It will be politics rather than economics (or Q€) that drives the shorter-term outlook in Greece. Goldman Sachs warns that the new Greek government’s position is turning more Eurosceptic and confrontational than most (and the market) had anticipated ahead of last weekend’s election. This increases the risk of a political miscalculation leading to an economic and financial accident and, possibly, Greek exit from the Euro area (“Grexit”) and while many assume European authorities have the 'tools' to address market dislocations arising from this event risk, Goldman expects significant market volatility. Rather stunningly, against this background, and in spite of Q€, recommends closing tactical pro-cyclical exposures in peripheral EMU spreads (Italy, Spain and Portugal) and equities (overweight Italy and Spain).
Via Goldman Sachs,
- It will be politics rather than economics that drives the shorter-term outlook in Greece. Our base case remains that, eventually, some accommodation will be found between the new Greek government and Greece’s official creditors. This view has led us, so far, to expect modest spillovers from financial tensions in Greece to other Euro area markets. Thus far, this has proven correct.
- But the new Greek government’s position is turning more Eurosceptic and confrontational than we anticipated ahead of last weekend’s election. This increases the risk of a political miscalculation leading to an economic and financial accident and, possibly, Greek exit from the Euro area (“Grexit”). While the European authorities now have better tools to address market dislocations in general (and the re-emergence of convertibility risk in particular), these are unlikely to be activated in a manner that entirely pre-empts market tension should Grexit risks intensify or materialise. We would expect significant market volatility surrounding an event of such systemic nature as Grexit. The intensity and persistence of such volatility would depend on the process by which Grexit occurred, and on the nature of the policy and political response to it in other Euro area countries.
- Against this background, we recommend closing tactical pro-cyclical exposures in peripheral EMU spreads (Italy, Spain and Portugal) and equities (overweight MIB and IBEX vs. SXXP) until more clarity emerges about the direction ongoing negotiations between the new Greek government and the European authorities are taking. However, we continue to see the medium-term prospects for the European equity market as attractive given the high equity risk premium, the impact of QE in moderating deflationary fears, and improving cyclical prospects driven by the impact of lower oil prices and a weakening Euro exchange rate. We continue to see tighter intra-EMU spreads, steeper EURIBOR and ‘core’ yield curves over the balance of this year, and forecast 390 on the SXXP and 3800 on the SX5E over 12 months.
Greece: Taking stock post-election
Background – Pre-election expectations
1. Ahead of the Greek elections, it was widely anticipated that a new Greek government led by the radical-left Syriza party would embark on its promised renegotiation of the terms at which Greece receives financial support from the European and international authorities. Key elements of such a renegotiation would be: (a) demands for debt relief; (b) less strenuous (or even a reversal of) fiscal adjustment; and (c) relaxation of the conditionality and control over Greek policies imposed by the ‘troika’ (the European Commission, ECB and IMF overseers of Greece’s adjustment programme). These demands run counter to the terms offered by the European authorities in their proposed extension to the existing Greek adjustment programme.
2. The threat of renegotiation promised a period of heightened political tension between the new Greek government and the European authorities, as each staked out its bargaining position. In turn, these political tensions were likely to create strains in the Greek financial sector, reflecting market participants’ concerns that external financial support could be disrupted by the political stand-off.
3. In these circumstances, the risk of a Greek exit from the Euro (“Grexit”) would rise. Whatever the economic incentives to seek a compromise, in a fraught political situation the danger of a miscalculation leading to disorderly exit always exists. Yet nevertheless, ahead of the elections our base case was that ultimately a new accommodation would be found (see: "Greece: Uncertainty to persist and peak well after the election", Global Markets Daily, January 23, 2015).
On the Greek side, the stated ambition of Syriza (and its leader, the new Prime Minister Alexis Tsipras) – in line with the overwhelming view of Greek public opinion (as reflected in polls) – was to retain the Euro and Greek membership of the Euro area. The realities of financial and economic dependence on external support, as well as the moderating effect of the anticipated more pro-European coalition partners in the new government, would eventually lead Syriza to seek some compromise.
On the side of the European authorities, the unwillingness to risk further systemic disruption through contagion to the wider Euro area would also lead to accommodation. Yet a new agreement would fall short of the face value debt write-offs demanded by Syriza. Rather it would entail additional maturity and interest rate extensions, which would serve to further reduce the burden of debt overhang faced by Greece.
