the program.  I think both the IMF and U.S. government would support the greater emphasis on debt relief. Another last minute and chaotic scramble—not a great way to run policy.

This is how Grexit happens. Following the collapse of negotiations between Greece and its creditors, the European Central Bank (ECB) has halted emergency liquidity assistance. Facing an intensified bank run, the Greek government on Sunday introduced banking controls and declared a bank holiday. With substantial wage and benefit payments due this week and local banks out of cash, economic conditions are likely to deteriorate quickly in Greece ahead of a planned referendum for July 5 asking Greek voters whether the government should accept a creditor-backed reform plan. Creditor governments have left the door open for an agreement, one that if fully implemented and coupled with debt relief could be transformative for Greece. But that deal never seemed close and now seems out of reach. I am skeptical that economic or political conditions exist to allow a prolonged period of controls (e.g., Cyprus). Pressures to exit the euro and monetize government spending will become acute, and could outpace the sort of political transition or realignment within Greece that would allow a deal. Where are we? First, here’s a quick review of the weekend. On Friday, the Greek government surprised creditors by rejecting their compromise proposal and announcing their intent to hold a referendum on the plan on July 5 (with a “no” recommendation from the government). Markets had rallied on expectation of a deal, and even deal skeptics thought negotiations would continue up to and after the June 30 deadline for making payments to the International Monetary Fund (IMF). Eurozone finance ministers reacted sharply, announcing that negotiations had ended and that discussions had turned to “Plan B." This led several ministers (perhaps alluding to Greek Finance Minister Yanis Varoufakis’s frequent references to game theory) to suggest it was “game over." Late Saturday night, Parliament approved the referendum for next Sunday, July 5, and the proposal now goes to Greece’s president, Prokopis Pavlopoulos, for approval. Unless the vote is called off, and given the escalating rhetoric domestically against creditor governments, it is difficult to see the Greek government returning to the table before that vote. Given these developments, on Sunday the ECB suspended the provision of additional liquidity under its emergency lending facility (ELA). It is hard to fault the ECB: the additional liquidity provision (€9 billion in past week alone) had required forbearance under their rules, and had been justified by continuation of the negotiations. It is my understanding that should there be formal finding that Greek banks are insolvent, the ECB would need to end the program, but for now a freeze in access at current levels is a significant forcing event. Lastly, Greek Prime Minister Alexis Tsipras this evening announced the imposition of broad banking and capital controls. All banks--including branches of foreign banks--will remain closed for six business days, until after the referendum.  ATM withdrawals will be limited to €60 per day (foreign bank cards would be exempted, presumably as a concession to the tourism sector).  Wages can be paid online, but there will be tight controls on transfers abroad. This leaves unanswered the extent to which payments can be made electronically within the country.  The Athens stock exchange also will be closed for an indefinite period. What’s next: Four Points Banking controls and a banking holiday will cause a rapid deterioration in the Greek economy. Economic activity in Greece has already been badly damaged by arrears and a loss in confidence, and disintermediation of the banks has been reflected in greater reliance on cash-based transactions. Households reportedly have hoarded euros, but firms have been stretched by the crisis. Going forward, reduced expectations for a deal, concerns about currency redenomination, and limited availability of euros all work to trigger a cascade of business failures, rising numbers of non-performing loans, and further reduced tax compliance. Moreover, around 75 percent of Greek primary government spending is for pension, wages, and benefits, and large payments are due in coming days. Without an operating banking system, the dislocation from non-payment of these obligations will be substantial even without the panicked bank lines that formed Sunday night. External default will have a lesser effect in the near term. There is little doubt now that on Tuesday the Greek government will miss its €1.6 billion payment to the IMF, and the Fund’s board likely will move quickly to enact its normal procedures for arrears. I do expect European governments to show restraint and not call their loans in default based on the IMF move, but it will make any program in the future more difficult to negotiate and finance. A Cyprus-like extended period of capital controls and restructuring within the eurozone does not look economically or politically viable for long. In a situation of severe financial stress, the government will quickly have to decide whether to issue IOUs to cover its expenses. In this case, a de facto "dual currency" would start to circulate domestically. If there was a creditor-backed program in effect, and the ECB was providing liquidity (as for example, was the case in Cyprus), this situation could be sustained for a period of time while debt is restructured and banks recapitalized. IOUs would trade at a discount, but those in critical need of liquidity could find it. That will not be the case here, and further the existence of a primary deficit means that the government will be unable to finance high-priority social spending. There may be some useful lessons to be learned from the Argentina default, where dislocations were reduced by developing a secondary domestic payments system that allowed for transfers within the country between frozen accounts. Even in this case, the government paid a high political price for reneging on their commitment to protect depositors.  From this perspective, the focus should be on what happens in the week after the referendum, as cash balances are exhausted and when pressures to reopen the banks will be strong.  In this environment, the incentive to turn to the printing press will be substantial. Contagion will be less than in 2010, but we should still be worried. European policymakers are at least publicly sanguine that there will be limited contagion from this weekend’s developments. No doubt, we are in better position than 2008 and 2010, given European rescue facilities that have been put in place, other reforms (e.g. banking union) and the existence of the ECB’s quantitative easing program (QE). Further, there is limited bank exposure and most of the debt is owed to the official sector, limiting the risks from financial market interconnectedness. The Eurogroup and the European Central Bank have both signaled their intent to “make full use of all available instruments to preserve the integrity and stability of the euro area.” Taking a page from the U.S. crisis playbook of 2008, that indicates a willingness to bring overwhelming force in coming days. At a minimum, it suggests aggressive purchase of periphery sovereign debt (which is already allowed under the existing QE, though statements suggesting an extension of the policy may make sense), additional liquidity operations, and perhaps even the activation of swap lines. Still, I suspect markets have underpriced the risk of dislocations in coming days. In addition to poor positioning by investors that came back into risk assets on hopes of a deal and limited market liquidity, markets can now no longer avoid acknowledging that substantial loses will need to be borne on Greek assets. Questions may also be raised about debt sustainability in other periphery countries. Any sense of a loss of political resolve elsewhere in the periphery also will be a source of contagion. My expectation is that the rise in sovereign spreads will be modest, with the main contagion seen on assets the ECB does not buy under its QE program. That could include bank stocks and high yield bonds. The euro should see a significant depreciation against the dollar, reflecting expectations of extended monetary easing from the ECB with a safe-haven effect towards the United States. This safe-haven effect could be counterbalanced if markets believe the turmoil in Europe will delay the Fed’s plans for an interest rate increase. The referendum freezes negotiations, but neither a “yes” nor a “no” vote creates a clear path to a deal. Early polls suggest a small advantage for the yes position–that Greece should agree with creditors on a package—but local analysts caution against reading too much into these early reads. In particular, it may be much easier to campaign against austerity (with government support) than for tough reforms. Much will depend on the reaction to the bank controls, and opinion polls will drive markets in coming days. There is a broad consensus that a no vote on July 5 would strengthen the government’s resistance to a deal and make an eventual Grexit more likely. Even if the referendum passes on July 5, it is unclear that it would lead to rapid agreement on a new package. First, the government has rejected the terms on the table, so that trust that they would implement any agreement is low. Further, the financial package offered last week would have expired once the current program ends on June 30. Of course, creditors could offer those terms again, but that would require a new program and new parliamentary approvals, substantially raising the political impediments to a deal. In sum, time is short to avoid exit. The week after the referendum could be decisive.