In Sunday’s referendum, the Greek populace overwhelming voted to reject the terms of the programme for reform and fiscal adjustment put forward by the European Commission, European Central Bank (ECB) and the International Monetary Fund (IMF). Greece now risks a banking collapse and a potential exit from the Euro.
Although the current situation is causing some market volatility, it is not as much as the amount of media attention might suggest. It is worth noting that Greece is a small economy, representing only 1.3% of GDP in the European Union. In our view, although whatever happens will be painful for the Greek people, it is unlikely to have a severe longer-term impact on Europe or global markets.
Greece – more pain to come
The Greeks may feel that they have made their point by rejecting the European notion of austerity, but this is likely to be at a significant cost. This is most likely to be felt though a continuation of capital controls and a closed banking system as the ECB feels less able to provide assistance and emergency liquidity assistance (ELA) remains frozen. In fact, the ECB could request additional collateral from Greek banks to cover the risk of losses on the emergency lending it’s already provided, which the banks are in no position to do.
If capital controls remain, it will seriously threaten the whole economy, including Greece’s most important industry – tourism. In addition, it will increase the number of nonperforming loans from individuals and businesses, further damaging Greece’s banks and financial system. In order to remove capital controls, depositors need to feel that the Greek banking system is safe enough to start returning their deposits. However, that would require depositors to be confident that ‘Grexit’ was a remote possibility. Unfortunately, the weekend’s ‘No’ vote makes ‘Grexit’ much more likely and perhaps even unavoidable. If nothing else, the result will harden the negotiating stance of both sides, potentially rendering any attempt at a deal impossible as the level of trust on both sides disappears. One thing that does seem certain is that Greece has further hardship to come.
Europe – threat of contagion much lower than in 2011/2012
Financial contagion in Europe has been mitigated by three main factors since the ‘Grexit’ threat of 2011/2012. Greek debt is now in public rather than private hands (mostly European sovereign creditors), so financial contagion via the banking system is a lower probability. The ECB’s quantitative easing programme is helping to support European markets and avoid the deflationary forces that have been plaguing the Eurozone. US and European economies are in better shape than they were in 2011 so a ‘Grexit’ and default is now likely to be more contained than before.
One of the biggest threats to Europe is if this vote encourages anti-austerity and Eurosceptic parties in other nations, such as Italy, Spain, France and Portugal. In the short term, the European economy and budget deficits are improving and the need for increased austerity is declining, which should weaken anti-austerity parties. However, if Greece leaves the Euro, it means that any country could potentially leave a single currency that was intended to be permanent and unbreakable. As a result, it is likely to have a destabilising effect – when any member country is in economic distress in future, it will raise speculation about a possible Euro exit.
Global markets - should prove resilient to Greek crisis
Unsurprisingly, the initial market reaction to the ‘No’ vote was for the ‘risk-off’ trade to return. There is likely to be some volatility over the coming weeks while Greece’s future remains uncertain. However, unlike in 2011/2012, markets have proven to be fairly resilient to negative news from Greece in recent weeks and we expect this to continue.
In terms of the US, the economy is on a more sustainable path than it was in 2011/2012 and the risk of contagion is much reduced. As a result, we still envisage the US Federal Reserve starting to lift rates in September although this will very much depend on how the US dollar behaves. If the Greek crisis causes the US dollar to strengthen significantly, then this could slow down the pace of rate tightening, which would support the US bond market.