4. In this context, we expected the spillover to other European markets to be modest. Relative to the situation in 2011/12 (when Grexit last threatened), direct private sector exposures to Greece are much reduced: the overwhelming bulk of Greek sovereign debt now lies on official balance sheets (see Annex), and central bank facilities provide a back-stop for bank funding. Albeit with the usual statistical uncertainties, Greece has achieved both a fiscal primary surplus and a current account surplus on its balance of payments, making it less dependent on external financing for current spending than in the past (even if these achievements are brought into question by the prospective policies of the new Greek government and private sector actions in anticipation of them, see below).
5. Moreover, the Euro area’s institutional machinery has been upgraded, via the ESM bailout fund, the OMT backstop from the ECB, banking union and – since last week – the prospect of central bank purchases of sovereign debt. With an accommodation between Greece and the European authorities in prospect, even after a period of political posturing on both sides these firewalls would prove sufficient to contain contagion.
6. That said, we were sceptical of the view that an actual Grexit could now be managed without disturbing markets elsewhere. Once exit from the Euro became a reality (even in one supposedly ‘exceptional’ case), the possibility of exit elsewhere – and thus the re-emergence of what Mr. Draghi called “convertibility risk” back in 2012 – cannot be ruled out. As we saw three years ago, such convertibility risk is likely to disturb markets: an aggressive policy response would be required.
Electoral outcome has introduced new complications from markets’ perspective
7. The outcome of the election last weekend has brought some challenges to our view (see: "Anti-austerity, Eurosceptic parties win in Greece", Global Markets Daily, January 26, 2015). Syriza performed better at the polls than had been anticipated, coming very close to achieving an absolute majority of parliamentary seats. Emboldened by its electoral performance, it has eschewed coalition partners from among its more pro-European ideological cousins on the left in favour of forming a government with the Independent Greeks, an equally Eurosceptic party on the right. Moreover, the composition of the new Greek parliament is much more Eurosceptic than its predecessor: explicitly pro-EU parties occupy only 106 of the 300 seats. All in all, this reflects a reorientation of Greek politics away from the traditional left / right dimension towards a pro-European / Eurosceptic divide.
8. Initial contacts between the new Greek government and the European authorities have been adversarial. Last Friday, the new Greek Finance Minister Yanis Varoufakis has stated that Greece will neither engage further with the troika nor extend its current financial programme beyond end-February (when the current support expires). Ministers in the new Greek government have announced plans to suspend privatisations and reinstate sacked civil servants, contrary to agreements made under the existing troika programme.
9. These confrontational assertions and actions have been met with a frosty response from the European authorities. This appears to have prompted some conciliatory remarks from PM Tsipras (among others) over the weekend, who stated (according to some accounts, after exchanges with Messrs. Draghi and Juncker) that “we will soon manage to reach a mutually beneficial agreement, both for Greece and for Europe as a whole” in a context where “it has never been our [the new government’s] intention to act unilaterally on Greek debt”. Identifying the relative importance of various (and sometimes contradictory) statements from Greek political leaders, as well as distinguishing between bargaining rhetoric and substantive positions, remains challenging.
10. Yet the prospect of radical policy changes is also affecting the situation on the ground. With the reversal of tax rises and new tax amnesties in prospect, the incentive to delay paying tax has increased, leading to a shortfall in fiscal revenues. This threatens the achievement of primary fiscal surplus, even before new spending plans and a relaxation of public spending restraint is implemented.
Whither Greece? – Three interrelated potential drivers of a new Greek crisis
11. Against the background of this more challenging political situation, we discuss three potential drivers of a deterioration in the financial and economic outlook in Greece.
12. Political breakdown. One can account for the provocative initial statements and actions of the new Greek government in terms of (a) political posturing in an attempt to stake out a strong and bold opening position for the anticipated tough political bargaining over debt relief and economic adjustment, before eventually coming to a new accommodation with the European authorities; and/or (b) the growing pains of a new government that is inexperienced in office, unfamiliar with the norms of European negotiations and institutions, subject to weak internal discipline and with little or no cabinet experience. (The contrasting recent statements of PM Tsipras and Finance Minister Varoufakis mentioned above should be read in this light.)
