Three months have passed since the Greek government took office promising a fundamental renegotiation of the country’s EU/IMF bailout terms. But so far it has managed only to trash the nascent economic recovery that appeared in place at the back end of last year. Uncertainty is weighing on private spending, the banking sector is haemorrhaging deposits, leaving it reliant on emergency central bank financing, while the government is controlling expenditure by withholding payments. Opinion polls suggest that government approval has near-halved. And appalling diplomacy – personified by Finance Minister Varoufakis – has alienated creditors, expunging any goodwill that might have provided the seeds of a more generous and lasting bailout settlement.

The destructive role of Varoufakis was illustrated at last week’s Eurogroup meeting when he was accused as a “time-waster, gambler and amateur”. So, Monday’s re-shuffle of the Greek bailout negotiating team, apparently side-lining him and his deputy from the detailed talks, has raised hopes that a deal might be unlocked. Indeed, PM Tsipras suggested later the same day that agreement might be reached by 9 May, in time to release funds before more than €750m is due to the IMF a few days later. But is that really possible?

Glimmers of light? At face value, there appear to be some signs of progress, most notably plans for the Cabinet to discuss this evening a new “omnibus” fiscal bill aimed at implementing a dozen of the commitments made in February, including revenue-raising and anti-tax-avoidance measures. But this is unlikely to be enough for the Eurogroup. The bill has been prepared without significant involvement of the Troika, only partially addresses what is being demanded, while including contentious or counterproductive elements. We therefore remain some distance from this “omnibus” bill representing the “global deal” needed to conclude the current programme and release the remaining €7.2bn of multilateral funds the Greeks need to have any hope of avoiding default and which are only available until end-June.

So, while there might now be agreement to lower the primary surplus target to a more achievable level – maybe 1-1½% of GDP – there is no agreement on how to deliver it. And for the creditors, maintaining the reform programme aimed at strengthening Greece’s low-growth potential and boost its ability to service its high and rising debt burden (>175% of GDP) is sacrosanct. Although they will grant the Greek government some discretion, they will not accept its plans to undo earlier progress in key policy areas such as pension reforms, minimum wage levels and collective bargaining.

So, we hesitate to interpret this week’s developments as compelling evidence of Tsipras switching to a more conciliatory mode. And for funds to be released in May, the Greek government needs swiftly to devise and start to implement a comprehensive reform programme that the EC, IMF and ECB deems acceptable. Achieving that before the 12 May payment of more than €750m to the IMF seems unfeasible, although, we do think the authorities will just about have sufficient cash to meet that payment. And we still see a scenario of belated agreement, perhaps securing a deal in early June, just about the most likely outcome, if only because the majority of Greeks wish to retain the euro.

Choices and risks ahead But for agreement to be reached in time, Tsipras needs to be laying the groundwork for a dignified retreat now. The longer he fails to start that process, the greater the risks of a disorderly outcome, not least because of the government’s ineptitude and Tsipras’ misjudged negotiating tactics. One way or another, Syriza needs to gain parliamentary backing to deliver something approaching the 20 February agreement. Tsipras might well be a sufficiently skilful politician to engineer the U-turns required. But it is far from clear that he could retain the parliamentary support of the radical left wing of his party – some thirty MPs and a handful of ministers – forcing him to seek an alliance with others, perhaps the centre-left parties To Potami and Pasok. And if insufficient MPs appeared ready to back a pro-deal alliance to compensate for the mutiny of far-left Syriza parliamentarians, a bailout-focussed referendum – already mooted by Tsipras – would seem likely to be required to force the issue. That could imply a delay to any disbursement of funds to July, leaving government and banking sector cash-flow vulnerable until then.

And, of course, Tsipras might just decide to continue to fail to acquiesce to the creditors’ reform demands, instead continuing down the dead end of offering too little, only to be rebuffed, ultimately allowing the end-June programme deadline to lapse.

And that would be the road to default. Quite how large Greek government cash reserves are right now is hard to tell. Greece might be able to scrape together the funds needed to meet IMF repayments due even in June. However, even if it can secure €3bn from prepayment of energy transit costs from Russia, to meet those obligations will also likely require spiralling arrears and perhaps also some recourse to IOUs. Additionally, capital controls might well be required by then, either because deposits fall even faster, Greek banks run out of eligible collateral or the ECB raises haircuts on Greek debt used in its operations. And with close to €4.5bn of bond redemptions and coupon payments due in mid-July, principally to the ECB, without the €7.2bn, Greece would by then be in default.

Extreme measures: The beginning of the end?Capital controls and even default need not imply exit from the single currency. As illustrated by Cyprus, which earlier this month unwound the remaining restrictions imposed in 2013, capital controls can be consistent with continued euro membership. Similarly, credit rating downgrades to default status (as briefly happened during Greece’s debt restructuring), or dependence on ELA when ECB refinancing facilities cannot be accessed (Greece’s collateral waiver was suspended once before, in 2012) need not automatically be followed by Grexit. However, the more extreme the measures upon which the government ends up relying, the more likely the end of Greece’s membership of the euro.

For example, international experience, e.g. in the US and Argentina, suggests that the issuance of formal government IOUs in lieu of payments could only ever offer a very temporary fix. Among other things, their introduction would accelerate the disappearance of euro liquidity from the banking sector and general circulation. And the greater their use, the greater would be the erosion of the tax base and hence the inability of the authorities to service debt in the future.

If Greece fails to repay the IMF in May or June, at face value the immediate consequences might not seem too harmful: a country in arrears to the Fund has two months grace before even a formal complaint is issued to the Executive Board. But Greece would immediately lose access to further resources from the IMF, specifically the €3.5bn share of the remaining €7.2bn funds from the current bailout programme. So, the amount of official sector funds available for disbursement would be almost halved, increasing the probability of default on the ECB bond repayments in July and/or August (totalling around €7bn) even if the shame of entering into arrears with the IMF somehow coaxed Greece belatedly into reform.

Indeed, crucially, default on bonds held by the ECB should be expected to have particularly potent consequences. If it has not done so by then, the ECB would have little option but to cancel emergency liquidity assistance (ELA) to Greek banks, whose solvency would be placed in doubt on account of their sizeable holdings of sovereign debt, their dubious capital structure, and explicit state guarantees on Greek bank. And without the provision of alternative liquidity by the Greek central bank, which could only take the form of a new currency, that would imply large-scale bank failures.

Time for responsible leadershipSo, if agreement with Greece’s creditors cannot be reached soon, the summer might yet see the Bank of Greece have no choice but to start printing an alternative currency. While there is arguably no legal basis for a country’s formal departure from the euro area, in this desperate scenario, associated questions such as whether Greece would immediately have to forsake its seat in the ECB’s Governing Council and even what happens to the Eurosystem’s large TARGET2 claims vis-à-vis Greece (currently around €100bn) would be of secondary concern. Whether this would technically constitute a “Grexit” would be a matter of semantics, perhaps of law, but neither will matter in the face of the huge economic and social costs that would ensue. And continued brinkmanship would set Greece on the slippery slope to that outturn. To avert it, Greece needs responsible leadership. Now.

Greece: Debt repayments

Source: Bloomberg, IMF and Daiwa Capital Markets Europe Ltd.

Greece: Private sector deposits and TARGET2 liabilities

Source: Bank of Greece and Daiwa Capital Markets Europe Ltd.