Schroders: Greece faces the abyss

Months of negotiations have failed to deliver a deal to unlock much needed bailout funds for Greece. Prime Minister Alexis Tsipras gambled and lost over the weekend when his counter-proposal to what was widely seen as a take-it-or-leave-it deal was rejected by creditors. Negotiations are now over and in response, Tsipras has called a referendum on whether to accept the bailout package in return for pensions and fiscal reforms.

Under the guise of defending the democratic will of the Greek people, Tsipras is asking voters to reject the deal and to continue to push for a better bail-out package. However, the Greek press, political opposition and almost the rest of the world can see that this will be a referendum on whether Greece stays in or leaves the monetary union.

Capital controls

In reaction to the collapse in negotiations, the European Central Bank (ECB) has decided to maintain the Emergency Liquidity Assistance (ELA) programme at €89 billion, but crucially, not to cut Greece off. In exchange for not withdrawing the ELA, capital controls have been put in place to stem the haemorrhaging of banking deposits. Greek nationals are limited to withdrawing a maximum of €60 per day, although direct debit payments are reportedly still functioning.

Two events approaching

Before the referendum takes place, there are two events worth noting. The first is the €1.54 billion repayment due to the IMF on the 30th of June. It looks like Greece will miss its repayment and go into arrears. This may trigger a ‘default’ status being applied by sovereign rating agencies, although this is unclear given the IMF’s supranational status. Also, it may force the IMF to pull out of a future bailout for Greece, which would increase the burden on Europe. The consequences will be negative, but the extent of which are unclear.

The second event will be the official end of the previous bailout for Greece, also on the 30th of June. In theory, the ECB could then withdraw all support for Greece as the nation will no longer be subject to a bailout package or negotiation. We think this would be harsh and expect the ECB to maintain the ELA programme at least until the referendum is held. However, this is not guaranteed.

Referendum

As for the referendum, opinion polls have consistently shown a large majority in favour of remaining in the euro. It's worth remembering that Syriza’s popularity only gained critical mass after it dropped its policy on exiting the monetary union. However, when asked the question on the euro in conjunction with the fiscal/structural reforms, the majority drops. The opinion polls give a range of 45-60% in favour of remaining against 30-35% in favour of leaving. The debate that will take place this week should focus the minds of the people. This is no longer a protest vote. This is a final “in or out” vote, with huge and permanent repercussions.

Ideally, this would also be a referendum on whether Tsipras’s disastrous tenure should end in addition to euro membership. International creditors are tired of Tsipras and do not trust the Syriza government to implement many of the reforms asked of them. There is still a danger that even with a referendum result in favour of remaining in the euro, if there is no change in leadership, international creditors could still proceed to pulling the plug.

The situation is very fluid, but we think there are five possible scenarios:

The ECB does not wait for referendum and pulls the plug (5% probability).

Greece votes to reject the bailout and leave the eurozone (25% probability)

Greece votes to accept the bailout, but without leadership change leading to an exit (15% probability)

Greece votes to accept the bailout, but without leadership change, international creditors work with existing government (15% probability)

Greece votes to accept the bailout and Tsipras is replaced by a grand coalition government led by someone else, or a technocrat (40% probability).

Limited impact on wider Europe

Our long-standing view is that Grexit would have a minimal impact on the rest of Europe. Greece is just 1.8% of eurozone GDP (2014), with trade flows relatively small. There will be a larger impact from losses on outstanding debt, but depending on who that debt is owed to will determine whether it needs to be recognised as a loss immediately. We estimate that about 77% of Greek debt is held by official institutions (with the rest mainly by domestic pension funds). European exposure is potentially up to €355 billion (3.5% of eurozone GDP). However, most of these debts are owed to either the ECB or the EFSF, which means that losses do not have to be recognised for some time.

Peripheral contagion

The bigger concern is the indirect impact of contagion on other peripheral markets. As we saw in 2010/11, there is a risk that investors decide to shun peripheral government bond markets, causing bond yields to rise, increasing the funding costs of governments and worsening their debt dynamics. However, unlike 2010/11, there is an entire arsenal of tools at the disposal of the ECB and European authorities. The ECB is already buying €60 billion of bonds per month, and could easily front-load purchases, or even increase purchases further. Moreover, the recent ruling from the European Court of Justice on the ECB’s use of its Outright Monetary Transactions (OMT) programme means that the ECB could buy unlimited quantities of debt when markets are distressed as long as a government enters a bailout programme. In addition, European authorities could trigger the European Stability Mechanism (ESM) to bail-out banks or governments before funding becomes an issue.

The ECB’s statement on Sunday read: “The Governing Council is closely monitoring the situation in financial markets and the potential implications for the monetary policy stance and for the balance of risks to price stability in the euro area. The Governing Council is determined to use all the instruments available within its mandate.”

However, if it rejects the offer and effectively decides to leave, then it will be the beginning of a very painful era in Greece’s history.

Further effects

Could events in Greece have wider ramifications? It seems unlikely given the scale of the Greek economy, but of course the impact through financial markets and an increase in risk aversion could be more significant. Markets have sold off significantly this morning, but this largely reverses gains made earlier in the month. Should the situation deteriorate further, in the event of a “no” vote for example, then we would see further weakness in equities, peripheral spreads and the euro. The ECB would step up QE in these circumstances, but there would also be pressure on the Bank of England to keep rates lower for longer as sterling strengthens against the euro and concerns over a Grexit and the potential for a wider break-up of the single currency weigh on activity.

The Federal Reserve will have to factor in a stronger dollar and would be concerned if the increase in risk aversion significantly hit the US equity market. In these circumstances, expectations of a first US rate hike may be pushed out into 2016. More generally, central banks are likely to adopt soothing tones.