Is Grexit Back on the Table?

Defying the expectations a few months ago, Greece remained in the Economic and Monetary Union.  It recently succeeded in implementing sufficient reforms to earn another tranche of aid.   However, the entire exercise exhausted whatever trust there may have been.  It has also further soured Greece's attitude toward the EU. This leaves officials ill-prepared to deal with other issues.

The refugee challenge is such an issue.  The Financial Times reported that some EU officials are threatening to suspend Greece from the Schengen Agreement, which allows for passport-free travel since 1985.     At the heart of the issue is Greece's inability or unwillingness to tighten its borders and registration of the some 700k refugees.

Greece (and Italy) are frontline states for the people fleeing Syria, Libya, and other parts of Africa. They have complained of not receiving sufficient support from the other European countries. However from the EU point of view, the real situation is more like the old adage of taking a horse to water, but unable to make it drink.

The issue, they say, is that Greece has refused to accept the help that has been offered. Specifically, it has not called for a special mission of Frontex, the EU border agency that could assist. It is also unwilling to accept the humanitarian aid offered.  Greece has also refused to improve its own processing efforts.

The home affairs ministers will meet before the weekend.  The idea is that Greece will be given until the heads of state summit in the middle of the month to begin addressing these deficiencies or proceedings will begin, which could take three-months, that would lead to Greece's suspension from the Schengen Agreement.  To be sure, this agreement is not the same as EMU, so it would not be a Grexit in that sense.

However, many see Schengen as a keystone to EMU.   The essentialists have made numerous claims of what is truly necessary for EMU.  When Cyprus was forced to adopt capital controls, some said this negated monetary union (a euro in Cyprus was not worth the same as a euro in Rome or Madrid, let along Frankfurt).   We argued against such claims at the time, and there is not doubt that even though Greece too has had to put capital controls into place, that both countries remain members of EMU.

Why is Greece dragging its feet?  There appear to be technical and political reasons.  Greek laws, it appears, require the country's external borders to be monitored by Greek nationals.   There are also some other idiosyncratic reasons offered.  There is an unspoken reason that could be key.  From a Greek perspective, the country has already experienced a profound encroachment on its sovereignty.   Remember the key link is between solvency and sovereignty.  Greece's problems with the former lead to the erosion of the latter.

Some observers also suspect that Prime Minister Tsipras is seeking more concessions from EU. This is realpolitik.  It depends on which side of the negotiating table one is on.  It could be shrewd negotiations.  It could be obstructionist.

As was the case this summer when we were among the very few that did not expect Greece to be ejected from EMU, so too we do not expected Greece to be suspended from Schengen Agreement. Instead we anticipate a compromise will be forged.

There are other reports that deny that Greece has been threatened with suspension, including from the EU presidency, which resides in Luxembourg presently.  Indeed, from the heads of state summit later this month, it is possible that an agreement is reached, at least in principle to create a joint border force that would be charged with defending the external frontiers of the Schengen area, even if it is against the wishes of frontline states.

Greek officials argue that it has already spent 1.5 bln euros despite its fiscal straits to address the refugees challenge.   They claim that request Frontex assistance for its sea borders five months ago.  However, the government refuses to allow Frontex land operations.  After all Greece does not share a land border with and Schengen member.

While the prospect of diverging monetary is the key driver of the euro (and we note that the US premium over Germany on two-year money is at new multi-year highs today), the erosion of the Schengen Agreement, with border checks reintroduced, and the possible suspension of Greece, does little to build confidence in the European project.  It also does nothing to help Greece.  The 10-year yield has risen 53 bp over the past week, and 12 bp today alone.  Greek equities have fallen by about 2.6% over the past five sessions, while the Dow Jones Stoxx 600 is up about 1.2%.