Greece: Paradise Postponed?

Andrew J. Belshaw
Head of Investment Management, London

Executive Summary

  • Given all the uncertainly surrounding the Greece situation, with Prime Minister Alexis Tsipras now calling for a July 5 referendum vote that takes the country past its June 30 IMF payment deadline, the probability of a Greek exit from the euro has risen.
  • The ECB and how it handles the Greek banking system’s funding needs will now be the focus of the market’s attention.
  • If Greece votes No on the referendum, Syriza will remain the ruling party and could become more emboldened. The EU may re-enter negotiations with Greece or, more likely, the situation will devolve into a standoff.
  • A Greek Yes vote would likely be the quickest way to a third bailout package. A new government may be formed, paving the way for more constructive talks with the Troika, but either way, the end result would be an agreement to a plan along the lines of the Troika’s previous proposal.
  • Whatever the outcome of the current situation, recent events will have a negative impact on the economic performance of Greece and potentially the eurozone over the coming months.

Update

In our previous note, we expounded the view that ultimately Greece and its creditors would come to an agreement over the extension of the bailout package as both sides had much to lose. That remains our view, but, clearly, after the events of last weekend, uncertainty has risen, as has the probability of a Greek exit, or “Grexit,” from the euro. Accordingly, we have moved from Scenario 1: Agreement/No Default (as presented in our whitepaper last week) to Scenario 2: No Agreement/No Technical Default.

Late Friday evening, Greek Prime Minister Alexis Tsipras walked out of talks with creditors and announced that the Greek government would hold a referendum on the terms of the bailout extension as proposed by the Troika. The referendum is scheduled for Sunday, July 5, crucially taking Greece past its June 30 deadline to pay the IMF €1.6 billion, which was postponed from earlier in the month. With no means to pay, the Greeks risk being declared in default. Whether it was a calculated gamble by the Greeks to force more concessions from the Troika or not, the end result has been to increase the stresses within the Greek banking system and heighten the risk of a Grexit.

The response from the EU was decisive. It declared the end of negotiations and increased pressure on the Greek government by formally withdrawing the offer under discussion, emphasizing that the bailout extension would expire on June 30. Effectively, the Greeks are now voting on a set of proposals that are no longer on offer!

With the end of negotiations, Greek citizens did the rational thing and intensified their withdrawal of cash from the country’s banks. This put the banking system under renewed pressure and the European Central Bank (ECB) in a political bind. Without recourse to Emergency Liquidity Assistance (ELA) funding, the Greek banking system would collapse, yet, if Greece was to default on its IMF debts (and was declared to do so) it would potentially trigger a range of cross-default clauses that would leave ECB financing untenable. Consequently, the ECB decided to leave ELA financing unchanged at €89 billion, leaving the Greek banks little buffer against further deposit withdrawal. The Greek government responded to the incipient banking crisis by declaring a bank holiday that will run until July 6, imposing capital controls on banks such that domestic depositors can only withdraw €60 per day and are banned from transferring money out of Greece.

With Greek banks and the Greek economy now in stasis, global markets await the result of Sunday’s referendum. Given investors' muted reaction to the events of last weekend, it appears that most expect the outcome to be one of acceptance of the Troika’s terms. This may be true, but, the coming days, weeks and months will be filled with uncertainty as the latest installment of this drama plays out.

How do we see events developing? Broadly speaking, we envisage three distinct stages:

The Next Week

This week, the ECB and its response to the funding needs of the Greek banking system will be at the forefront. This should be intensified when the Greek government fails to repay the IMF its rolled-up €1.6 billion loan, raising the issue of whether it is in default (arrears).

With the referendum less than a week away, we believe it is unlikely that either the ECB or the IMF would want to precipitate a worsening of the banking crisis or, in extremis, a Grexit. For this reason, and despite IMF Managing Director Christine Lagarde’s comments to the contrary, we believe the IMF will not immediately declare Greece to be in “arrears.” (Only Lagarde can make this determination.) This gives the IMF sufficient leeway to await the result of the referendum. If it does not decree Greece to be in arrears, this would take the pressure off the other creditors (ECB/European Financial Stability Facility) by preventing the activation of cross-default agreements.

For the ECB, the incentive is high to avoid being seen as the entity to expel Greece from the euro by withdrawing ELA funding. Despite being a rules-based institution, there is enough flexibility in the current situation to allow the ECB to maintain ELA, deeming the Greek banks solvent. By not raising the ELA cap, the ECB will not antagonise the “core” members of the council, while maintaining it at existing levels at least ensures the Greek banks can function, if on a much reduced level. Similarly, we feel it would be precipitant of the ECB to enforce higher haircuts on Greek collateral, and thus, unlikely before the July 5 result.