But should the more adversarial statements and actions reflect Greek unwillingness to remain in the Euro area on anything other than their own terms, then this is a route to Grexit. Unilaterally dictated terms from Greece involving explicit debt write-offs, a reversal of fiscal adjustment and absence of conditionality for external financial support are simply not acceptable to the rest of Europe – certainly not to Germany, but also elsewhere (e.g. in Portugal and Ireland, countries that have accepted the demands and pain implied by a troika-managed adjustment). If the new Greek government is determined to lead Greece out of the Euro area unless all its demand with regard to debt relief and financial support are met, then the rest of the Euro area can do little about that: such is the ultimate primacy of political sovereignty in these circumstances.
13. Sovereign default. The timeline for the negotiation between the new Greek government and the European authorities will be dictated, in part, by the schedule of sovereign debt repayments, redemptions and interest payments. Greece has to repay loans to the IMF in February and early March, as well as roll Treasury bills (some of which are held externally) (see Annex). Outstanding Greek law government bonds (held by, inter alia, the ECB) will mature in July and August. Were Greece to lack the cash reserves to make these payments, it would either need to find new resources elsewhere to meet them or it would need to reschedule its obligations. But Greece lacks market access and obtaining financing from domestic banks via issuance of Treasury bills is unlikely to be accommodated by the ECB (see below).
Were Greece to act unilaterally in defaulting on these obligations, then this would precipitate a suspension of external financial support. Moreover, the ECB would no longer accept Greek debt in default as eligible collateral in its refinancing operations (on which Greek banks depend). And if the Greek authorities are unwilling to re-engage in a political dialogue with their European partners on the terms on which further financial support – even in the limited form of a short-term rolling over or postponement of the upcoming payment obligations – would be made available, this would precipitate a Grexit situation. Unilateral action on the Greek side to repudiate sovereign debt (here to official holders) would create a political situation where continued Greek membership of the Euro area becomes untenable.
14. Banking crisis. Anticipating a suspension of Greek banks’ access to ECB liquidity, concerns about a banking crisis are already mounting. As in 2011/12, it appears that this is leading to a strong outflow of deposits from Greek banks, either into offshore accounts or into banknotes. (Official public data on deposit flows are lagging; this conclusion therefore relies on informal reports.) Given the potential pace and magnitude of deposit outflows, it would likely by through this channel that an acute crisis would first emerge.
Of itself, this deposit outflow can be managed by access to central bank liquidity facilities, at least while they remain open. Even if a lack of eligible collateral were to preclude access to the ECB’s monetary policy operations on which Greek banks currently rely, there is scope to shift to emergency liquidity assistance (ELA) offered by the Bank of Greece. Either way, the shift from deposit funding to central bank funding exacerbates the politicisation of the Greek outlook, as official exposures substitute for private exposures.
A number of issues arise:
ELA is a national responsibility. Nonetheless, there is an obligation on national central banks to seek approval from the ECB for the provision of such liquidity, which is renewed on a fortnightly basis. Moreover, should the ECB Governing Council take the view that ELA threatened the integrity of the single monetary policy, it can decide (by a two-thirds majority under Art. 14.4 of the ECB statutes) to suspend ELA by a national central bank. Furthermore, were ELA to be provided to clearly insolvent banks and/or be used to fund purchases of Treasury bills by banks so as to prevent a government default on sovereign obligations, this is likely to be seen as a violation of the Treaty’s prohibition of monetary financing, again precipitating a suspension of liquidity provision via ELA.
But experience elsewhere in the Euro area during the financial crisis – notably in Ireland and Cyprus – suggests that the ECB is likely to take a relatively generous attitude towards liquidity provision via ELA as long as it is part of a comprehensive and cooperative programme of adjustment agreed by the national and European authorities. We would not expect the ECB to take its own a unilateral decision to suspend ELA in a political vacuum.
If the Greek government acted unilaterally to default on sovereign obligations, the ECB would suspend ELA – but with the support of the wider European authorities. And if the European authorities decided to suspend financial support for Greece, the ECB would act in concert by suspending liquidity provision. In other words, the ECB’s decisions with regard to ELA by the Bank of Greece will reflect political decisions taken by the national and European authorities.
Were Greece to act unilaterally in a manner that caused the ECB to suspend ELA, the Bank of Greece may nevertheless be instructed by the Greek government to continue providing liquidity to domestic banks. In that context, the new liquidity created by the Bank of Greece would not be Euros, but rather an embryonic new Greek currency. Bank holidays, deposit blocks and capital controls would likely be imposed, so as to force domestic deposit holders to hold these ‘pseudo-Euro’ deposits.
