We have discussed the probability (around 50%) and possibility of a Greek exit from the Euro ad nauseum; how the post-election anti-austerity rage is bringing the world to a new realization that this is probable not possible and the widespread risk aversion of this event is much more of a global event than local - no matter how many times you are told how small Greece is. Critically, as BofAML notes, it is the systemic threat of an untamed banking and sovereign crisis in Europe which makes multiple-sigma events less 'tail' and more 'normal'. With money due to run out at the latest by July, new elections mid-June (that show massive support for the anti-bailout party), and the impacts on the real economy, exchange rate and inflation fears, and default and ECB balance sheet implications; it seems there are also strong incentives to keep Greece in. However, there is a political line of compromise and austerity that will be hard to cross for both parties which, if it failed - and it doesn't have much time - would mean a very fast 'ring-fencing' would need to occur for this not to thermonuclear with the three main channels of volatility transmission to the rest of the world being: banking and finance, trade, and confidence - all three of which are active already with Asian trade (and banking exposure) seemingly under-appreciated in our view with Singapore dramatically exposed with a stunning 60%-plus of GDP tied up in European bank claims.
Widespread risk aversion linked to fears of a Greek euro exit underscores the global nature of the European crisis. As we argued in the new year, the systemic threat of an untamed banking and sovereign crisis in Europe would push reluctant outsiders to preventively bolster IMF funding. This indeed materialized in March. However, both IMF and European firewalls still fall short of the amounts needed to protect Italy, Spain and the rest of the periphery. Global markets thus remain sensitive to rising probabilities of tail-risk scenarios. So how would the global economy be affected in the event of a serious adverse shock in Europe?
There are three main channels through which the volatility in Europe could hit the world economy: (i) banking and finance; (ii) trade; and (iii) confidence. These channels have already been active, transmitting the ongoing pull-back in European banks’ international exposure as well as the significant downturn in euro area activity seen since mid-2011. So far the retrenchment of global European banks from emerging markets has proved less disruptive than feared, while the damage to Asian exports appears worse than expected. The trade hit, however, may have been greater in Asia. But the greatest danger remains the threat of a severe blow to global sentiment.
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Risk reassessment
The much more significant risk comes if market panic and financial contagion runs ahead of the European response. A sharp withdrawal of reserves from other peripheral countries could lead to global liquidity concerns. European banks pulling out of the US market could be an opportunity for domestic lenders, but in a financial crisis, overall lending is likely to fall. The resulting flight to safety should strengthen the US dollar and push Treasury yields even lower. However, it would almost certainly produce an equity market sell off. More than half of the big moves in the stock market since the end of February have been at least partly the result of events in Europe, and European news looks likely to continue to dominate movements in the US stock market regardless of the resolution to the latest Greek drama. The resulting worsening of financial conditions and softer activity data would likely get the Fed to respond with additional easing, in our view. The key factor would be collateral damage to the US outlook. The Fed knows QE doesn’t do much to help Europe. (For more discussion, see this week’s Fed Watch.) Only a very bad outcome in Europe would be enough to trigger a US recession.
The bigger risk comes year-end, when US fiscal dysfunction will likely have its biggest negative impact on growth. If the US and European crises interact, and feed on one and another, a recession becomes a real risk. This would be a replay of Japan’s experience of the mid-1990s, when a combination of premature fiscal tightening and the Asian crisis triggered a recession and deflation.
Overall, we see about a one-in-three chance of a recession starting sometime in the second half of this year and the first half of next year.
This will be the third year in a row that uncertainty should rule the day in the spring and summer months — and the risk is that, given the fiscal debates in the US and Euro zone, a risk-off environment will drag on further. We foresee at least one more year of living dangerously.
The risks of a Grexit
The recent political paralysis has now brought Greece to what could prove to be the worst stage of its crisis. Following the failure of the elections of May 6, another election has now been called for June 17. The latest polls suggest the risks of a coalition government against the austerity programme, or no agreement on a government at all – are increasing. Although polls in Greece show very strong support for the euro, we believe that the current situation could trigger a chain of events that could lead Greece to exit on its own.
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If Greece were to exit, the implications would be profound both for Greece and the Euro area economy. This suggests euro zone policy makers would go a long way to keep Greece in the euro.
Real economy
Although Greece is currently expected to run a primary deficit of 1% in 2012, in the event of a Euro area exit the fiscal contraction would likely be more severe as receipts would fade away as households and corporate try to increase their savings. Consumption and investment would contract sharply. Exports would fall but imports would likely stumble even more. By comparison, when the Czech Republic departed from the Slovak Republic (1991), consumption contracted by 21%, investment 29%, and imports 33%. Overall, GDP contracted nearly 12%.
Greece has never known such a severe contraction. The worst recession was in 1974, when GDP contracted 6.4%. The IMF estimates Greece would go through a 10% GDP contraction in the first year of departure from the euro zone.
Exchange rate and inflation
The same IMF report estimates the real effective exchange rate for Greece could depreciate by 50% before recovering (over the course of four years) to about 85% of its initial level, thus boosting inflation by about 35% in the first year, recovering slowly to below 5% in about 4-5 years.
Default and the ECB
The ECB is exposed to Greece through two channels, repo operations of various maturities and emergency liquidity assistance (ELA). The respective amounts are €109bn and ca. €60bn. Should Greece default, we think it is highly likely that the ECB would terminate the repo operations. And, the ECB could veto the ELA, which would cause the Greek banks to run out of liquidity.
In this case, looking at examples from various emerging market precedents suggests two types of measures may help to avoid a massive run or limit the liquidity crunch: 1) Close exit channels, i.e., ring fencing the banking system, limiting access to cash and prohibiting transfers to foreign banks; and 2) using the central bank, in this case, the Bank of Greece, to provide liquidity by becoming the lender of last resort. That being said, it could also be the case that the ECB decides to keep some liquidity lines open to avoid a bank run (with possible spillovers to other euro periphery countries), or to let Greece pursue ELA under some monitoring.
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Finance Private sector balance sheets would be damaged by cross-exposure (which is very difficult to estimate), and then subsequently by inflation. Greek banks, significantly exposed to their sovereign would collapse in the wake of bank runs, the collapse of capital values and not having access to ECB liquidity (see below for a discussion of costs to the private sector in the euro zone).
For the Euro area, we assume that a forceful set of policy measures would be implemented, but they would nevertheless result in elevated costs. Greek assets of around €450bn could also be at risk of significant losses in the immediate aftermath of a Euro exit. In addition, a Greek exit could spill over to other countries, resulting in deposit flights threatening the stability of banking sectors and destabilising sovereign bond markets. As policymakers assess the effect of Greece leaving the euro, the high costs and risk of contagion will, in our view, raise the impetus to keep Greece in.
In our view, the situation in Greece is distinct from elsewhere in the periphery. So while expectations of spillovers may be understandable, they might not be rational. The euro governments may look to use pan euro deposit guarantees and capital injections to contain the potential contagion through the banking sector.
The ECB may commit to provide liquidity to banks and act as a backstop on the sovereign bond markets, provided the Bank was backed by the 16 euro governments.
And The Implications across asset class...
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