Ever the optimist, I ended yesterday’s post writing that a deal remains the base case outcome. But unfortunately, this does not mean a deal gets done. And so we should look again at what could happen if no deal gets done. My sense is that we are just looking at a range of possible effects of a default rather than at what is likely to occur.
The situation today is as follows: Greece has submitted what could be its final public proposal to act as the basis of Eurogroup negotiation. Immediately upon receiving the letter from Greek finance minister Yanis Varoufakis, Eurogroup president Jeroen Dijsselbloem called a meeting for the Eurogroup which convenes at 1500 hours in Brussels today. Shortly afterwards, the German finance ministry indicated that the offer made by Varoufakis was insufficient and documents have since leaked demonstrating why. We have since learned, that the Deputy Dutch finance minister has also said the letter is insufficient as it stands.
The German government has clarified its position by indicating that the Varoufakis letter is sufficient as a basis for negotiation but insufficient for reaching an agreement. The Germans feel the Varoufakis letter is a “Trojan horse” for rolling back commitments because it is not explicit enough about exactly what Greek commitments would be. The meeting, as it now stands will be used as a vehicle to create more specificity in language regarding existing commitments under the existing program to assuage the concerns of Germany and like-minded eurozone countries. Reports indicate ministers do not believe a deal is likely today.
If the Eurogroup is unable to come to a negotiated agreement, Greece will run out of money and be forced to default. I believe this is an uncontrolled scenario with lots of inherent uncertainty which could damage incumbent eurozone politicians, the eurozone economy and financial markets. It would be Europe’s Lehman moment in terms of black swan events if not in terms of political, economic and market outfall.
If Greece were to default, the following actors and markets are relevant for consideration.
- Greek banks: we are already seeing deposit withdrawals from Greek banks, making the Greek banks’ need for liquidity under Emergency Liquidity Assistance very large. If the Greek government is unable to pay its bills, the biggest vulnerability is the banks because the deposit withdrawals will increase markedly and the Bank of Greece would need to step up liquidity assistance even though it is already at the limits given by the ECB.
- ECB on Greek banks: The Greek banks make the ECB a key actor. Will they continue to permit Emergency Liquidity Assistance to the Greek banks? Or will they deem the Greek banks’ financial position to be impaired due to the Greek government’s insolvency? At this juncture it is not clear which is true. If the ECB tells the Bank of Greece that it can no longer fund the banks under ELA, as it did with Ireland and Cyprus earlier, then the Greek banking system would face collapse.
- Greek government: two decisions are of greatest importance if a negotiated agreement is not reached. First, how will the Greek government choose to pay its bills. A few days ago, Credit Writedowns ran a proposal by Rob Parenteau for creating local scrip IOUs that are usable for tax purposes as a means of paying domestic bills that come due. Greece would then have to decide which other bills it would pay with euros in order to maintain as many euros as possible in its coffers. Yanis Varoufakis tweeted approvingly of an article by Philip Legrain at Foreign Policy magazine which contains an identical recommendation, suggesting Greece might take this option. The second big decision Greece would have concerns its banks. Given the potential for capital flight, it would likely have to impose capital controls in order to prevent the banking system from complete collapse.
- ECB on containing fallout: The ECB has quantitative easing to fall back on and the ESM is available for other countries should contagion pop up. The elements of the German policy making community which believe Greece’s default can be finessed believe these tools will be sufficient to limit the damage.
- German government on Grexit: just because Greece defaults, it doesn’t mean Greece has to exit the eurozone. German Chancellor Angela Merkel today reiterated her desire to keep Greece in the eurozone. Therefore it could be the case that Germany would accept a default and capital controls as temporary. That would likely mean a principal writedown and losses for the ECB and EU on their credit obligations from Greece.
- Peripheral banking system: A key part of the common currency area is the free flow of capital. There might be capital flight after a Greece default. If so, it could be flight out of periphery into the core or just out of the eurozone altogether.
- Sovereign bond markets: if capital flight occurs within the eurozone out of the periphery, much of it will happen via bond markets, not just banking systems because investors will want to hold safe euro assets like German bunds. And this will drive down the yields of bunds. The German 5 year is already trading below -0.08% on the news of the precarious Eurogroup negotiation. We should expect yields to drop further if Greece runs out of money
- Euro: I believe the euro could appreciate if Grexit leads principally to contagion within the periphery rather than flows out of the eurozone as a whole. The point is that redenomination risk would express itself as an appreciation in the euro, which has been made artificially weak due to the crisis in the periphery.
There are a lot of issues to contend with and that’s even before we get to a Greek exit from the eurozone. And note that a taxpaying scrip IOU in Greece helps make Grexit easier to execute. In my view, a negotiated agreement remains the base case outcome because it is simply the best outcome. But many outlier scenarios are still viable including Grexit.