In all probability Greece will hold elections as it seem very unlikely now that a coalition can be formed. What has not been discussed is on May 15th Greece has bond redemptions worth €450 million which are governed under English Law. These were the bonds that refused to be restructured earlier in the year. The big question, with no government in place what happens to the repayment of these bonds and will Greece end up defaulting on them?
New elections have been mooted for some time in June but the new Government faces the prospect of putting together medium term spending plan for 2013/2014 which is due to be delivered to the Troika for June 30.
Timeline of events for Greece
The next weeks are crucial for Greece, as political paralysis could threaten the new program, potentially triggering tail risk scenarios that could eventually result in an exit from the euro area. New elections in June (10 or 17 June) appear very likely, but it remains unclear whether these would deliver a government that implements the agreed-upon program, or even a government at all. At this stage, based on media reports, in our view two options still appear to be on the table: a coalition led by New Democracy that allows for further muddling through, and, with similar probability, a government led by Syriza that refuses the Troika program and eventually is forced by a collapsing economy to exit the euro. A low probability scenario would be a temporary exit, as that would implicitly include support from the EU.
If Greece was to leave the Euro what would the consequences be?
Before Greece decides to default and eventually exit the euro, the country could face the temptation of closing its budget deficit by using IOUs to pay salaries and fund a bank recapitalisation, which risks establishing a shadow currency. How long Greece could be within the euro and live with its own internal currency is an open debate. The main issue in our view, would be that this domestic shadow currency would not enable Greece to fund its current account deficit, making it likely that Greece would default on its external debt (about €370 billion including portfolio and other foreign investment liabilities).
In the event of a default and an exit scenario, Greece must reintroduce its own currency and ensure the proper functioning of its banking sector. Failure to meet its payments would put Greece into default position, the effects of which could in our view result in the following:
- Deposit flight would be very likely (not only in Greece but possibly spreading to other peripheral banks). Indeed, Greek banks have already lost 30% of heir private sector deposits since their peak in late 2009.
- Greek banks would likely require an immediate recapitalization and face a liquidity shortfall, given that Greek debt would no longer be eligible as collateral for ECB operations (through Target 2 Greek NCB owes about €109bn to the ECB; although the ESCB holds c.€50bn of government bonds directly through the SMP). And, the ECB would likely veto the Emergency Liquidity Assistance (another €60bn) following a default, again making an exit from the euro area likely following a default.
The consequences for the other eurozone countries would mean a downgrade as Fitch has already threatened if Greece leaves. Although this might not affect Portugal and Ireland for the moment because they are in a program with the Troika it would have massive implications for the other eurozone countries hit with a downgrade.
ZeroHedge writes of actions needed should a Greek exit and default happen.
Given the contagion risks to large countries, the piecemeal approach with limited commitment would have to be replaced by the “full bazooka.”
- The ECB could cut rates to 0.50%, and renew its liquidity provisions (most likely in the form of another 3-year LTRO); The ECB would probably have to commit to buy unlimited amounts of Spanish and Italian government debt to stop contagion to these countries. This commitment would have to be supported by all remaining euro area countries to be credible and require a renouncement of the ECB’s effective senior creditor status.
- Major central banks could open currency swap lines to avoid funding problems in major currencies, as during 2008/09, but possibly at lower costs.
- Banks would have to be ring-fenced, via deposit guarantees and capital injections, over and above the ECB’s liquidity support described above. This would possibly entail state injection of capital (even if only in the form of promissory notes), ie, nationalization, or European money (euroization). The deposit guarantee would have to be backed jointly by euro area governments to be credible.
- A European funded bank recapitalization, a European deposit insurance scheme, as well as the ECB’s purchases of government bonds would require further surrendering of fiscal power to the European Commission.
- Capital controls would potentially need to be introduced between the euro area and the rest of the world. Such controls are allowed under special circumstances that could threaten stability, and the scenario under consideration clearly qualifies.
- Going forward, the fiscal stance as well as other economic policies (such as industrial policy) would have to be redesigned at the euro area level to ensure growth could kick start as quickly as possible