There is still an outside chance that a last-minute deal is reached between the Troika and Greece. Reportedly, EU Commission President Jean-Claude Juncker made a revised offer to Prime Minister Tsipras that could be acted upon. Given the heated rhetoric that has been exchanged over the last few days, and the sharp U-turn it would involve from the Greek government, the possibility, unlikely though it is, cannot be ruled out. If nothing else, the chance of an agreement highlights the fact that there are substantial differences of opinion within the Greek government, which may make the formation of a new government easier in the event of a Yes vote for the referendum.

The Next Month

Assuming no last-minute agreement is reached, the next month will be dominated by the referendum result and its aftermath. Whatever the result, if Greece is to remain in the eurozone, a third bailout package will have to be negotiated.

In our view, two results are possible.

1. A "No" Vote

Within Greece, this would be a vindication of the negotiating position taken by Prime Minister Tsipras, strengthening his position politically. Syriza would remain the ruling government party and it would likely feel emboldened to extract more favourable terms from its creditors.

The outcome from here would depend on the EU’s response and the depth of its commitment to keeping the eurozone intact.

In the benign scenario, the EU would be willing to re-enter negotiations with the Greeks on the basis of relaxing the terms previously agreed upon. To facilitate the necessary time needed for agreement, the ECB would maintain its ELA funding and perhaps raise the Treasury bill ceiling to allow the Greeks to repay the missed IMF payment. With Greece likely to miss the July 20 €3.5 billion ECB bond repayment, this would not be deemed as an event as Greece was in the midst of negotiations for a new package. Eventually, agreement would be reached allowing Greece to remain in the eurozone and credit controls to be lifted.

We view this benign scenario to a No vote as unlikely. It would be a stark reversal of the EU’s current position and engender a degree of moral hazard with the other periphery nations that would be unacceptable to a large majority of the EU member states. For this reason, a No vote would be more likely to descend into a standoff.

With positions entrenched and no flexibility likely to be shown by either side, the outcome may ultimately be decided by non-political actors. The IMF could make the decision to declare the Greek government in arrears, triggering cross-default clauses with the IMF and ECB that would result in the withdrawal of support for the Greek banking system, thereby causing its collapse and the de-facto end of Greece’s membership in the eurozone. A more likely catalyst is the Greek bond maturing on July 20 that is held by the ECB. Non-payment would likely cause the ECB to either restrict ELA funding by applying higher haircuts on collateral or cease ELA altogether. This would lead to a banking collapse in Greece, more capital controls and ultimately, the introduction of a scrip currency to facilitate transactions. Undoubtedly, the Greek government would attempt all legal measures to remain part of the eurozone, but ultimately, would be forced out to enable it to recapitalize its banks (with a new currency) and begin the long haul back to economic stability.

2. A "Yes" Vote

From a market perspective, this is the most likely outcome and the one that should quickly lead to agreement over a third bailout package. The immediate reaction to a Yes vote would be felt domestically in Greece. It is hard to see how Prime Minister Tsipras could continue to lead a government having advocated the opposite view. A new coalition or government of national unity could be formed, paving the way for easier and more constructive talks with the Troika. In extremis, a new election could be called. This would not be preferable as it would take time and exacerbate the hardship in Greece as it would remain outside a bailout mechanism. Either way, the ultimate outcome would be an agreement broadly on the lines of the previous proposal, perhaps with some debt restructuring thrown in to ameliorate the reform process and “reward” a new government. With an agreement in place, the ECB would then decree Greek assets eligible for quantitative easing (QE) operations and the pressures would lift off the banking system as ELA and Treasury bill ceilings would be lifted.

The Next Six Months

Whatever the outcome of the current situation, recent events will have an impact on the economic performance of Greece and potentially the eurozone over the coming months. The freezing of the Greek bank system and the resulting downturn in activity is likely to force the economy into recession. This, in turn, will worsen the fiscal projections and, at worst, increase pressure for more austerity and reform or, at best, lengthen the adjustment period.

A bigger concern is the effect the current situation may have on the wider eurozone economy. Having engendered a recovery, and a more sustainable recovery at that, with domestic demand in core countries leading the way, the ECB should be worried that the Greek situation could have a significant negative impact on general sentiment such that the recovery starts to wane. If domestic households begin to save more as a precautionary measure, or, in the case of periphery economies, withdraw bank deposits, current growth forecasts will prove optimistic.

As the only player in town, the ECB will have to respond to the situation created by Greece. Monetary policy will have to be aggressive, and if uncertainty persists, an acceleration in QE will be needed. By lowering the current yield curve structure and preventing contagion by lowering premiums on risky assets, the ECB can ensure the economic recovery remains on track. Ultimately, in our view, the Peloponnese will not dictate what happens in eurozone financial markets. The outcome of the referendum vote may add to near-term volatility, but it will be the ECB, through its pursuit of its monetary policy objectives, that will determine the behaviour of financial assets in the eurozone.

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