Greece Euro Zone Exit Seems Unlikely
By Win Thin
The euro took another leg lower in thinned afternoon North American markets after Der Spiegel online reported that Prime Minister Papandreou is contemplating a Greek exit from the euro zone and that the EC is calling a "confidential" meeting in Luxembourg tonight to discuss this urgent matter. European officials have of course come out and denied the report, including Juncker and Schaeuble. Our view still remains that the costs of a euro exit would be too much for Greece and the euro zone to bear, and that such action will be avoided at all costs. Consider what might happen. There would likely be a run on Greek banks which in turn would lead to a collapse of its new currency that feeds into higher inflation, while those banks and the sovereign would most likely be blocked from capital markets, sending Greek interest rates even higher. On the other side, we think some sort of Greek default would go hand in hand with a euro exit. Since German and French banks are the largest holders of Greek debt, this could certainly lead to some sort of systemic banking crisis in the EU. No one wins under this scenario, in our view.
Considering the favorable terms of the Portugal package just announced, it seems more likely that Greece may be playing a game of chicken with euro zone policy makers in order to negotiate a more favorable aid package, with perhaps an extension of duration on its debt, or loosening up of tough austerity measures. In other words, Greece is using the threat of a potential collapse of the euro zone as a means to get concessions from the core euro zone in attempt to quell the rising complaints of the Greek people. Both Greece and the euro zone will be worse off if they choose the scorched earth solution. From a game theory perspective, the question is whether the two sides can come up with a cooperative solution.
With that said, no one really knows the actual thought processes going on in official circles on both sides, but it seems clear that the political will to stick with austerity is breaking down in Greece and that some kind of drastic action, no matter how unlikely it actually is, is being threatened. This political aspect has always been the debate at the heart of previous EM debt defaults/restructurings. At some point, policy-makers in Greece, Ireland, and Portugal too will face the decision of whether austerity is worth the political cost domestically. Hence, that is why Greece is perhaps using threats to ease those terms.
If the debate really moves from one of orderly Greek debt restructuring (that markets have priced in) to one of disorderly Greek default (not priced in), then risk off trading seems likely to come back with a vengeance, despite some small measure of feel-good trading coming from this morning’s jobs report. It will be important to see how Asian and European markets digest this news come Monday. We will be monitoring developments over the weekend to see if any new details emerge regarding Greece, but continue to feel that a Greek debt restructuring and renewed peripheral stresses could be a major offset to divergent monetary policies in euro zone and US that has so far boosted the euro.