Markets which seemed priced for a yes were disappointed by the No vote in Greece.
The creditors and the Greek government are faced with difficult negotiations. However, there is little time left to agree.
Limited contagion effect on the rest of the Eurozone and even less so on the rest of the world, even in case of a Grexit.
The Greek referendum saw a victory of the No vote with a very significant margin. Markets, which going into the weekend, seemed priced for a yes were disappointed: in the Eurozone bond market spreads against Bunds widened and equities opened lower. Rather than declining, the uncertainty is even higher than before the referendum. The creditors and the Greek government are faced with difficult negotiations and the latter may adopt a tough stance now that it has received a plebiscite in the referendum. However, there is little time left to agree at least on temporary funding. In the absence of such an agreement, the risk of a Grexit could rise significantly, meaning this scenario can no longer be excluded.
A prospect of difficult negotiations
Greece is in arrears in its payments to the IMF, and with next to no money left, the negotiations, which will be more difficult than ever, will need to start again quickly. The ongoing uncertainty of the past months has come at a real cost, leading to a decline in economic activity and a worsening of public finances. At the end of April, Greece was running a primary deficit (the public sector budget balance excluding interest charges) of 1.9% of GDP. Reaching the previous objectives in terms of primary surplus will be all the more difficult.
The Greek government on the other hand may adopt a tough stance on the basis that it has the support of a large majority of the people. It seems difficult to find a quick agreement in such a situation.
An agreement is urgently needed
However, speed is of the essence. On 20 July, a bond held by the ECB is due (EUR 3.5 bn). In the absence of a reimbursement, it seems difficult to assume that the ECB will maintain the amount of Emergency Liquidity Assistance (ELA) which is provided, via the Greek central bank, to the Greek banks. Applying tougher conditions with bigger haircuts on the collateral, something which may arrive sooner rather than later, would put the Greek banks between a rock and a hard place with on the one hand deposit outflows (albeit at a slow pace since the cash withdrawal limits have been introduced) and the possibility of reduced access to ELA.
In case of no agreement: implications
In case of no quick agreement with its creditors Greece it seems likely that Greece will have to introduce IOUs, which is a system of arrears. Rather than paying invoices or salaries with euros, there would be a promise that the money would follow later (although when would not be clear). In a similar way the government would also need to support the banking system which would be facing a liquidity squeeze if the ECB would have tightened the conditions for its ELA. These IOUs could be used to pay taxes and for electronic transfers although companies and households will prefer payment in cash. These are however increasingly hard to make because of cash withdrawal limits. One easily sees the complexity of the growing role of IOU’s and an increasing preference for cash. Eventually this could force the country to leave the Eurozone.
If Greece were to leave the Eurozone, there would be a legal vacuum
There are no clauses in the Treaty which underpins Economic and Monetary Union which would allow a country to leave the Eurozone and a country can’t be forced out either. In the European Union treaty, there is the possibility that a country would leave, but that would be on its own volition: it can’t be forced out. This implies that if Greece were de facto to leave the Eurozone, there would be a legal vacuum which would eventually require a treaty change.
Limited contagion effect on the rest of the Eurozone and even less so on the rest of the world, even in case of a Grexit
Although the developments of the past months and those which still are to unfold will have a significant negative impact on the Greek economy, even more so in case of a Grexit, the impact on the rest of the Eurozone should be very limited. The exposure of the private sector, in particular the banking sector, to Greece is very limited. Exports of the Eurozone to Greece only represent 0.5% of Eurozone exports. Moreover, countries like Portugal, Spain or Italy, which in 2011-2012 had suffered considerably from Greek contagion, have since seen an improvement in their economic fundamentals (public finances, current account) and this should limit the contagion effect this time around. On the other hand, ongoing uncertainty about what will happen with Greece will cause uncertainty beyond Greece and this may have some short term economic impact.
For this reason we also believe that the US Federal Reserve may very well postpone its first rate hike in this cycle to December rather than in September as we previously thought.
All eyes turned towards the ECB
The ECB will continue to play a key role in the upcoming days and weeks, not only in view of what it will decide on the ELA but also because it can step in to stabilise markets if need be. Quantitative easing, which is ongoing, the possibility of Outright Monetary Transactions (buying government bond on the request of a country in exchange for economic adjustment efforts) as well recent comments from several ECB officials that more measures could be introduced should help in calming down market nervousness.
In the short run, Greece will continue to dominate the headlines
ECB and the prospect of doing more, limited contagion and a favourable cyclical environment in the Eurozone should eventually cause investor confidence to improve. However, in the short run Greece will continue to grab the attention causing the pendulum to swing between hopes of a last minute agreement and realizing that in the absence of such an agreement the risk of the country leaving the Eurozone would increase significantly.
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