The implications of a nation leaving the Euro (and its contagion effects) are becoming clearer but are by no means discounted by the market. The risk of an interruption in the Greek adjustment program has increased significantly - and as Goldman notes - is the most likely eventual outcome for Greece and fears of the missed interest payment in June continue to concern many. The tough decision and dilemma for the international community remains between a rock (of acquiescence and just funding a belligerent member state) and had place (ECB deciding to let Greek banks go) with an odd middle ground seemingly the most likely given Europe's tendency for avoiding the hard decisions. There is no doubt that the near term implications from such an unfortunate turn of events would be profound for markets; fiscal risk premia would widen, the EUR would decline in value and European equities would underperform. The true question though, is how much lasting damage such a situation can do and whether, in the long run, systemic risks can be contained. In principle, to the extent that no other country chooses to go down the same path as Greece, there is no political or practical hurdle for the ECB to crucially safeguard the stability of the Euro area with unlimited liquidity provisions. A liquidity driven crisis can be averted in that sense. Whether risk premia stay on a higher tangent after such an event is a separate and complicated question but game-theoretically it strengthens the renegotiating position of Ireland, Portugal, and obviously Spain with the ECB (and implicitly the Bundesbank) being dragged towards the unmitigated print-fest cliff.
Current Adjustment Program Nears its End
As we argued in our note on the Greek election result on Sunday, the risk for an interruption in the Greek adjustment programme has increased. After a few days of additional political developments in Greece, we now believe that an interruption of the programme is the most likely eventual outcome for Greece. More specifically, thinking through the reasonable scenarios:
- A (majority or minority) government is formed in the current parliament. It will likely be unable to legislate the types of measures required from Greece by June. Which means it will likely only serve to postpone elections for a very brief period of time.
- Elections are called (e.g. mid-June) and New Democracy is able to form a coalition government (with PASOK and other moderates) with a thin majority. Still, the pressure on this government from the fringes will be high. The moderate parties participating in this government will quickly decline in popularity and pave the ground for elections where the fringes are likely to stage a come-back with an anti-reform agenda.
- New elections are called and Syriza (Coalition of the Radical Left) leads the vote, becoming thus able to determine a core anti-reform agenda for the next government.
Of course there is always the case that, in fear of a payment miss in June, Greek people vote for a large majority government by New Democracy and PASOK. But the results of the last election round indicate that “fear” is not a sustainable strategy of passing structural reforms.
The Dilemma for the International Community
In the event that Greece brings the current program to an end unilaterally, its international lenders (countries of the Euro-area and the IMF) have three potential options to choose from:
- They continue to fund Greece beyond June.
- They interrupt the funding to the Greek government but allow the ECB to remain the unconditional lender of last resort for the country and/or
- They interrupt funding of the government and the ECB lets Greek banks go.
The first solution seems unlikely. First, countries under strict austerity policies are among the key providers of funding for Greece and such a decision would make it even harder to succeed in their own fiscal consolidation efforts. Second, it would likely send a contrarian message to other program countries that have not resorted to such practices (Portugal and Ireland). Third, even if the first two considerations were offset by systemic contagion worries, the current demands of the key anti-austerity parties would imply the commitment of additional resources (demands such as a reversal of structural reforms and cuts, retroactive compensation for past losses to taxpayers and public sector employees/pensioners, nationalization of the banking system, full moratorium on debt etc). Surely, the other Eurozone governments would find it hard to convince their own parliaments for the wisdom of such a move towards a country that has just defaulted on them.
The second solution seems more likely. On the one hand it implies a significant plunge in growth in a concentrated period of time as the primary deficit (worth about 2.3% of GDP in 2011) shuts down abruptly and arrears fail to get paid (worth about 3.5% of GDP) leading to a temporary disruption in supplies to public sector companies. Wage inflexibility means that the level of wages will likely be sticky and that the growth plunge is absorbed via higher unemployment. Product market rigidities also imply sticky inflation (or even higher prices). But at least, the banking system would stay up and running and the country would be able to avoid the consequences of a collapse of credit to corporations, households would be able to use deposits to smooth their income shortfall, exporters would still retain some marginal access to trade finance and importers would still supply the economy with basic goods such as energy, oil and food. It is worth highlighting that it is not unusual for an IMF program of the size and scale of the Greek one to experience periods of interruption.
The third solution is not impossible but we still think it is not the most likely outcome. This is because it implies extreme outcomes for the country whereby the activity shortfall discussed earlier (and its consequences) would be compounded by the collapse in private sector credit and a bank run (already the decline in deposits has been sizeable and has been met by an increase in ECB funds). Such an event would significantly raise the risk for a Euro exit and we think such outcomes are to no one’s best interests.
Whether the second or the third option materializes will likely depend on the degree to which a Greek government would attempt to interfere in the organic relationship between the ECB and the Bank of Greece by compromising the ECB’s monopoly in monetary decisions for the country (bank nationalizations, issuance of bills to finance deficit, non-servicing of bonds used by Greek banks as ECB collateral).
How Big is the Systemic Risk from such an Event?
There is no doubt that the near term implications from such an unfortunate turn of events would be profound for markets; fiscal risk premia would widen, the EUR would decline in value and European equities would underperform. The true question though, is how much lasting damage such a situation can do and whether, in the long run, systemic risks can be contained.
In principle, to the extent that no other country chooses to go down the same path as Greece, there is no political or practical hurdle for the ECB to crucially safeguard the stability of the Euro area with unlimited liquidity provisions. A liquidity driven crisis can be averted in that sense.
Whether risk premia stay on a higher tangent after such an event is a separate and complicated question beyond the purposes of this note. But crucially, the market assumption is that Greece is a unique case (even Portugese and Irish spreads for example have narrowed significantly from their highs). The extent to which Greece itself verifies that distinction with its own policy choices and its own actions will be key. The more Greece’s authorities try to actively move away from the Euro area institutional framework and opt for an economic regime shift, the more clearly they will confirm that Greece is indeed a special case as policy makers have so far claimed.