Greece: Raising the stakes

Events of the past couple of days have raised the stakes considerably – with the decision by the Greek government to hold a referendum on the proposed bailout programme and the rejection of even a small extension of the bailout, which expires on Tuesday (30^th June), by the Eurogroup. Although we continue to believe that ‘Grexit’ is unlikely, a bank holiday and the imposition of capital controls in Greece have been announced.

Our hope is that the Greek government ends up accepting the terms of a deal at some point, but this may happen after a further escalation of the situation, which could involve formal Greek default and/or withdrawal of the €90bn of emergency liquidity assistance (ELA) to the Greek banks by the ECB, which they’d be unable to meet.

• At the very latest, that would be 20^th July, when €3.5bn of Greek government bonds owned by the European Central Bank mature.
• At the earliest, it could be Wednesday (1^st July), when Greece’s current bailout expires and the €1.5bn that Greece owes to the IMF would be in arrears.

The referendum, if it indeed takes place on 5^th July, is another key risk event.

As such, the vital players at this stage of the drama are the Greek government of the day and the European Central Bank. The key issue for the former is clearly if and when to capitulate and, for the latter, if and when to withdraw liquidity support.

Just as the tone and stress has now escalated, so have the costs. That’s especially the case for Greece. But the risks posed by the situation to Euroland’s immature recovery are also growing. If these risks do start to materialise, markets should expect a meaningful policy response.

The most proximate issue is the liquidity support that the ECB provides the Greek banks which have haemorrhaged deposits over the past six months, such that financial support has increased, to close to €90bn as at last Friday (26^th June). Given reports of large withdrawals from the banking system since the announcement of the referendum, Greek banks will need further extensions of that liquidity support from tomorrow (29^th June) to remain operational. Withdrawal of that support in full would effectively render them insolvent, inasmuch as they would be unable to repay it.

The other option is what the ECB just announced yesterday (28 June): it is keeping ELA support to Greek banks but capping it at current levels – meaning that it will likely be difficult, if not impossible, to keep banks open and functioning normally. Greek authorities have imposed a bank holiday and capital controls to limit further declines in liabilities from the Greek banking system.

There’s also a material risk that the ECB’s support is withdrawn in full. It’s possible that could happen as early as Wednesday (1^st July), once Greece is no longer in a formal bailout programme and has failed to pay the IMF. However, as a trigger for such a catastrophic move, Wednesday is sufficiently fuzzy to give the ECB some latitude if it chooses. As failure to pay the IMF need not formally constitute default, the ECB could respond by requiring larger haircuts on the collateral it receives for ELA loans, rather than pull the plug entirely. But the ECB would have a legitimate case to withdraw support if it wanted to.

As we’ve discussed before, a tougher deadline is 20^th July, when €3.5bn of Greek bonds owned by the ECB mature. Default on those could render it impossible for the ECB to accept Greek government and government-guaranteed debt as collateral. At that point, liquidity support would likely be cut off. As such, Greece may have a few more weeks, albeit under a prolonged bank holiday or capital controls, to avoid a more catastrophic outcome. And in that respect, next Sunday’s (5^th July) referendum – if it indeed goes through – clearly remains a key event. The large parliamentary majority with which the referendum was passed, with no dissent from any Syriza MPs, means that an imminent collapse of the Greek government looks unlikely –but that could change if the Greek financial system is closed down, particularly in holiday season. Any new government would likely be more conciliatory to the creditors.

Consequently, and absent new ideas in the days ahead, the next key political event will be the referendum. Although this will be on a proposal that, theoretically, will no longer be on the table as of Wednesday (1^st July), opinion polls suggest that the Greek electorate will vote in favour of the package. That may change, especially as Syriza is campaigning for rejection.

• A vote to reject the bailout would likely mean default and withdraw of ELA on 20^th July.
• A vote supporting it could allow for a bailout to be salvaged. But it would be politically and logistically challenging and it’d require a new Memorandum of Understanding, supported by a new Greek government and by Euroland member states. It is unlikely that the current Greek government could be regarded by member states as able to deliver that, meaning that some form of emergency national government (as in 2011-12) would be necessary.

Our central view remains that a deal will be done but that’s looking increasingly hopeful and to happen the Greek government, or the electorate, would need to move fast to avoid a more serious financial outcome in late July. And there’s a logistical risk that once the current bailout expires on Tuesday (30^th June), the ability of the players to bring about a resolution will be impaired. But as Mrs. Merkel has stated, ‘Where there’s a will, there’s a way’.

Meanwhile the introduction of a bank holiday and capital controls could mark a deterioration in conditions and for the Greek economy, a dodgy financial system and enormous political uncertainty at the start of tourist season is likely to be very negative leaving the recession and its pernicious effects on government revenues likely to deepen.

In terms of the broader Euroland position, in financial terms, a key risk is the banking sector because although the asset side of Euroland banks’ balance sheets are now relatively immune from Greece (apart from the ECB), contagion could spread  through  the  liability  side  of  the  balance  sheet. Greece is the second euro area economy to impose bank holidays and capital controls on its banks and investors and depositors in other peripheral banks may choose to cut some financing in order to mitigate the risk of similar circumstances happening there. A tightening in credit conditions for banks would do much to reverse the easier financial conditions of the past nine months, which have been a key factor behind the recent improvement in growth.

That risk would clearly be rendered more acute – and markets would become more sensitive – to any political channels of contagion. Increases in support for other extreme left- or right-wing parties in Euroland could frighten investors after the precedent that is now being set in Greece.

And then there’s economic risk. Last year, Euroland business and consumer confidence softened in the wake of heightened geopolitical uncertainty in Russia and the Ukraine, leading recovery to stall. There’s a clear risk that the Greece situation has become sufficiently pernicious to erode confidence in the rest of Euroland again, above and beyond the effects of tighter financial conditions.

As such, these circumstances suggest that there are material downside risks to consensus Euroland economic forecasts. We’ll be watching metrics of financial stress and economic confidence closely.

Meanwhile, markets will be watching for a policy response in the coming hours and days- and a material loosening of policy – for example, a sustained period of larger sovereign asset purchases than under the ECB’s current QE programme – would require evidence of a material deterioration in financial and economic conditions. So an aggressive response tomorrow (29^th June) may be unlikely. But the ECB is likely to be very visible in its implementation of current asset purchases, and if it becomes apparent that financial conditions are worsening and economic activity is weakening, market participants should price for a reaction from the ECB.

So the conclusions we can draw are that a truly ‘bad outcome’ in Greece (which is still readily avoided, possibly after one last round of ‘extreme stress’, which we now seem to be entering) would have systemic repercussions, and the key determinant of whether there is a systemic shock is whether the current round of negotiations complete on time. With that looking increasingly unlikely, we can see the need for the market to price for a systemic shock. That suggests that the market will react very negatively to the news on Greece over the weekend, with significant ‘safe haven’ flows and the periphery suffering. Government bonds should benefit from both safe haven flows and also from any significant increase in the size of the ECB’s QE programme. The risk to the trade would be the introduction of EuroBonds or EuroBills as a policy response.

We can also expect a significant spread widening on Monday morning and liquidity close to zero in peripheral markets.

Gilts should benefit from flight-to-quality flows, while market expectations for the timing of the first rate hike will be pushed back. Risk-off positions should perform well in this environment, with gilt yields likely to fall. The risk to this scenario is a strong enough policy response in Europe preventing a systemic shock – or any early agreement by Greece. Don’t hold your breath.