News In Charts: Grexit Ante Portas? – Greece Is Not An Island

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The tension between Greece and its creditors has intensified in recent weeks as both parties pull in conflicting directions ahead of Greece’s inevitable default. The Troika, which represents Greece’s three principal creditors, remains reluctant to lend funds from its bailout agreement until Greece’s anti-austerity party recants. Meanwhile, Greece’s leaders continue to berate the Troika’s demands; labelling them as “absurd” and accusing them of asphyxiating democracy.

With the most recent proposals still at logger-heads, a Greek debt default appears imminent. Greece is due to repay €1.6bn to the IMF this month, another €452m to the IMF and €3.5bn to the ECB next month, and a further €176m to the IMF and €3.2bn to the ECB in August. Failure to reach an agreement will have real consequences. Already, the Greek government has taken advantage of a rarely used administrative procedure permitted under IMF rules. This allows governments to roll debt payments to the last day of the calendar month.

Without access to emergency funds, Greece will be rendered bankrupt. And, while not our central scenario, it is conceivable that this could lead to Greece’s exit from the euro area. Indeed, according to Fathom’s Probability of Exit metric, markets now ascribe a 100% probability to Grexit.

From our perspective, this would be an unfavourable outcome for all parties. Indeed, there would be negative ramifications for the whole of Europe, and probably beyond. Interestingly, this view is in contrast to what appears to have become the market opinion. The charts below demonstrate that while the perceived risk of a Portuguese exit rose in tandem with Greece in 2011/2012, markets are now more confident that Grexit will be an isolated event.

We view this equanimity as both surprising and dangerous for several reasons. Firstly, as confirmed by BIS data, Greece owes much of its debt to the foreign official sector. In the event of a default, creditors would hope to get at least some of their money back. But in the event of Grexit, any repayment is highly unlikely. This could prove troublesome to the likes of Spain and Italy.

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Despite the market’s apparent sanguinity, we suspect that government bond yields across Europe would come under pressure in the event of a Greek exit. With government balance sheets still bloated, this could force the ECB’s hand resulting in an extension of the existing QE programme.

At Wednesday’s ECB press conference, Mario Draghi went to great lengths to emphasise the Governing Council’s commitment to QE. Indeed, his introductory statement contained three individual references to the programme’s “full implementation”. We suspect that, eventually, around €2 trillion of asset purchases will be made. This is double the planned amount.

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Many Greek nationals are not waiting and have begun withdrawing deposits from the Greek banking sector at a rapid rate. This presents the Greek government with another dilemma. Like Cyprus, it could be forced to implement capital controls to stop the withdrawals becoming a rout.

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Currently, Greece benefits from Target2 which seamlessly recycles deposit flows from around the euro area; shielding Greece from some of the problems associated with capital flight. In the event of Grexit, however, Greece would no longer be a beneficiary and domestic capital controls would be necessary.

Outstanding Target2 balances could also prove problematic for the rest of Europe since the credit accumulated would be revealed for the liability that it is — a liability on the banks’ balance sheet owed to Greek depositors.

Further aggravating the negotiation process is the fear that if Greece’s leaders are deemed to have been successful in managing to renegotiate loan terms, it would encourage other anti-austerity parties elsewhere in Europe. Of particular concern is Spain’s Podemos party. The alternate scenario of Grexit is no prettier — leaving Greece vulnerable to Russia’s advances.

In summary, despite what appears to be irreconcilable differences, the formation of a mutual agreement between Greece and its creditors is still by far the best solution for both parties. But even so, some sort of default now seems inevitable. Amidst all this confusion one thing is clear — the path ahead is littered with obstacles. As the ECB carefully navigates its route, we expect it to err on the side of caution resulting in an enhanced and prolonged programme of quantitative easing to help stem the spill over from Greece to other bond markets.

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