James Bevan: Grexit risks and issues

Last-ditch negotiations between representatives of the Greek government and its creditors collapsed on Sunday. The European Commission says that the talks in Brussels broke up after just 45 minutes as the gap between what creditors asked of Greece and what its government was prepared to meet remained significant.

The focus now shifts to a June 18 meeting in Luxembourg of euro-area finance ministers, which may become a make-or-break session deciding Greece’s ability to avert default, and perhaps its continued membership of the euro area.

Even at this late stage, we expect some form of compromise between Greece and the EU/IMF in the short term and, further down the road, debt restructuring. Compromise is likely because:

• 70% of Greeks in recent polls want to stay in the euro. This suggests that if there is a referendum or election based on whether Greeks want to accept the bailout conditions to stay in the euro, the result would likely be yes and a coalition would emerge without the far-left members of Syriza.
• Greece runs a primary budget deficit if EU aid is excluded, and there’s no real need to default when there is a primary budget deficit.
• Following deposit flight of 15% YTD, the loan to deposit ratio in Greece is 120%. This leaves Greek banks critically dependent on emergency liquidity assistance and thus gives the European Central Bank (ECB) particular influence over Greece. Capital controls become increasingly likely and if imposed, could be expected to lead to a loss of support for Syriza.

From a European perspective, the incentive to compromise is the fact that 70% of Greek debt is owned by the European Financial Stability Facility and the ECB. From a geopolitical angle, Europe would likely also be incentivised to have Greece in the euro, thereby avoiding Greece having closer ties with Russia.

But while compromise seems to be in the interests of all parties, there are clearly risks. Thus there appears to have been a significant loss of trust between Greece and its creditors, backward steps have been taken on the reform front (especially pension reform) while a third of Syriza are on the far-left and do not seem to mind the prospect of Greece being outside the euro.

As is typical in these situations, compromise may only be accepted when the situation appears critical –  that point when it appears politically acceptable for Syriza to compromise, or when there has been a clear-cut loss of popularity for Syriza, allowing a compromise with more centralist elements.

We can worry that compromise may happen only after capital controls have been introduced, with, in all likelihood, an election/referendum to be fought on the issue of whether the creditors’ proposals are acceptable and/or whether Greece should leave the euro. The political deadline for compromise is the end of June (when the current programme expires), but the financial deadline is July 20^th when €3.5bn of ECB-held bonds mature.

If there were a Greek exit, we can expect that European markets in dollar terms could initially fall 10% on concerns about the freezing of business contracts and €28bn of assets that the Bank for International Settlements claims that non-Greek banks have in Greece, albeit that much of that would be offset in repo operations.

Perhaps the biggest risk of a Grexit is that if Greek growth recovered quickly, then it would provide a clear alternative to other countries battling with the austerity and bring with it re-denomination risk elsewhere.

The medium-terms effects could however be more moderate than seems to be expected. Given that Greece accounts for only 1.8% of euro area GDP, and with the rest of periphery now undergoing or having undergone painful reforms, the EU might allow an easing in fiscal conditions and the ECB might be willing to temporarily accelerate QE.

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