The risks related to Greece are rising. The negotiations between the Syriza government and its international partners on a reform programme and continued financial support are progressing only slowly while the government's budget situation and debt service schedule appear increasingly challenging. Find all the latest commentary from UBS here, updated regularly as the situation plays out.
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Debt sustainability has been at the heart of the Greek crisis. However, debt sustainability is not a uniquely European problem – it matters to the Anglo-Saxon world, and is an ever present problem in Japan.
Debt sustainability is the interplay of three forces: nominal interest rates, nominal growth and the primary surplus of the government. Nominal interest rates should be below the nominal rate of income growth (otherwise existing debt will tend to rise relative to income). For a government, nominal GDP growth can serve as a proxy for nominal revenue growth (unless the tax structure is changing significantly). Therefore government debt sustainability is about achieving a nominal interest rate below nominal GDP growth. A primary surplus (government surplus ignoring interest payments) helps to lower the debt level.
Much attention is paid to the fiscal aspects of debt sustainability, but the path of nominal GDP growth is potentially more important. Nominal GDP forms the denominator of the debt: GDP ratio, and nominal GDP is normally the driver of fiscal revenues.
- Following the longest summit in the history of the European Union, the Eurozone leaders reached a unanimous accord. The way forward will still be challenging for Greece. However, a three-year ESM program should give the Greek economy a chance to recover over time.
- The ECB is under pressure to enable Greek banks to open as soon as possible to avoid an even greater fiscal shortfall. However, the governing council may wait for a decision on the Memorandum of Understanding (MoU). Even then, some restrictions are likely to remain in place until banks are recapitalized.
- The negotiations took a big step forward, allowing us to reduce the exit risk for the first time this year. We currently see the exit risk at the lower end of the 40-50% range, while the situation remains very fluid. We expect Greece to sign the MoU, but more hurdles have to be overcome. The road ahead remains bumpy.
- In terms of the longer-term outlook for financial markets, we believe the key remains the ECB's recently confirmed willingness to step in if necessary and the strong economic fundamentals in the Eurozone. What's more, an exit could potentially lead to a postponement of the first Fed hike.
The next steps – the ball is back in the Greek court
As part of the deal, the Greek parliament is to pass a first set of legislation related to tax reform, pension reform, the independence of the statistical office, and public finance reform by Wednesday, 15 July. Once this is done, the Greek government and its creditors will set up a Memorandum of Understanding (MoU), which would serve two purposes. Firstly, it would kick-start the negotiations on a new multi-year bailout from the ESM. Secondly, it would pave the way for the front-loaded disbursements of funds that would enable the Greek government to avoid defaulting on two ECB debt redemptions of €3.5bn on 20 July and €3.1bn on 20 August, respectively. Yet, the MoU also has to be signed off, over the following few days, by Eurozone governments and/or national parliaments (including the German Bundestag, on Friday).
ESM programme to be tied to comprehensive conditionality
The ESM programme will likely have a size of €82-86bn, with €10-25bn earmarked for banking sector recapitalisation/resolution. As part of the deal, the Greek parliament has to adopt, by 22 July, the EU's Bank Resolution and Recovery Directive (BRRD), according to which not just equity, hybrid capital and junior debt, but also senior debt can be bailed in. The Greek government will set up a privatisation fund with the aim of generating proceeds of €50bn, 50% of which will be devoted to the banking recapitalisation and 25% each to debt reduction and domestic investment.
Debt relief to be considered after successful conclusion of first ESM review
The EU statement acknowledges "serious concerns" over the sustainability of Greece's debt and hints that the Eurogroup will consider lower interest rates and longer maturities after the first ESM programme review. But, the statement explicitly rules out "nominal haircuts". Debt restructuring would also pave the way for the IMF to get involved in the programme again – a step the statement envisages for March 2016.
ECB to maintain wait and see stance for now – no major changes on Thursday
The ECB did not adjust its ELA limits (€89bn) and haircuts today and we would expect the Bank to maintain a wait-and-see stance towards Greece over the coming weeks, at least until the MoU has been signed and the 20 July debt payment is out of the way. As a result, the capital controls in the banking sector are likely to remain in place for now.
Concerns remain over the viability of the deal
Given the strict conditionality, PM Tsipras will have to fight hard for parliamentary approval, but we expect him to be successful. Hence, we lower the Grexit probability (in the short-term) from 45-50% to c.30%. Still, significant concerns remain. Firstly, the negotiations on an ESM programme might still fail, particularly if Greek politics were to become a lot less stable. Secondly, and perhaps more important, significant doubts remain on the medium term viability of the programme. Given the risk of weak reform implementation, serious disagreement between the Greek government and its creditors might flare up again around future programme reviews and raise fresh doubts about Greece's future in the monetary union. Therefore, a successful conclusion of this first part of the negotiations and the introduction of a programme would further reduce the probability of Grexit in our view, but it would not eliminate it.
