Posted on 29 June 2015
Events in Greece are moving at a rapid pace, but there were certain developments over the weekend worthy of note. Firstly, Greece called a referendum for July 5th on its creditors’ proposals for continuation of the bailout programme. This came as a shock to negotiators, as it involves further delaying a process that had appeared to be nearing a workable compromise. In essence, Greece objects to the extent of government expenditure cuts that are required by creditors, proposing instead to replace losses with additional taxation and other revenue-raising measures. One suspects that its creditors are sceptical that such taxes will actually be paid, and the fact that Greece’s Prime Minister committed to campaign against the proposals will have caused consternation.
Recently the European Central Bank (“ECB”) has been funding Greece’s banking system despite a massive run on the banks by depositors wanting to avoid any chance of their money being redenominated into Drachmas. The risk for Greece was that the ECB would respond to this additional and unanticipated delay by ceasing to funding the banking system and that is exactly what happened. The ECB decided to cap its lending to Greek banks at current levels meaning that Greek banks will no longer receive additional funds to replace those that are being lost.
As a result, Greek banks did not open for business on Monday morning, thus stopping the flow of deposits out. This does not imply exit from the Eurozone but, rather, aims at stabilising the banking system while other events are ongoing. However, it certainly increases the economic stakes for Greece, while raising the probability of default for its creditors. It is still an open question whether Greece can default on its debt obligations and remain in the Eurozone. Greece’s population is, and has been, throughout the negotiations, overwhelmingly in favour of keeping the Euro. Therefore this weekend’s events are likely to lead to further and more “eventful” negotiations, rather than to a sudden climactic “Grexit”. After all, Greece is still a member of the European Union, something which may not change even if it ceases to be a member of the Eurozone.
The ECB is likely to use its existing Quantitative Easing (“QE”) programme to stabilise Eurozone bond prices – including those of Portugal, Ireland, Spain and Italy. Euro will weaken as a result of this, as well as a consequence of increased risk aversion towards Eurozone assets. On top of the Euro, expect most volatility to be experienced in European stockmarkets, which may well appear to challenge the hypothesis that the Greek crisis is economically inconsequential. However, it is unlikely we will see a repeat of events in 2012: the exposure of other European banks to Greece has been massively reduced, plus their balance sheets have been stress-tested and bolstered where necessary to withstand just such a shock. Other southern European economies are in much better shape and those countries are less susceptible to a run on their own banks’ deposits. Moreover, the ECB now has an enormous amount of firepower at its disposal, which could be used to contain market volatility.
Depending on how events play out, any volatility may be used as as an opportunity to increase exposure to European stockmarkets at more favourable prices. There are few regions in the world where both company profits and the broader economy are growing at relatively attractive levels - that makes European companies an important constituent of any equity portfolio, despite the short-term volatility.
Certain commentators and analysts are of the opinion that a potential Grexit fundamentally changes the Eurozone from a common currency area to something less stable, more a series of currency “pegs”, each with their own probability of breaking (and, therefore, reverting to a local currency). This may be technically true, but it is not particularly relevant. The market is already free to price, for example, Spanish and Italian bonds with a Euro-exit risk premium, irrespective of whether Greece is in the Eurozone. The decision market participants must make is how likely it is that Spain and Italy actually exit the Eurozone. This probability is currently close to zero, and could even fall further were the potentially disastrous impact of a Grexit on the Greek people to become apparent to Spaniards and Italians. Indeed, there is another body of opinion that Grexit could actually reinforce European currency union.