An update on the Greek debt crisis
In recent days, share markets have been heavily focused on the position of Greece, with its government’s debt bail-out package expiring on June 30th. At the time of writing, Greece has failed to repay €1.6 billion owing to the International Monetary Fund and the Greek banks are closed with no additional liquidity assistance being provided by the European Central Bank (ECB). This situation is unlikely to change prior to the holding of a referendum in Greece on July 5th.
The surprise calling of a referendum for this Sunday will determine whether or not Greece will accept loan bailout conditions. If the referendum is passed it will send a clear signal to the Greek Government to engage constructively with the rest of Europe to provide funding and then work with the creditors to put Greece's debt burden on a more sustainable footing. However, a “yes” vote would not provide immediate resolution though, as it may mean a new government would have to be formed. A “no” vote would put Greece on the messy path to an exit (or Grexit) from the Euro.
Typically, share markets respond negatively to uncertainty and there has been a sell-off on markets over recent days in response to the above developments. Despite being economically and geographically distant from Greece and Europe, the Australian share market fell 4% over the final week of June.
No change to longer term outlook
Clearly developments over coming days will have significant implications for the Greek economy and its citizens. However, from an Australian investor’s perspective it is our view that the longer-term risks from the Greek crisis are limited. Greece no longer poses a systemic risk for the Eurozone or wider global financial system. Although the recent falls on share markets are unsettling, we do not believe that recent developments in Greece change the longer-term financial market outlook or risk.
Dr. Shane Oliver from AMP Capital has closely monitored the Greek debt crisis over recent years and has provided his views on a number of key questions in relation to the crisis. These views are detailed below:-
Is a deal still likely?
Our assessment is that a deal is more likely than not for the simple reason that it’s in in the interest of both sides to reach agreement. For Greece it’s to avoid the economic mayhem that would follow default and a forced exit, which would include a banking crisis and associated credit crunch, a huge loss of confidence, further austerity as a rising budget deficit forces more aggressive spending cuts and a likely 50% or so collapse in the new currency Greece adopts. With 70% or so of the Greek population wanting to remain in the Euro, such an outcome would likely lead to the demise of the government led by Tsipras and the Syriza party.
For Greece’s creditors, the reasons to reach a deal are to preserve their roughly €300 billion exposure to Greece, to head off any blow to confidence and perceived threat to other peripheral countries via “contagion” and to avoid the perception that membership of the Euro is reversible, which could weaken integration long term.
In this regard, the war of words around Greece that escalated recently is very similar to that amongst US politicians ahead of its various debt ceiling deadlines, all of which ended in a deal. So our assessment remains that a deal will be reached and the positive developments seen so far this week are consistent with that. Once Greece actually signs up and starts delivering on reforms some form of debt relief is likely to be offered.
What is the problem with Greek banks?
With uncertainty running high in Greece, its citizens naturally fear they will wake up one day and their Euro bank deposits will have been redenominated into a new Drachma worth 50% less. So they have been taking their money out in droves and this has forced the closure of the banks.
What if there is no deal? Will default lead to Grexit?
If no deal is in prospect, Greece will be declared to be in default sometime in July. There would be two scenarios here: default but no exit from the Euro; or default leading to Grexit. A Greek default would not automatically mean that it will leave the Euro. Much would depend on how supportive the ECB would be of Greek banks after a default. Any continued support though may be limited and this, plus the loss of confidence and the likely downwards spiral of the Greek economy, would likely add pressure on the Greek Government to sign up to a deal.
But if ECB support for Greek banks evaporates and no deal eventuates, then in order to avoid even more aggressive austerity and support its banks Greece may decide that it needs to start printing its own money. Since it can’t do this in the Euro it would have to exit. This may take several months to unfold and it could be very disorderly which would be bad for financial markets in the interim and be very bad for stability in Greece.
What is the risk of contagion if there is no deal?
If Greece defaults, the risk of a contagion – like that seen in the Global Financial Crisis where financial institutions stopped lending to each other due to fear that the counterparty might be exposed to sub-prime debt or Lehmans – resulting in a freezing up of global lending markets is very low. After various debt haircuts, private sector exposure to Greek public debt is very low at around €50 billion with more than 80% of Greek public debt held by the EU, ECB and IMF and after more than five years the risks are well known. Also, because private ownership of Greek debt is so small Greece may not default on this portion, preferring to try and keep potential access to private markets open. Of course, this does not mean a hedge fund does not have a leveraged position, but the risks are low.
Rather, the main concern is that a Greek default followed by an exit from the Euro prompts investors to look for other countries that may follow suit leading to a contagion which could become self-fulfilling. This is what started to happen in 2010-12 till the ECB put an end to it with President Mario Draghi’s commitment to do “whatever it takes” to keep the Euro together. The risks are clearly there, but there are several reasons to believe the risks are now lower. First, peripheral Europe is now in far better shape than was the case in 201012:-
· Portugal and Ireland are now both off bailout support.
· Budget deficits are coming under control in Portugal, Ireland, Spain & Italy. The average deficit in these countries was around 4% of GDP in 2014, versus 14% in 2010. This is set to see average public debt levels fall this year.
· Economic reform has been underway. One guide is unit labour costs which reflect productivity growth and labour costs. Spain and Portugal have made significant progress in cutting costs relative to Germany.
· Another guide is the ease of doing business. The ranking of peripheral countries relative to Germany in the World Bank’s Doing Business Survey has improved significantly. Eg, Spain has gone from 38 countries behind Germany to 19.
Second, defence mechanisms to support troubled countries are also stronger with a strong bailout fund, a banking union and a more aggressive ECB. The ECB’s €60 billion per month in debt purchases and the threat of buying individual country bonds (under its Outright Monetary Transactions program) should help keep bond yields in peripheral countries from being pushed too far away from levels in Germany. To this end, it’s noteworthy that 10-year bond yields in Spain and Italy at around 2.2% are a long way from the 7% plus level they reached in 2012.
What is the relevance to Australia?
Greece is only 0.25% of global GDP and a trivial market for Australian exports. So the direct impact on Australia is virtually non-existent. Rather the relevance comes via Greece’s membership of the Eurozone and its potential to de-stabilise it and hence European economic growth. And here, the impact is via investor sentiment and hence share market volatility and also via China since Europe is China’s biggest export market.
What about Eurozone assets?
A “reform for funding” deal that avoids a real default and at the same time does not bend over so much to Syriza that it emboldens Podemos in Spain would likely be greeted positively by Eurozone shares and peripheral country bonds, as seen by the reaction this week to news that a deal is in prospect. By contrast a default leading to a Grexit would initially be taken badly. However, even here the fall out is likely to be limited as Eurozone shares are cheap and the ECB is now aggressively undertaking quantitative easing. In fact, financial markets might ultimately celebrate were Greece to leave the Euro.
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