It has been a volatile week in markets. Investors have weighed the possibility of a Greek exit from the Eurozone, heightened volatility in Chinese stocks, and uncertainty over the course of Federal Reserve interest rate policy.
Through the volatility, we believe that overweight positions in Eurozone equities and US and Eurozone high yield bonds are warranted.
The Greek government submitted a comprehensive proposal for a multi-year reform programme to the Troika last night. It contains plans for public finance, tax and administrative reform, pension and labour market reform, and privatisations. The reform package signals meaningful concessions by the Syriza government, which might reduce the risk of failure in this weekend's crisis negotiations in Brussels. Hence, we feel the risk of Grexit has declined, but it has not disappeared; it remains high. Decision makers will be faced with a number of problems - Programme conditionality, Greek banks & interim funding. EU leaders will also need to give political backing to the ECB - either sending a signal for the ECB to switch off ELA if negotiations fail, or by signalling that ongoing ECB support for the Greek banking sector has the necessary political backing.
After the ‘no’ vote in Greece’s referendum on Sunday, Prime Minister Alexis Tsipras may feel he has won a tactical victory, but it may end up being a strategic failure. Syriza is now in the position where it cannot compromise. But Greece’s creditors will find it hard to compromise as well.
- Grexit risks rise after no: While we did not expect a resounding "no" vote to the Greek referendum, we did consider it likely enough for us to contemplate the eventualities such an outcome would imply. Within our framework, a No vote raises the probability of GRexit significantly (from 40% to 70%). And this probability is only set to rise as time goes by without an agreement.
- Market reaction indicates low contagion risk: The market reaction we have so far observed makes sense compared to our projections – 'especially' in core rates and FX, less so in equities, as seen in Chart 1 below. The ongoing resilience in peripheral spreads confirms our intuition that the probability of contagion in the event of GRexit has declined (to near 30%).
- Q&A on Greek Crisis escalation: In today's note we argue that Greek banks cannot start operating normally again without an agreement with Euro-area partners; an agreement which in our view is fairly unlikely. Time is working against Greece as timelines have become more binding. In the absence of an agreement, it is the Euro-area leaders that may have to decide on a series of actions that ultimately lead to the ECB cutting ELA off.
- The prospects of Greece remaining in the Eurozone have suffered a setback. The Greek public has voted to reject creditor demands, with early indications suggesting around 60% of voters in favor. This increases the risk that the nation will become the first nation to exit Europe’s currency union.
- We expect a near-term sell-off in Eurozone equities as events unfold. However, we believe that an overweight position in Eurozone equities is still warranted over our tactical 6- month horizon. We believe that the European Central Bank (ECB) will be able to mitigate contagion if necessary. As the ECB continues to execute its quantitative easing policy in the months ahead, the risk premium on peripheral bonds is likely to narrow again, and the Eurozone equity rally should resume and strengthen as earnings grow.
- GRexit probability still at 40%
Developments in Greece have continued to play out in line with our broad framework. In that vein we are keeping our GRexit probability constant at 40%. We now also provide probabilities of short-term GRexit in the event of a Yes (20%) and No (70%) vote, alike.
- We Lower Our Probability of Contagion from 40% to 30%
The market shift to the escalation of the Greek crisis has been consistent with our modelled market response across most key assets. That said, peripheral spreads have widened by less than we expected. Only part of that resilience can be attributed to muted contagion risks. But this is enough to make us lower our probability of contagion to 30% from 40% initially.
- Favourable Risk Reward for Long Bunds and UST Positions
Relative to current levels, and adjusted for the probability of contagion due to GRexit, we find that risks are not priced symmetrically. In fact the risk reward (downside in a Yes vote vs upside in No) favours receiving Bunds and Treasuries heading into the weekend. Peripheral spreads are also likely to widen.
We believe staying invested in Eurozone equities through this period will prove the correct path, and we maintain our overweight position in Eurozone equities. Over our six-month investment horizon, ECB action should mitigate contagion effects to other markets or economies in case of a Greek exit. In our base case, investors should see a sell-off in European equities around this referendum as a buying opportunity.
We examine the current dynamics around a) the probability of GREXIT and b) the probability of contagion. We also imagine the most negative outcome for markets: GREXIT coupled with noncredible policy response at least within the market relevant timeframe (please see below for details and milestones). The intersection of these three sub-exercises paints a picture of uncertainty for this coming, critical first week, which will need to be priced but also likely to be adjusted with the help of policy makers.
