In June, a pro-euro Greek government was sworn in, pledging to bring the country's public finances back on track to avoid a 'disorderly' default and eventual Greek euro exit ('Grexit'). Despite the temporary respite provided by the election, Grexit risk is still fuelled by four destabilising factors: an economic depression, ongoing political instability, a social catastrophe and strained relations between Greece and its international lenders in the EU and IMF.

Between the third quarter of 2008 and the first quarter of 2012, the economy contracted by 16%, and the Economist Intelligence Unit expects a further decline of more than 7% this year and around 2% next year. The depression reduces tax revenues and rises welfare costs, making it highly unlikely that the government will meet the tough fiscal targets set by the troika of international lenders; the troika wants Greece to reduce its public debt from above 165% of GDP at end-2011 to 120.5% by 2020. However, the fiscal austerity measures and structural reforms outlined in the Memorandums of Understanding (MoU) that accompany Greece's two bail-outs (worth a total of €240bn) have so far only led to an intensification of the depression. With no growth in the economy in sight until at least 2014, debt reduction will be virtually impossible without further debt relief.

Despite the formation of a nominally pro-MoU government, political instability prevails. The three-party coalition is fragile: the centre-right New Democracy party won the election on a platform pledging to renegotiate the MoU, while its two junior partners (the centre-left Pasok and Democratic Left) are even more reluctant to implement the MoU given the social and economic costs. The centre-left parties, in particular, are also wary of the rise of a strong left-wing, anti-austerity opposition party, Syriza, which could win a new election if the government falls. These pressures decrease the government's ability to implement the MoU and receive further bail-out funds.

The social costs of implementing the MoU are reflected in a record-high unemployment rate of 22.5%, with youth unemployment well above 50%. Moreover, with public insurers often unable to pay their bills to pharmacies, a healthcare crisis is emerging, with major shortages of prescription drugs. These factors increase the risk of destabilising social unrest that could trigger a government collapse and eventual Grexit.

Finally, Greece's relations with its EU/IMF creditors have become increasingly strained, and the new government is desperately trying to restore some confidence. But Greece is still missing more than 200 MoU targets, including reducing the public-sector payroll and privatising state assets. The patience of key stakeholders, especially the IMF and Germany, could soon run out, leading to their withdrawal from the bail-out deal.

Restoring confidence is a priority

To overcome these risks, Greece will first have to restore confidence among its international creditors. The first step in that direction appears to have been made, with the government agreeing on additional budget cuts worth €11.5bn for 2013-14 in the hope that this will lead to a more positive troika assessment of Greece's MoU progress. Greece needs to secure the next bail-out tranche of €31.2bn in September. The troika will return to Greece for a final assessment of progress in early September. A negative assessment could result in withholding bail-out funds and 'Grexit' within weeks.

Another key deadline is August 20th when Greece has to repay two bonds worth €3.2bn, mainly held by the ECB. As Greece has not received any bail-out funds in recent weeks amid the political uncertainty, the country cannot currently repay the bonds. It has three options: 1) it can sell 3-month Treasury bills (but these are costly); 2) it may try to convince the euro zone to provide bridge financing; or 3) the ECB may grant an extension for the debt redemption. We think a compromise will be found, but the episode highlights that more cash flow crises are likely to occur even if this one is overcome.

Tough negotiations ahead

Developments in Greece will remain in the spotlight in 2013-14 when the government will hope to renegotiate the MoU's targets. However, even extending fiscal targets by two years (from 2014 to 2016) may require a third bail-out worth around €20-€50bn. Amid growing 'bail-out fatigue' in Northern Europe, this will be difficult to achieve. Moreover, with debt sustainability unlikely to be achieved through the MoU and given the lack of economic growth, there is a case for debt relief by the ECB, other central banks, the bail-out funds and other public holders of Greek debt--so-called 'official sector involvement' (OSI)--in addition to March's 'private sector involvement' (PSI) that reduced Greek government debt held by the private sector by more than 50%. Although OSI is already said to be discussed by Greece's creditors, it would be politically difficult to justify, not just by EU institutions but also by governments in countries such as Germany and Finland that face growing Euroscepticism among voters.

Does all this mean that a Grexit is becoming more likely? Not necessarily, at least in the short term. At the moment, the costs of Grexit for Greece and the euro zone are still too high. For Greece, the costs (hyper-inflation, banking-sector collapse, erosion of household savings etc.) currently outweigh the benefits (improved competitiveness, lower debt). Likewise, the euro zone would not only face direct costs (via trade and banking channels) but, more importantly, indirect costs (via contagion to other vulnerable countries such as Spain), that still outweigh the potential benefits (appeasing Eurosceptic voters, avoiding moral hazard etc). A key role for Greece's survival in the euro area will be played by the ECB: without its liquidity provisions to the Greek banking sector, Grexit would be almost inevitable.