While the Cypriot experience demonstrates that such restrictions on deposit flows are compatible with continued Euro area membership, it was the multilateral nature of the agreement that underlay the Cypriot troika programme (embracing the European authorities) which ensured the credibility of the commitment to eventually re-establish full convertibility. Were convertibility restrictions to be imposed in a unilateral and adversarial manner by the Greek authorities, in our view the outcome would be different: this is the mechanics of a Grexit.
The primacy of politics over economics
15. We draw the conclusion that it will be politics rather than economics that drives the shorter-term outlook in Greece. Now that Greek sovereign debt is largely held on official balance sheets and Greek banks are reliant on central bank facilities rather than market funding, the crucial decisions will be taken at the political level.
16. In all of this, the ECB will be a key player: an important and informed adviser to the European authorities, and – via its control over the flow of liquidity to the Greek banking system – an important lever through which pressure can be applied to Greece. But we do not foresee the ECB acting unilaterally to precipitate a Greek exit or to prevent one. Rather its actions will be a reflection of political decisions taken by governments.
17. Objectively, there is scope to improve the design of the Greek adjustment programme, recognising the unsustainability of the existing debt burden, focusing on institutional reforms, promoting measures to support growth, and improving incentives and the allocation of risks. But any shift to a new regime has to be the result of a negotiation and agreement with the wide European authorities under a set of common rules. If the new Greek government is unwilling to retain the Euro on anything short of its own terms (involving face value debt write-offs, no conditionality and a reversal of austerity), then it is likely we are on a path to Grexit. The rest of Europe cannot accept being ‘blackmailed’ in that way (not least because it would encourage similar behaviour elsewhere).
18. But the economic cost to Greece of Euro exit would be considerable: introducing a new currency is likely to prove costly and painful at least in the short run, as all contracts need to be renegotiated. And the Greek public remains favourable to retaining the Euro (at least according to recent opinion polls. Whether support for the Euro would be maintained after a hostile confrontation between Greek and European authorities is open to question). The European authorities fear the systemic consequences of a disorderly exit. Viewed through a narrowly economic lens, the incentives for some accommodation remain strong – as we argued prior to the election last week.
19. Our base case remains that, in the end and after a period of potentially intense political posturing and tension, the underlying economic reality will prevail and some accommodation can be found that maintains financial support for Greece, provides further debt relief via maturity extensions and coupon reductions (but falls short of large face value write-downs of official holdings), and maintains the ongoing process of economic restructuring and adjustment.
20. Yet the risk of Grexit has clearly increased as a result of the election outcome and its aftermath – both because the Greek position is more Eurosceptic and confrontational than we anticipated and because this, in turn, increases the risk of a political miscalculation leading to an economic and financial accident. This is of concern, since we continue to believe that Grexit would be likely to have systemic implications, as intra-Euro area 'convertibility risk' re-emerged.
21. The intensity and persistence of the resulting market tensions and volatility would depend on the process by which Grexit occurred, and on the nature of the policy and political response to it, both at the area-wide level and in other Euro area countries. For example, a Grexit forced by more aggressive 'disciplinary' actions by the European authorities could lead markets to re-interpret the Euro area as a conditionally (rather than irrevocably) fixed exchange rate regime: peripheral spreads would widen permanently as a result. By contrast, efforts to bolster risk sharing and deepen integration among remaining countries after Grexit could increase the workability (and thus credibility) of the Euro area, thereby serving to narrow spreads and lower risk premia over the medium term (albeit probably after an initial spiking as the reality of Grexit is digested).
Spillovers to the rest of the Euro area, and broader market implications
22. Over the past week, Greek sovereign yields have risen sharply, Greek bank equities have fallen significantly, and deposit outflows have restarted. Yet, the spillovers from the more adversarial than anticipated situation in Greece to broader European market developments have been modest. Peripheral sovereign spreads have widened modestly (and some profit-taking in the aftermath of the strong compression seen ahead of the ECB’s announcement of sovereign QE was anyway on the cards). Meanwhile, the decline in stock prices in recent days appears to reflect fears of a slowdown in macroeconomic growth rather than fear of sovereign contagion, let alone Grexit.
