Greece Update: 48 hours to satisfy creditors
0James Bevan comments on the fast developing Greek financial crisis
23 June
European leaders this week gave Greek Prime Minister Alexis Tsipras’s government 48 hours to make the final push needed to satisfy creditors and end a five-month standoff over aid that risks splitting the euro. As reported on Bloomberg, leaders from Greece’s 18 fellow euro-zone countries agreed that Tsipras’s government was finally getting serious about striking a deal after it submitted a set of reform measures that began to converge with the terms demanded by creditors. They agreed to step up the pace of negotiations to secure a breakthrough on Wednesday (June 24th) that leaders can sign off at the end of the week. The package of proposals represents “a certain step forward, but it was also said very clearly that we’re not yet where we need to be.” German Chancellor Angela Merkel said after an emergency summit: “Hours of the most intensive deliberations lie ahead of us.”
22 June
Technically, the EU summit on Thursday this week represents the “hard” deadline for these negotiations. The absence of a deal by the end of the month would mean Greece was no longer be in a bailout programme and would not have paid the IMF the €1.5bn due in June. Those circumstances would imply failure – default and the imposition of capital controls, at a minimum – as the ECB could choose to withdraw its liquidity support to the Greek banking system.
But circumstances are likely to accelerate that deadline. News reports suggest that the deposit outflow from Greek banks has intensified in recent days. The ECB has maintained a determinedly neutral political stance when providing Emergency Liquidity Assistance to the Greek banks, and has cautiously but steadily increased it on demand.
That stance was summed up by the ECB’s note this week:
“As long as there is no default and as long there is a perspective of an agreement between creditors and Greece which could prevent a default, the collateral we accept will be valued according to normal rules by which we value ELA collateral”.
That’s a relatively clear assertion that the ECB will remain willing to provide support to the Greek banks until the end of the month, and beyond if there is a deal. But that’s not the only binding constraint. As the ECB also noted:
“At a certain point in time, with the bank run accelerating so that the withdrawn amounts are so large that in the end the concerned bank doesn’t have any collateral left to give to the central bank to get ELA, the bank will fail”.
That point may not be far. If this week fails to deliver a deal or the prospect of one, the problem could become the capacity of the Greek banks to borrow from the ELA, rather than the ECB’s willingness to extend it. If so, capital controls would likely be imposed.
We continue to believe that an agreement will be found g that would extend the current programme. It could take the form of a final “take it or leave” plan, that includes some of the requests made by the Greek government (including likely some explicit but conditional concessions on debt relief, we believe), in exchange offora precise list of prior actions for structural reforms that the government will have to vote on in parliament for the deal to be finalised and monies to be disbursed. This would be in line with what the IMF’s chief economist, Olivier Blanchard, has said.
Crucially, the consequences of Greece not achieving a bailout, and having the ECB withdraw its Emergency Liquidity Assistance would be extremely negative for Greece. Faced with a choice between that and a deal, we expect the Greek government to take the deal.
If there is failure, one likely consequence would be the imposition of capital controls to contain the haemorrhage of deposits, such as was seen in Cyprus is 2013.
Capital controls would be negative for the Greek economy, by limiting economic transactions and likely affecting this summer’s tourist season, for a start, which is already showing some signs of weakening due to the current uncertainty. However, they would not be disastrous in themselves. As we saw in the case of Cyprus, capital controls can be effective in – eventually – stabilizing financial conditions. Cyprus’ TARGET2 balance steadily improved from a large deficit, reflecting the banking sector’s falling dependence on liquidity support from the ECB. It is now in surplus. And capital controls have been lifted.
As such, capital controls by themselves do not imply an exit from the euro. They could be a necessary step on the way to the reintroduction of a new currency. But they could also be – as they were in Cyprus’ case – a policy tool to allow stabilization and financial recovery.
But capital controls in Cyprus were imposed against the backdrop of a bailout programme and crucially continued ELA support from the ECB. In the event of a “failure”, and Greece leaving the bailout programme, the ECB could choose to withdraw ELA. If so, Greek banks would be deemed insolvent and a process of resolution and recovery would theoretically begin. Given that ELA comprises close to 20% of Greek bank liabilities, the risk is that a significant part of the capital structure of those banks would be bailed in, generating further financial and economic distress.
We can expect that that’s an outcome any Greek government would find unpalatable. So even if there is a failure this week, there’s the possibility of the current or a different Greek government reversing policy and accepting a bailout deal to maintain ELA support, albeit under a state of capital controls.
Importantly, a failed outcome in Greece would also have negative implications for the rest of Euroland and it looks as if the risk of contagion would be more prevalent through the banking system than through sovereign debt. But it’s important to be humble: there may be unanticipated or under-appreciated channels of contagion and risk that could prove surprisingly powerful.
The imposition of capital controls and, possibly, bail-in of creditors of the Greek banking system would be perceived to be a consequence of the Greek government’s actions, not the asset quality of its banks. That’s a material difference from the Cyprus episode. And through the channel of politics, rather than sovereign debt, it could rekindle the risks that governments pose to their banking systems, and vice-versa. Creditors of banks elsewhere in the periphery may seek to mitigate or hedge that renewed risk, putting stress on the quantity and price of bank liabilities.
Although we may expect that any pressure on bank liquidity would be amply matched by generous support from the ECB – unlimited liquidity at a very cheap price – banks would likely be less willing to extend credit to the real economy if their balance sheets were increasingly funded by liquidity provided by the central bank rather than deposits and credit.
In turn, that would likely lead to a material tightening of credit conditions. A key driver of the recent cyclical upturn in the euro area has been the easing in financial conditions over the past nine months, we think. So such a tightening would likely have a negative impact on growth in the euro area.
At this stage, we’d note that such contagion is not in evidence: this is a risk that may not necessarily materialise. A simple metric of that, an estimate of the marginal market funding costs for peripheral banks, remains low. It has risen a little, but likely not enough to have a material effect.
Of course, if it did, markets would be entitled to price for a policy response from the ECB. That’s one reason why we can be less concerned about contagion through sovereign debt: the ECB’s QE programme is likely to be intensified in such an event.
The longer term risks, however, appear greater unless there is a step change in the governance of Euroland. Financial contagion would likely materialise more visibly in the next downturn, with markets questioning which country would be the next one to undergo capital controls and possibly exit the area. On the political front, risks of polarization between “creditor” and “debtor” countries in the Union could make it very difficult to provide further support.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
Photo (cropped): George Rex, Flickr
