Chance of Greek sovereign default now at 50 per cent… but what happens next is not black and white, says Stephanie Flanders, chief market strategist for Europe, J.P. Morgan Asset Management
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The way this latest round of the Greek crisis has been handled so far - by both sides - does not bode well.
We believe there is now a 50 per cent chance of some form of Greek sovereign default. Carefully handled, a partial default does not have cause lasting damage to Greece or European markets.
Nor does it have to lead to a Greek exit from the Eurozone. But at a minimum, investors should be prepared for a messy few months for Greek financial markets - and some potential volatility in other European markets as well.
Technical negotiations between the Greek government and its official creditors are still proceeding at a snail’s space. The slow progress is surprising when you consider how little time Greece has left to avoid default.
It is worth remembering that drawing down these deposits would make Greek banks even more dependent on financing from the ECB”
In addition to paying wages and supporting pensions, the Greek government must repay the IMF on maturing loans, fund T-bill redemptions, and make coupon payments on GGBs. A decree issued on April 20th gives the government access to most of the cash balances of state-owned entities.
Assuming this is passed by parliament, the measure might well enable the government to meet its May repayments to the IMF; the latest statistics, dating back to February, showed total bank deposits of local and state government entities of well over €10bn. However, it is worth remembering that drawing down these deposits would make Greek banks even more dependent on financing from the ECB.
What happens if Greece defaults?
So, Greece might or might not be able to fund itself through to the end of May, but there are plenty of IMF repayments looming after that. Without further external financing, it is inevitable that one or more of those will be missed. A missed payment to the IMF sounds like a sovereign default, and a default sounds a big step towards eventual “Grexit.” But the reality is not so clear-cut.
Greece might or might not be able to fund itself through to the end of May”
If Greece misses a payment to the IMF it technically has 30 days to make good before the IMF considers it a default. An IMF default would automatically constitute a default on the country’s European Financial Stability Facility (EFSF) loans, but the European Central Bank’s Vice President, Victor Constancio, has confirmed that Greek banks would probably still be eligible for emergency liquidity assistance (ELA) from the ECB in this situation, just as long as they were considered solvent and could offer appropriate collateral.
Greek bank holdings of government debt are significant, accounting for about 3% of their total assets. But they are not so large that a default would automatically render them insolvent. But in the event of a bank run, the distinction between liquidity and solvency is notoriously hard to draw.
Greek banks would all be bankrupt if Greece left the Euro”
Greek banks would all be bankrupt if Greece left the Euro, and they would all face enormous pressure before that if Greek deposit-holders decided that was where the country was heading.
The costs and implications of a default come down to politics and perception. Politically, the ECB will want to avoid anything that looks like a unilateral decision to cut off the Greeks.
ECB officials are already nervous”
But ECB officials are already nervous about the amount of support the central bank has extended to Greek banks as part of the ELA (see chart below) and have been looking for ways to limit their exposure. It cannot lend money to banks that are clearly insolvent. And it probably could not continue to support the Greek banking system if the Greek government missed the July 20 repayment to the ECB itself.
Greek banks’ reliance on ECB funding (EUR mn)
Without ECB support, the Greek government would need to resort to capital controls and possibly other unconventional measures, such as IOUs or a new internal currency, to prevent the banking system from collapsing entirely.
This would be uncharted territory: it might be possible to stay in the Eurozone for some time with these measures in place. But such a halfway house would be immensely damaging to the economy and to public confidence in the banks. At that stage Prime Minister Tsipras might decide it was better to exit the Eurozone.
”Without ECB support, the Greek government would need to resort to capital controls”
With any luck, the negotiations with creditors will reach a successful outcome in the next few weeks and all this speculation will turn out to have been unnecessary. The important point to remember is that there a range of possible scenarios after Greece “runs out of money,” and most them revolve around the support that is or is not offered to Greek banks.
At that stage Prime Minister Tsipras might decide it was better to exit the Eurozone”
Greece can potentially default on certain obligations and still be part of the eurozone, if that is what the rest of the Eurozone ultimately decides. But the importance of popular perception in all this - and the psychology of bank runs - shows the risks of brinkmanship.
If Greek businesses and ordinary citizens hear the mood music and decide Greece is heading out of the Euro, the river of money flowing out of Greek banks will become a flood and a “Grexident” will that much harder to prevent.
We can expect Greek asset markets, especially sovereign bonds and bank stocks, to suffer continued volatility as this crisis drags on and the negotiations come to a head. The associated uncertainty is also likely to have a paralysing effect on the Greek economy. The more important question for most investors is whether any of this can derail or delay the broader European recovery.
Recently we have seen limited signs of market contagion”
There is much less contagion risk from Greece now than there was two years ago, when the Eurozone crisis was at its height and European banks were much more directly exposed to Greece.
It is also clear that the deteriorating situation in Greece since the start of the year has not prevented a major improvement in market sentiment elsewhere in Europe and an impressive rally in European equities and bonds. In general, we have seen little or no correlation between rises in Greek bond yields and bond markets in other periphery economies such as Spain or Italy since the start of the year - though recently we have seen limited signs of market contagion.
At current valuations, it would not take much to cause a correction in European asset markets”
On balance, we think that Greece is likely to remain in the Euro. But the risks of a messy exit are greater than they were a few months ago and certainly much higher than a year ago. As discussed above, the probability of some form of Greek default is higher still. If either or both of these occur, the market consensus appears to be that the rest of Europe could carry on as if nothing had happened. That seems too complacent.
At current valuations, it would not take much to cause a correction in European asset markets - particularly equities and periphery bond markets. A messy and protracted crisis in Greece could easily be the trigger for that kind of volatility, even if the longer term recovery in the European economy remained on track.
A messy default or exit from the Euro is not the most likely outcome for Greece. But nor is it an outcome that investors can afford to ignore.
Stephanie Flanders is chief market strategist for Europe, J.P. Morgan Asset Management