With the Greek tempest-in-a-teapot about to hit Whale-size, as Tsipras says he will not join the coalition and Venizelos says that Syriza's participation is a prerequisite (via Bloomberg), it seems now would be an opportune time to look forward (not backward at the GGB2s dropping below EUR17 for the first time ever!). As we were among the first to state that their would be a second (if not more) election in Greece, we look at the schedule of events in Europe over the next few weeks (including the payments due on the PSI holdout bonds), and discuss the scenarios and consequences of a Greek exit (for both Greece living without Euro support and the Euro-zone coping with a Lehman-event).
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In a former piece analyzing scenarios for the euro area (here), we highlighted that in order to stabilize the euro economies, the euro area needed to address its three main problems: a beleaguered banking sector, sharply deteriorated fiscal positions and weak EU institutions. We believe all three are inter-related and should be dealt with in a coordinated manner. Six months down the road, we have a look back at the extent to which these problems have been addressed and how the euro area could tackle a Greek disorderly default scenario. We find the euro area has so far failed to make meaningful progress on the banking sector, has not strengthened EU institutions materially and in particular in the case of Greece made little progress on the fiscal position. Therefore the threat from Greece remains real, and Greece exiting the euro area would likely have contagion effects that cannot easily be addressed in the current set-up.
Timeline of events for Greece
The next weeks are crucial for Greece, as political paralysis could threaten the new program, potentially triggering tail risk scenarios that could eventually result in an exit from the euro area. New elections in June (10 or 17 June) appear very likely, but it remains unclear whether these would deliver a government that implements the agreed-upon program, or even a government at all. At this stage, based on media reports, in our view two options still appear to be on the table: a coalition led by New Democracy that allows for further muddling through, and, with similar probability, a government led by Syriza that refuses the Troika program and eventually is forced by a collapsing economy to exit the euro. A low probability scenario would be a temporary exit, as that would implicitly include support from the EU.
Consequences are not only for Greece but also for the euro area
There are two streams of events and policy responses when analyzing the consequences of Greece exiting the euro area. One is how Greece copes with the exit – which is important, as it will make the government follow a harder or softer stance when trying to negotiate with the Troika. The other is how the euro area ring-fences itself to avoid a Lehman-type – or worse – event.
Greece: living without euro support
Before Greece decides to default and eventually exit the euro, the country could face the temptation of closing its budget deficit by using IOUs to pay salaries and fund a bank recapitalisation, which risks establishing a shadow currency. How long Greece could be within the euro and live with its own internal currency is an open debate. The main issue in our view, would be that this domestic shadow currency would not enable Greece to fund its current account deficit, making it likely that Greece would default on its external debt (about €370 billion including portfolio and other foreign investment liabilities).
In the event of a default and an exit scenario, Greece must reintroduce its own currency and ensure the proper functioning of its banking sector. Failure to meet its payments would put Greece into default position, the effects of which could in our view result in the following:
- Deposit flight would be very likely (not only in Greece but possibly spreading to other peripheral banks). Indeed, Greek banks have already lost 30% of heir private sector deposits since their peak in late 2009.
- Greek banks would likely require an immediate recapitalization and face a liquidity shortfall, given that Greek debt would no longer be eligible as collateral for ECB operations (through Target 2 Greek NCB owes about €109bn to the ECB; although the ESCB holds c.€50bn of government bonds directly through the SMP). And, the ECB would likely veto the Emergency Liquidity Assistance (another €60bn) following a default, again making an exit from the euro area likely following a default.
Euro area: coping with a Greek Lehman
Contagion could follow quickly, through two channels: the banking sector, and the fear of other countries defaulting on their debt. As recent data show, adjustment in Portugal is proving difficult, particularly due to weak growth. Ireland could also be affected, especially in the context of today’s slower global growth environment. Contagion would imply that Italian and Spanish yields, already under pressure, could rise further.
In the event of a disorderly default, the euro area would be expected to proceed with forceful policy actions. We believe the euro area would need to use all policy tools at its disposal. Given the contagion risks to large countries, the piecemeal approach with limited commitment would have to be replaced by the “full bazooka.”
- The ECB could cut rates to 0.50%, and renew its liquidity provisions (most likely in the form of another 3-year LTRO); The ECB would probably have to commit to buy unlimited amounts of Spanish and Italian government debt to stop contagion to these countries. This commitment would have to be supported by all remaining euro area countries to be credible and require a renouncement of the ECB’s effective senior creditor status.
- Major central banks could open currency swap lines to avoid funding problems in major currencies, as during 2008/09, but possibly at lower costs.
- Banks would have to be ring-fenced, via deposit guarantees and capital injections, over and above the ECB’s liquidity support described above. This would possibly entail state injection of capital (even if only in the form of promissory notes), ie, nationalization, or European money (euroization). The deposit guarantee would have to be backed jointly by euro area governments to be credible.
- A European funded bank recapitalization, a European deposit insurance scheme, as well as the ECB’s purchases of government bonds would require further surrendering of fiscal power to the European Commission.
- Capital controls would potentially need to be introduced between the euro area and the rest of the world. Such controls are allowed under special circumstances that could threaten stability, and the scenario under consideration clearly qualifies.
- Going forward, the fiscal stance as well as other economic policies (such as industrial policy) would have to be redesigned at the euro area level to ensure growth could kick start as quickly as possible