- The structural reform proposals submitted by the Greek government on Monday offered markets some reprieve. The country's international creditors hinted that the proposals could offer sufficient compromise to lay the foundations for a resolution.
- Turbulent price action has presented a buying opportunity
- Confidence in the Eurozone economic recovery over the long term
- Negotiations have finally been re-launched against the background of a Eurogroup meeting and a Euro summit, helping the Eurostoxx rise 4% on Monday.
- Time is of the essence as the current bailout extension runs out on 30 June and parliamentary approvals are needed in the Eurozone for a further extension. All sides are now working towards an agreement at Wednesday's Eurogroup meeting.
- We expect an agreement this week. If negotiations fail, a Greek referendum on euro membership is likely. The ECB is expected to continue providing the necessary liquidity for the time being. Our estimate for the exit risk remains for now at 30-40%.
- Should a Greek exit occur, we expect the ECB to lead the policy response. Even if there is a lag before it takes effect, we believe the response should mitigate the market impact on non-Greek assets over the tactical six-month investment horizon of our House View.
- In our view, the risk of Greece exiting the euro has increased to 30-40% and we think it is becoming less likely that Greece will be able to service its bundled IMF payments on 30 June. On the positive side, the likelihood of an ECB reaction to contagion in case of an exit has clearly increased.
- Negotiations broke off again on Sunday as Greece and its creditors could not close the remaining gap of up to EUR 2bn annual spending cuts and tax increases. Viable debt restructuring options could bridge the gap, but creditors want more before offering the promised debt restructuring.
- As positions differ and the program extension ends in two weeks, negotiations may drag into July. Missing the 30 June IMF payment may lead to capital controls, harm the economy further and accelerate negotiations. Also missing ECB payments on 19/20 July would tighten access to central bank liquidity and the economic pressure may finally lead to an agreement.
- Should a Greek exit occur, we expect the European Central Bank (ECB) to lead the policy response. Even assuming a lag before it takes effect, we believe the response should mitigate the market impact on non-Greek assets over the tactical six-month investment horizon of our House View.
Key considerations for investors:
- The events of the weekend suggest that time is running out, and increase the potential for policy accidents. Volatility in European assets is likely to remain high until a solution has been found.
- We expect to see a pattern of equity and peripheral bond sell-offs, with investors flocking to the safety of German Bunds – and rapid reversals of these movements.
- Under our base case assumption, we see the current equity and bond sell-off as a potential buying opportunity.
- The probability of Greece leaving the Eurozone continues to hover at the upper end of the 20-30% range, a probability that needs to be continuously reassessed. Greece and its creditors have put forth reform proposals that differ substantially.
- The next step will be to base negotiations on one of the reform proposals, likely that of the creditors, and fine tune it. Such discussions will last beyond this week, in our view. We think the Greek debt restructuring proposal offers some viable options to reduce pressure on the country in the next few years.
- A third program extension will likely be needed, and an agreement on the reforms should materialize by early in the week that begins 22 June. Without it, Eurozone parliaments will not have enough time to approve a renewed extension and Greece would lose EUR 7.2bn of remaining bailout funds.
- Should a Greek exit occur, we expect the European Central Bank (ECB) to respond by easing monetary policy further. Even assuming a lag before it takes effect, the response should mitigate the market impact on non-Greek assets over the tactical six-month investment horizon of our House View, we believe.
- Bundling of IMF payments shows that risks remain high
- Greece using the "Zambian option"
- Negotiations in crucial phase, but positions still far apart
- Negotiations have entered the decisive phase, while talks continue to be difficult. The risk of capital controls has increased to 40-50% in our view, while the exit risk is currently at the upper end of our 20-30% range. Furthermore, scheduled IMF loan payment dates in June are likely to be missed.
- The ECB has not provided additional emergency liquidity to Greek banks in the last two weeks despite continued deposit outflows. EUR 3-4bn of liquidity remains, while recent monthly deposit outflows stood at EUR 3-7bn.
- The parties involved are increasingly aware of contagion risks attached to a euro exit and we expect an agreement in June. Should an exit happen, we expect that an ECB-led policy response, even with a lag, would mitigate the market impact on non-Greek assets over the tactical six-month investment horizon of our House View.
- On Monday the Eurogroup took stock of the progress in terms of process and substance since the last Eurogroup in Riga. The Eurogroup statement welcomed the progress achieved but asks for further progress and highlights Greece's intention to accelerate negotiations even more.
- We now think that the threat of additional ECB pressure will keep negotiations going and support an agreement on reforms in May. In any event, agreement is necessary by early June at the very latest as procedures to conclude the second bailout may take three weeks in June. We continue to see the exit probability at 20-30%.
