Events in Greece are developing rapidly, driven more by politics than economics. At the time of writing, a deal on the bailout seems feasible subject to securing a staff-level agreement that has thus far remained elusive, but Greece also needs to calm its depositors to prevent a bank run forcing events.
Our base case remains that Greece will find a way to muddle through without defaulting but also without much-needed reform to the economy and restructuring of the debt that seems a pre-requisite for long-term economic viability.
Should Greece default or capital controls become necessary, the direct impact on markets is likely to be limited, but the effect of sentiment could be the catalyst to shatter some of the excessive investor complacency we currently see in the market.
What is happening?
Ever since the anti-austerity Syriza party came to power in Greece at the start of the year, the highly-indebted country has been heading towards a showdown (or series of showdowns) with creditors. After many months of failed negotiations and a pretty staggering array of one-off measures – which included tapping municipal finances, emptying emergency reserves at the IMF (ironically to pay off an IMF loan) and bundling loan payments to the end of this month – it seems Greece is now well and truly out of money. A payment of €1.5 billion is due to the IMF at the end of the month, and without assistance Greece is almost certain to miss this payment. Although it is widely believed that missing this payment would not automatically constitute a default it would mark a serious deterioration in Greece’s position which could then spiral rapidly out of control, potentially leading to capital controls and ultimately Greece’s exit from the single currency.
Against this backdrop, Eurozone leaders came to a tentative agreement at yet another 11th-hour meeting on Monday night. Reports suggest the Greek negotiators have made a number of concessions relating to pension provision, VAT and corporate tax, and in exchange may get some form of debt restructuring.
Still in the woods
Despite this high-level agreement, this is still a long way from a done deal and the devil, as always, will be in the detail. Participants will no doubt be feeling a sense of déjà vu from bailout discussions earlier in the year where a similarly top-level agreement failed to manifest in practice.
Discussion now passes back to the finance ministers and their departments to arrange a ‘staff-level’ agreement – the nuts and bolts of a deal – which has previously been the point at which these deals have fallen through as soon as the acute pressure has been lifted. We will see later this week whether this time will be any different.
Even if an acceptable agreement can be forged, it still requires the ratification of the Greek parliament, and it may be difficult overcoming the hard-line elements of Syriza.
Challenges are political, not economic
This has always been a political crisis rather than one borne of economics – which naturally lends itself to the kind of market-unfriendly brinkmanship of the last few weeks. A bailout payment of €7.2 billion hangs in the balance, but requires agreement between the two sides which has so far proved elusive. With a popular mandate handed to them by an electorate who have genuinely suffered under tough austerity, Syriza sees its role as undoing much of the previously-agreed reforms and to re-structure Greece’s debt.
Against this, creditors are insistent that reforms are essential to ensure Greece can eventually make good on the loans in the future – effectively they fear throwing good money after bad. The creditors also have their own political problems, both from electorates who may be unhappy with their tax money being used to support a recalcitrant nation’s economy and from the potential rise of anti-establishment parties, leading to a hard-line approach to the situation.
Despite the fiery rhetoric, there are strong political incentives to secure a genuine deal. Surveys show the majority of the Greek people want to remain in the Eurozone, whilst the leaders of other Eurozone countries will not want to set a precedent for any country to leave what is meant to be an irrevocable monetary union. In reality, both sides want to see Greece stay in the Eurozone, just not at any price.
Furthermore, even if Greece ends up leaving the Eurozone, it will almost certainly stay within the European Union and will continue to have close ties across Europe. As a result, any exit is likely to be a long, drawn out affair that will still need close co-operation between the various parties, as opposed to the clean break that some commentators envisage. Should Greece’s economy subsequently enter crisis, it will still be in the interests of its neighbours to intervene.
All of this provides some hope that a deal could stick this time around.
Vulnerable banking system and capital controls
A key risk remains the fragile state of the Greek banking system and this still has the potential to push the country back into crisis mode regardless of what happens with the bailout discussions. As the crisis has intensified, depositors have been withdrawing funds from Greek bank accounts fearing a forced conversion to a less valuable currency or an even worse failure of the banks, and last week such withdrawals accelerated to an estimated €5 billion. The Greek banking system is almost entirely dependent on the European Central Bank’s (ECB) Emergency Liquidity Assistance programme to meet these withdrawals. This in turn is dependent on the banks’ solvency, which would be seriously impaired should the Greek government default on its debt, which is widely held by the domestic banks.
Should the ECB withdraw support, or the current capital flight turn into a full-scale run on the banks, it is almost certain that capital controls would have to be put in place. Without the free flow of capital – a central pillar on the single currency union – or a functioning banking system, Greece would likely only be able to survive a very short time before it is forced into extreme measures, such as a full exit of the Eurozone and the rapid establishment of a new currency, which experience suggests would be sharply devalued.
Potential market and portfolio impacts
Markets have now had some time to prepare for a possible exit, even though default is not fully priced in to Greek government bonds. As such, near-term movements have been relatively muted. The situation continues to develop apace, and all scenarios remain in play, though the probability of each fluctuates in line with the vagaries of the politics.
In the somewhat unlikely event of a well-received, comprehensive and far-reaching agreement, this discount would be expected to dissipate, providing something of a boost to European markets, particularly equities. On the flip side, should the situation deteriorate further and default once again become a strong possibility, the biggest impact will likely be to Eurozone banks where credit default swaps linked to Greek debt will be triggered, and the complex web of debt instruments and derivatives will need to be unravelled. With Eurozone banks at the epicentre, some contagion to the wider market is foreseeable as confidence is sapped in thinly-trading markets.
At the time of writing, our base case continues to be that Greece muddles through, and that the current arrangement will do just enough to secure funding for the next few months. It seems unlikely the agreement will address long-term structural issues on both the economy and the debt burden, and instead continues the great European tradition of kicking the can down the road. In this event, there is unlikely to be a significant market impact beyond short-term and mild relief in the most event-sensitive assets.
As with the UK election, the heavy newsflow around the Greek bailout risks distorting the actual investment significance. There are much bigger unknowns that are more relevant to the macroeconomic environment: US monetary policy, Chinese slowdown, Russian geopolitical tensions and the oil price to name but a few – these are more likely to be key determinants of investment returns, though events in Greece do have the potential to drive short-term volatility through the effect on sentiment.
While Greece is a big issue for Europe at present, we believe that it is manageable, whatever the outcome of the political negotiations. What remains crucial is for Greece to retain the confidence of its depositor base, as a bank run would take much of the power out of the politicians’ hands and could precipitate a more acute crisis.
Regardless, the direct impact on most investor portfolios will be minimal. More feasibly, should events deteriorate further the effect on sentiment could shatter some of the complacency that has given rise to a five-year bull run that has experienced very few significant pull-backs, although such a deterioration is not our base case.
More broadly, we do have some concerns over excessive investor complacency in markets, and would view anything that reduces such complacency as a positive for markets in the long term.