In memory of Dr. Andreas Höfert

Thinking the unlikely: Grexit consequences

| Posted by: Andreas Höfert | Tags: Andreas Höfert

The negotiating heat is on. Oaths are being spoken. Ultimatums given. Lines drawn. Doors slammed. No one would have expected otherwise. We believe the horse trading taking place between Greece and its Eurozone creditors qualifies at best as a “lose-lose” situation.

On the one hand, giving into Greece’s demands opens the Pandora's Box of moral hazard. Why should one country get special treatment when others are battling the consequences of austerity? This is why fellow European peripheral countries have expressed little solidarity with Greece. Their governments know that a solution benefiting Greece and its leftist Syriza government too much would boost the fortunes of their own extreme, anti-European oppositions. Though not offering anything to Greece, on the other hand, opens the possibility that it could leave the Eurozone.

A Grexit scenario remains highly unlikely, in our view. Even after Monday’s unsuccessful Eurogroup meeting, we ascribe only a 10-20% probability to it happening. Why? Because its consequences are severe for Greece. Not only would it undermine the fragile “Grecovery,” i.e. this year will likely be the first that GDP grows since 2007. It would also cause inflation to soar in the country, since a new Greek currency backed by minimal trust in the Greek authorities would not be worth much. It is no surprise that 80% of the Greek population, according to polls, is against a Grexit.

Moreover, despite repeated assurances from German politicians that “everything would be under control,” a Grexit would also affect the Eurozone. First, losses on Greek debt would mount, either through defaults, redenomination or a combination of both. Official sector lending, which includes Greek bonds held by the European Central Bank (ECB) and TARGET2, makes up about 3% of Eurozone GDP ex Greece. The official sector would bear the lion’s share of the losses since most debt moved from the private to the public sector following the March 2012 Greek default and the restructuring of private-sector debt.

Second, though contagion signals haven’t flashed ex ante - the interest rates of European peripheral bonds other than Greece’s haven’t moved much - contagion could still spread ex post. CIO credit experts, drawing on the 2011-12 experience, estimate that the interest difference between Germany and peripheral countries in a Grexit case could widen by 300 basis points for Spain and Italy, and likely more for less-liquid markets like Portugal.

On the top of that, a precedent that the euro is not “irrevocable” would have been set. And it would likely cause deposits to flow again from the Eurozone periphery to its core, in turn creating higher imbalances in its payment system. Fortunately, thanks to institutions established since 2011 and the March onset of European quantitative easing, such a shock, while reducing confidence and growth, would likely be less severe than it was four years ago.

Finally, and this constitutes the biggest risk in my view, an “unknown unknown” could emerge that mocks all assurances that “everything is under control.” Politicians would be more honest if they only promised that “everything we know about now will probably be under control.”

That said, even without an unknown unknown emerging, the market impact of a Grexit would be “risk off.” My CIO colleagues estimate that global equity markets could fall by 10%, with Asian markets least affected and European peripheral markets like Italy (-20%) or Spain (-25%) most. European financial stocks could take a 30% hit. At minimum the euro, given all the uncertainties, would weaken, especially against the US dollar and the Japanese yen (-10% for each) but also, if to a lesser extent (roughly 5%), against the Swiss franc and the British pound.

Again it is not our central assumption and we attribute only a 10-20% likelihood to it. Nonetheless, as the saying goes: “Hope for the best, but be prepared.”