Market Update

Prepared by Dalton Nicol Reid

A Greek default on its sovereign debt has again raised its heads post their failed elections. A default would almost certainly trigger Greece’s exit from the monetary union, either voluntarily or by coercion. We discuss the probability of this occurring, the economic consequences and possible policy responses. 

The Political Situation

Some Greek politicians believe they can change the terms of the country’s EU/IMF and ECB funding lifelines because of the size of their debt to the official sector (around €130-180 billion). It is believed that the threat of defaulting on that sum should provide Greece with leverage to renegotiate the terms of its bailout. This logic is largely correct as Europeans are prepared to amend the terms of the bailout at the margins, but other Greek politicians go even further. The far left SYRIZA and other anti-bailout parties believe that they can ignore the terms of the bailout without facing significant consequences. These Greek politicians, however, underestimate the amount of political capital that German Chancellor Angela Merkel and her fellow core European leaders have expended on Greece. Were Greece to ignore the terms of its bailout, Merkel would have to answer questions from her voters about why their taxes have been cast into a Greek black hole. Thus, Germany and the rest of core Europe would have to impose punishment. Furthermore, Merkel does not want Ireland or Portugal to default on official sector debts. It would be in the interest of Germany and other European states to make an example of Greece. The next Greek government might therefore play a dangerous game that could result in its eventual exit from the euro area.

Probability of an Exit

The key issue is therefore whether Greece can produce a government that is committed to servicing the €130-180 billion official sector debt. Polls consistently show that the population wants all parties to cooperate in order to preserve Greek membership in the euro area. However SYRIZA retains significant support but their ability to form a Government would be difficult as they have historically had extremely poor relations with other far-left parties with which it would have to cooperate in order to form a government.

European officials have begun to threaten Greece with exit from the euro area and even from the EU, rhetoric that will only intensify in the next three weeks and likely weaken voters’ interest in SYRIZA.  As a consequence we think the probability of a Government that supports the bailout is stronger than the alternative.

Looking at some of the alternatives:

Should SYRIZA enter a coalition with like-minded parties seems unlikely but would pose the greatest risk of a Greek exit from the euro area.

SYRIZA with a centrist coalition would result in a government willing to renegotiate the bailout program the government’s stability would be tenuous at best. If so, eventual euro area exit due to failure to honor official sector debts would remain a possibility, albeit with a longer timeline.

A coalition by centrist parties (New Democracy, PASOK, and Democratic Left), remains the most likely outcome. However, even centrist parties would ultimately have to renegotiate the bailout program in order to satisfy the electorate. The ultimate success would depend on how lenient the Europeans are willing to be in giving the new Greek government a break.

The political risk in Greece is heightened by new elections with a possibility of an electoral outcome that leads to a Greek exit. However, if Europeans are willing to continue muddling through with Athens for the sake of euro area stability, and if Greece elects a government willing to continue with austerity, the eventual Greek exit could be delayed or avoided in a number of political scenarios.

Consequences of an Exit

It does seem surprising that the possibility of a Greek exit is spooking the market. Do we not already expect this? However the real threat is not Greece exiting the Euro, it is the pressure it is placing on Spain which continues to require a bailout of its banking system. Spain’s 10-year bond yield is back at 6.3%, a 5-month high.

If the EU/IMF decides to turn off the flow of bailout funds keeping Greece alive, then it would be a matter of weeks before they were unable to pay public wages or pensions. Funds would exit banks, banks would effectively be broke, a new Greek currency would result in a tremendous loss of economic value. Price of imports such as oil would surge. In short you would not want to live in Greece at that time.

The consequences for the broader economy of this would not be significant if it is contained to Greece. The bigger risk is the contagion impact it could have on more important economies such as Spain or Italy. Deposit funds could look to exit these markets. The market would then look for a policy response.

Possible Responses

There are a range of possibilities that could be undertaken. The ECB might try another 3-year or indeed longer term Long Term Refinancing Operation (LTRO).  Failing this we see two further possibilities.

Possibility 1: The IMF is proposing that the new bailout fund, the ESM, be allowed to lend directly to distressed banks without becoming part of a sovereign’s debt. This would require a change in the ESM’s charter. However, it would provide relief to governments and taxpayers that are on the hook for huge private sector credit bubbles bursting – notably in Spain and Ireland.

At the moment the ESM can only lend to sovereigns, which can then use the funds to recapitalise the banks. However, this lending is conditional on tough austerity programs which are only exacerbating the distress. The IMF argues that removing the sovereign as the intermediary will short-circuit the vicious circle from banks to sovereigns.

Possibility 2: Assuming the first possibility did not succeed then they could grant the ESM a banking licence. Quantitative easing would then commence and the liquidity crises afflicting the euro area’s sovereign debt markets would finally be resolved.  This proposal has so far received an outright rejection from Germany and the ECB. Both claim that granting the ESM a banking licence breaks EU rules that forbid the ECB to directly finance sovereigns. This is a political objection but if it came to a simple choice of breaking this final taboo or saving the euro project, what would Germany choose?

Market Implications

Risk is back on the table and markets have reacted negatively to this heightened uncertainty. The EU is placing pressure on Greece prior to elections which means they are reluctant to provide any soothing noises to the market. As argued, an imminent Greek exit from the monetary union is not yet a certainty. Nor would it have to trigger a catastrophic contagion into the euro area financial system. The issue for the market is the elections in mid-June seem a long way off at present.  It reminds me of the market prior to the Gulf War in 2003. The markets were waiting for resolution before investors felt comfortable buying.

We make the following points:

Despite the noise, recent economic data has been supportive. US housing starts are at 5 year highs and industrial production was strong. German growth was also better than expected.

  1. The market has sold down resources on global growth concerns and some concerns that growth in China is slowing. China is now providing added stimulus and recent BHP and RIO briefings provided a fair degree of comfort regarding the demand for commodities.
  2. Pressure on the domestic Australian economy is easing thanks to a lower currency and lower interest rates.
  3. The world has found solutions for the Lehman Brothers collapse and last year’s Euro bank concerns.   In moments of fear equities are sold down but even recent history has proven this is the time to look for quality businesses in which to add.
  4. Markets react quickly to uncertainty and rapidly price the uncertainty into equity valuations. Signs of moderates winning the next Greek election or signs of how EU will deal with the crisis will provide a platform to ease these concerns.

Kind regards

elliotts