- Greece managed to scrape together enough cash to pay the IMF on 12 May, with the next major payment of EUR 310m due on 5 June. We continue to see a risk of 50-60% for Greece to miss a debt payment in the coming months. A formal default event on bond market debt remains possible, but is no longer part of our base case for the period until the end of June.
- Exit from the euro should cause temporary contagion effects to risky European assets, but an ECB-led policy response, even with a lag, would mitigate market impact on non-Greek assets over the tactical six-month investment horizon of our House View.
The talks between the Greek government and its international partners are entering a crucial phase, overshadowed by a precarious fiscal situation, heavy debt redemptions, and concerns about the stability of the banking system. The time pressure is enormous: the stalled review of the current Troika programme has to be closed by end-June, and a follow-on programme would have to be in place soon after for Greece to manage very high debt service in July/August. Failure to reach a deal over the coming weeks would likely mean default and might put Greece on a slippery slope that could lead to Grexit. View chart
We sketch four possible scenarios for the road ahead and the impact on Equities, Bonds, Credit and FX:
- Our base case scenario – the negotiations eventually end successfully and Greece stays in the Eurozone.
- Greece suffers default, but Grexit can still be avoided thanks to a belated deal.
- The talks break down, leading to default, the end of ECB liquidity provisions, and quick Grexit.
- The Greek government increasingly issues IOUs, which would become a parallel currency, but over time this still leads to default and Grexit.
- Changes made after the recent Eurogroup meeting should prod negotiations. Positions nevertheless remain distant, so a disbursement of bailout funds immediately following the 11 May meeting is unlikely without more pressure.
- After the deadline for agreement on reforms passed today without success, we believe the European Central Bank will respond by tightening Greek banks’ access to central bank liquidity in May.
- As access to central bank liquidity tightens and external funding remains absent, we expect deposit flight to accelerate.
- Greek bonds recovered recently and peripheral bond risk premiums declined, but we foresee ongoing volatility in May. Exit from the euro should cause temporary contagion effects to risky European assets, but an ECB-led policy response, even with a lag, would mitigate market impact on non-Greek assets over the tactical six month investment horizon of our House View.
- Less than two months after the ECB began buying government bonds in its QE program, their yields have compressed. Long-term bonds have outperformed shorter-dated ones, with 30-year Bund yields down to around 0.5% from 1.4% at the end of last year.
- Spreads of lower-rated Eurozone government bonds narrowed until mid-March. They reversed course on fears of Greece defaulting and exiting the euro.
- The low yields stemming from QE make government debt more manageable, but we think countries that fail to use them to advance reforms to boost growth and lessen debt run the risk of rating downgrades.
- Time is running short for a much-needed breakthrough in negotiations
- Riga meeting on 24 April unlikely to bring a breakthrough
- Heavy debt service, worsening budget situation
- Time is running out and something has to give soon
Investors seem to have embraced the belief that if Greece were to walk away from the Euro, it would walk alone with minimum contagion to other countries. This belief is dangerous. UBS does not believe Greece will leave the Euro as our base case scenario. However, if Greece were to depart, there a distinct possibility that other countries would join Greece in exiting the monetary union. This is because of the way contagion is spread in a monetary union breakup, and it could happen within months of a Greek departure.
- Negotiations likely to remain bumpy amid heavy debt-service schedule
- Negotiations slow, protracted and tense
- The reform list is said to be on its way
- A challenging payments schedule looming in April
- If the tone from last week's Eurogroup meeting is any indication, negotiations between Eurozone leaders and Greece will be long and difficult. But we believe there is enough political will on both sides to reach an agreement on the way forward.
- Compared to 2011/2012, the Eurozone now enjoys a number of new firewalls that would provide greater stability if Greece were to exit and the government default. In addition, we would expect Greece to remain a member of the European Union. This would make capital controls more effective and help mitigate deposit flight.
- However, the shocks to the Greek economy in terms of company and bank defaults, trade disruptions and reduced spending would be enormous and culminate in a severe recession. The Eurozone would also face financial market volatility and economic activity would cool down initially. In addition, a partial break up of the Eurozone would haunt member states in the future when they find themselves in distress, while the deep Greek recession would likely improve member states' fiscal discipline.
After the famous "Grexit" and the less utilized "Graccident," neologisms for the Greek situation emerge daily within the analyst community. Worth mentioning is "Grimbo" — a contraction of Greece and limbo, a situation in which Greece would default but would remain in the euro zone. Also notable is a rampant form of "Grexhaustion."
- 'Crunch time' is approaching in the stand-off between Greece and the Troika.
- A compromise can be found, but will it take stress to achieve?
- 'Grexit' unlikely, but the risks are non-negligible and potentially very large
- Inside, we assess the implications of various scenarios across asset classes.
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