Greece: A resounding “No” to endless austerity

The content below was originally published on July 6th, 2015 and contained the thoughts of our strategists as of that day. Greece puzzle Uncertainty is high and rising as we enter the next phase of the Greek crisis. Inevitably, the No vote increases the likelihood of a Grexit, but it is by no means guaranteed. It all hinges on the negotiation position of the Greek government first and the ECB’s (European Central Bank) patience second.

Now what?

The negotiations between Greece and its creditors have broken down. Greek Prime Minister Tsipras’ decision to call a referendum and campaign for a No vote put an end to the negotiations. This was an unexpected move that throws up all kinds of questions like:
  • First, we have to await the new proposal from the Greek government to the Institutions. The ball is firmly in the Greeks' court to present a proposal to the Institutions as a starting point for new negotiations. If, as suggested by former Greek finance minister, Yanis Varoufakis, the Greek government insists on reaching an agreement on debt restructuring before entering talks on a new ESM bailout, we have to expect a firm rebuttal from the Institutions. Also, if the Greek government asks for significant new concessions relative to where the negotiations ended, it is unlikely the Institutions will seriously engage. However, if on the other hand the Greek government submits a proposal that is close to its latest version, we might see new negotiations starting. The fact that Varoufakis resigned at the request of Tsipras to further the negotiations is a good sign. It is undoubtedly a concession to the Institutions.
  • Second, we have to await the ECB’s stance regarding ELA (Emerging Liquidity Assistance) support. As long as the politicians are talking we assume the ECB will remain on hold, neither adding nor subtracting from its ELA support. It is clear it does not want to be the one pushing Greece out of the eurozone. There is a risk though that it will increase the haircut on Greek collateral or otherwise increase the pressure on the Greek banking system to show it is serious about maintaining the rules. In the end, the ECB is the deciding factor between an exit or not. If it retracts ELA support the necessity for a full scale bank recapitalization will likely force the Greek government to print New Drachmas. A bail-in of deposit holders, converting their savings into bank equity, might delay that moment, although it will likely come at a heavy social price. We expect the ECB to decidedly move against Greece only when it misses its repayment on July 20. As a result, that is the only truly hard deadline we see.
  • Third, it is highly unlikely the Greek banks will open in the next few days. Unless the emergency summit tomorrow goes well and the ECB consequently increases its ELA support, we don’t see how they can open. They would run out of money so fast they would have to close almost instantly again. Maybe the summit is able to cobble together some bridge financing that allows the Greek government to repay the IMF (International Monetary Fund), the ECB and recapitalize its banks. That would allow the banks to open again. However, this rosy scenario looks very unlikely for now. That means the economic pain will only grow and social tension will continue to rise while the politicians talk. In fact, it is very well possible that the Greek government will be forced to issue IOUs to pay its bills by the end of this week. This would not necessarily herald an exit, but it would bring it a step closer.

Our scenarios and probabilities

  1. A new ESM (European Stability Mechanism) deal is struck before July 20 (40%): This would be the best case outcome, but the roadblocks in terms of political hurdles and economic difficulties are numerous and large.
  2. No new ESM deal is struck (60%):
    1. Greece defaults on most of its debt, maintains capital controls and issues IOUs to pay its bill while staying within the eurozone (a bit like Cyprus) (30%): This is still where Greece is, but the question is how long it can stay here when it misses the ECB payment and has to recapitalize its banks. How long can it work with IOUs without issuing a secondary currency? We don’t know, but we would suspect not very long.
    2. Greece defaults on most of its debt, maintains capital controls and after the ECB retracts ELA support starts to issue IOUs first and New Drachmas second, starting the process of a eurozone exit (70%).
Our reason for optimism
  • We don’t believe even the worst case scenario is capable of derailing the eurozone recovery. Greece is only 1.8% of eurozone GDP and the vast majority of Greek debt is in highly transparent public hands which limits contagion risk and uncertainty.
  • We don’t believe contagion risk is high. Greece is unique in the eurozone in facing short-term solvency issues. No other country, even in the periphery, faces that problem. Combined with the fact that Greek debt has largely been transferred from private to public hands means contagion risk is limited. Of course, liquidity risk could theoretically resurface, but with the ECB providing a lot of support (to which they can always add more), that seems very unlikely.
  • We don’t believe the ECB will stop QE (quantitative easing). In fact it is more likely the ECB will step up QE when faced with liquidity problems in peripheral bond markets. The reason we mention it here is that we see the ECB as a major support to both the eurozone recovery and eurozone financial markets. That support will not go away anytime soon.