23. That financial asset returns in Greece and the rest of the Euro area would continue to decouple even in face of a more confrontational process of negotiation between the new Greek government and its official sector creditors has been long our base case, which we reiterated after the election outcome (see: "ECB QE and EMU bond markets", Global Markets Daily, 27 January 2015). This view has been based on a number of considerations:
First, out of a total public debt stock of around EUR300bn, the amount of Greek sovereign risk directly in the hands of the private sector is around EUR60bn (or less than one-fifth), and for the most part it is marked-to-market.
Second, by absorbing around 50% of the gross issuance of public debt over the coming 12 months, the ECB’s QE has reduced a substantial portion of ‘roll-over’ risk in the rest of the EMU government bond markets.
Third, investors broadly share our view that ultimately some agreement between the new Greek government and the European authorities can be found, as the new government does not have an electoral mandate to take the country out of the Euro area.
24. That said, we have also emphasized that Grexit is a systemic event that would significantly disrupt other markets, as convertibility risks resurface. While the Euro area authorities now have more readily available tools to address market dislocation in general and convertibility risk in particular, these are unlikely to be activated in a manner that entirely pre-empts market tension and volatility. With monetary policy already very accommodative, and inflation below zero, the macroeconomic consequences of an escalation of systemic risks emanating from the Euro area are unpredictable.
25. The escalation in the level of political confrontation, leaving open the possibility of an accident, is leading us to recommend closing existing pro-cyclical trades involving the Euro area until more clarity on which course the negotiations will take. Specifically, we would take profit on a long tactical position in 10-year Italian, Spanish and Portuguese bonds, against shorts in Germany and France. The trade was initiated on November 24 at 123bp and stood at 121bp on Friday’s close. We will mark the trade recommendation at the open price on Monday (February 2).
26. So far, the shorter-term risks around a Greek exit have largely been confined to Greek equities. The market seems to be taking a view that while the risks of a Greek exit are rising (though not yet to the point where they become the central view), the ability to contain the impact on the rest of the market and avoid systemic spillovers is high. While we agree with this over the medium term, we do think that any exit would generate heightened volatility and a higher risk premia in other European equity markets, particularly in the periphery. Given that the short-term risk-adjusted return has deteriorated, we take off our trade recommendation to be long MIB and IBEX (equal weight) relative to SXXP. We initiated this recommendation on November 24, 2014 and since then the relative return has been -5.0% (from the latest European Kickstart, January 30, 2015).
27. Nevertheless, we continue to be positive on the prospects for the European equity market over a 12-month horizon. The high ERP, low cyclically-adjusted PE (earnings remain close to their trough) and high dividend yield backed by strong balance sheets suggests that returns can remain attractive. Furthermore the QE programme launched by the ECB last month should go some way to moderating the tail risk of deflation, which has been the key factor holding back returns in European equities since the middle of last year. Additional support may also come from improved cyclical growth as a result of both the weaker Euro exchange rate and lower oil prices.
Annex – Funding needs and repayment schedules for Greek sovereign debt
- Greece owes EUR 315bn.
- There are three large blocks of officially held debt still outstanding: (1) the Greek loan facility (EUR 53bn, at EURIBOR+50bp, which matures from 2027 onwards); (2) EFSF / ESM loans (EUR 142bn disbursed, EUR 2bn committed; at EFSF funding plus small administrative fee, maturing in 30 years or after); and (3) IMF loans (EUR 20bn, maturing currently).
- There is also EUR 66bn of marketable debt outstanding, of which EUR 27bn is held by the ECB as a result of purchases under the Securities Markets Programme (SMP). There are EUR 15bn of outstanding Treasury bills. The remaining obligations are government and government-backed loans.
- Between 2016 and 2022, total debt servicing costs (both redemptions and interest payments) are small – between EUR 6 and EUR 10 bn.
- In 2015 financing requirements are more substantial (see Table 1). Core funding needs are about EUR 19bn. We have little information on available cash reserves.
- Key upcoming maturities are: (a) bonds held by the ECB in July and August (Table 2); (b) IMF loans in February and March of around EUR 3.5bn (Table 3); and (c) Treasury bills (Table 2) (most of which will be rolled by domestic banks, but a small portion of which are held by foreigners with a likely failure to roll resulting in a drain on government cash reserves).
Table 1: Greek Sovereign Funding Needs and Sources in 2015
Table 2 - Maturity Schedule of Outstanding Greek bonds
Table 3 - Repayment Schedule for IMF Loans