Exit from the Euro would be very painful for Greece. Cut off from the ECB’s liquidity facilities, the Greek banking system would face collapse. And, as foreign lenders cut their credit lines to Greece and depositors struggled to extract their deposits ahead of the banks’ failure, the Greek financial system – and with it the Greek economy – would seize up. Given the costs of exit for both Greece and other Euro area countries, a powerful incentive exists for the two parties to reach a compromise that permits continued Greek membership of the Euro area but in the meantime the pan-European game of chicken continues and with each iteration of this game, the political cost to the two parties involved has increased. Goldman sees three key scenarios from this: Muddle Through (this is their 'Goldilocks' base case and implies continued Greek EMU membership, and ECB funding for Greek banks, but also continued pressure on Greece to reluctantly implement reforms while at the same time the remaining Eurozone countries very gradually deepen their policy integration) - which is modestly positive (though likely more range-bound) for equities and bonds with weak growth and Fed QE3 potentially pushing EURUSD up to 1.40; a Fast Exit (the least likely and most bearish scenario with Greece walking away unilaterally potentially knocking 2 percentage points of Euro-area GDP - even assuming substantial central bank counter-measures - and if the firewall were ineffective, a Euro-unraveling and an associated double-digit fall in Euro-area GDP); and a Slow Exit (Greece excluded once firewalls are in place - with pan-European deposit guarantees now front-and-center as opposed to simple banking bailouts to avoid the now-critical bank-run's contagion - which constitutes modest GDP impacts and compression in risk premia - and appears to what the market is discounting as likely).
A Slow Exit with a modest 1% hit to Euro-area GDP appears to be priced in
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And the impact on the SXXP (Stoxx 600 broad European equity index)...
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Current SXXP pricing appears to be pricing for a 1% drop in Euro-GDP.
A fall back down to the 2009 low of 159 in the SXXP would be consistent with GDP contracting by around 5% to 5.5%. A fall back to the pre-LTRO low at the end of last year, 215 on the SXXP, would be consistent with the market pricing Euro area growth of around -2.5%.
The Scenarios
Scenario #1: Muddling through
In the most likely scenario, the new Greek government emerging from the June 17 election neither chooses to exit the euro nor agrees unconditionally to implement the existing EU/IMF programme. This will lead to a cessation of troika payments, but would not of itself constitute Greek exclusion from the Euro area, provided Greek banks continue to enjoy access to ECB facilities. Such a scenario is consistent with our forecast for European macro variables and asset prices.
At the same time, there will also be (slow) progress toward deeper policy integration (financial market and banking regulations, fiscal coordination, and ex ante risk-sharing), in order to build the firewall necessary to make the Euro area resilient to a possible future Greek exit. In this scenario, the very large insurance premium priced into US Treasuries and German Bunds should gradually dissipate. Equities would likely rise, but initially only modestly given the continued weak growth picture.
Scenario #2: Fast exit; Greece walks away
Were Greece to unilaterally exit and introduce its own currency, the ECB would presumably halt the flow of Euro liquidity to Greece. Greece would be cut off from capital markets, forcing the government to a primary cash balance. The knock-on dislocations to the real economy could lower Euro area GDP by up to 2 percentage points, even assuming that robust counter measures are taken by the policy authorities. Our expectation would be that the policy response would be substantial. The hit to earnings expectations would likely push the SXXP down to 225, although uncertainty could push the ERP even higher (from 8.7% currently), pushing the SXXP back to at least the 215 low of last September or more and 10-yr rates to as low as 1.5% and 1.0% in the US and Germany respectively.
Scenario #3: Slow exit; Greece is excluded
There is no legal mechanism to force Greece out, but in practice it would be possible de facto by denying Greek banks access to ECB facilities. We see this as less likely than #1 but more likely than #2; it is more market friendly than #2 being a more “managed” exercise. Most likely, peripheral countries’ would have received assurance that the ECB will intervene in bond markets to limit contagion preventing a sharp widening in spreads. The likely hit to GDP of up to 1% is already discounted in equities although uncertainty may result in an initial overshoot. If the policy response was powerful, we could see a strong rally from any lower levels.
Upside and Downside Risks Relative to the Base Case
In summary and in the worst case, further substantial EUR weakness is possible, including against the Dollar in scenarios where Greek exit cannot be ring fenced effectively. This could be due to a lack of time (Scenario #2) or simply because the European institutions fail to prepare well enough (Scenario #3). In most other scenarios a gradual rebound of the trade weighted EUR is likely after some temporary decline. With regards to EUR/$ specifically, we continue to think that the US balance of payment situation exerts gradual downside pressure on the USD, and hence contributes to the stabilisation of EUR/$. Any sign of a non-disruptive solution, in particular as part of Scenario #3, could lead to a rapidly declining risk premium and hence EUR strength. In that case even our 12-month 1.40 forecast in EUR/$ may be too timid. But this is not our base case. In the base case we expect range-bound behaviour of the Euro in the near-term.
Simply put CB counter-measures are assumed to save any dramatic downside unless Greece surprises unilaterally.