Greek 'contagion' and threats to the EU

The initial shock to global markets of the Greek banking crisis was extremely negative, as you can imagine.  Pre-market trading in the U.S. shows a 1.2% decline of the index.

As bad as the slump in stocks has gotten, it can get much worse.  That's because this is just phase 1 of the Grexit – the exit of Greece from the euro.  A total collapse of the Greek banks when they reopen next week might precipitate another sell-off and expose other European banks to large losses if they invested in Greek debt.  It's not as bad as in 2011 and 2012, when Spanish and Italian banks were teetering as a result of their possession of huge amounts of Greek sovereign debt and Greece was threatened with a default.  Since then, the European Central Bank (ECB) has shored up the banking system in those countries and others with emergency funding mechanisms and strict rules on reserves.

Today, the ECB acts as a credible backstop, both as a significant buyer of eurozone sovereign debt and also as a facilitator of low cost financing to banks. Money market rates have moved relatively little during the latest crisis – low interest rates remain an important stimulus for the real economy across the eurozone region, as evidenced by ongoing data trends. Moreover, the ECB has stated that it will use all tools available “within its mandate” to limit contagion and maintain financial market stability.

Another significant stabiliser is that European banks have less exposure to ‘toxic’ debt since the ECB’s Asset Quality Review and stress tests in 2014, which were widely accepted as robust and rigorous. Based on Bloomberg data at the end of 2014, our analysis of European banks’ exposure to total Greek debt is 8%, nearly all of it owned by Greece’s Eurobank, and to a lesser extent Piraeus. To place this in context, Barclay’s exposure is minimal at €1.29 million (or less than 0.01% of privately held Greek debt).

While the eurozone’s financing position is much stronger today than four years ago, broader market sentiment is not always predictable, and nor are the politics.  Greece is an economic problem requiring a political solution. It is not just an issue of the Greek electorate accepting the imposition of creditor demands, but on the other side a number of parliaments across the eurozone need to agree to Greek bailout measures.  European creditors, led by Germany, want to maintain the ‘moral hazard’ argument and not set a precedent for eurozone countries to renege on their financial commitments. There is a fear of emboldening the anti-austerity movements, especially as Spain and Portugal both have parliamentary elections later this year.

But there is one threat to the EU that can't be handled by the ECB or any other EU financial entity.  And that is the perception that the EU itself is indestructible and that membership is "irreversible."  A Grexit will almost certainly make a "Brexit" – the exit of Great Britain from the EU – more likely, although still a long shot.

To understand why Europe is investing so much time and effort on keeping Greece in the euro area, look no further than Mario Draghi’s celebrated speech three years ago.

At the height of the euro area’s sovereign-debt crisis in July 2012, the central bank president’s pledge to do whatever was needed to keep the region together underscored the principle at the heart of the currency bloc -- that membership is irreversible.

The risk of undermining that message may explain why a country that accounts for less than 2 percent of the bloc’s output has such a hold on policy makers and officials. It may also protect Greece, which has a population smaller than that of Ohio, from the risk of default and a euro-area exit.

“There’s a lot of political capital invested in the euro area to keep it whole,” said Elwin de Groot, a senior market economist at Rabobank International in Utrecht, Netherlands. “Indeed, when we allow Greece to get out of this, in a way it makes it clear to the market that the euro zone is no longer whole, it can be changed and is no longer irreversible.”

What’s at stake may also explain the relative lack of panic in financial markets even as talks on Greece’s future fail to make a decisive breakthrough. The euro was little changed against the dollar on Thursday and Italian and Spanish government bonds managed to eke out some gains by market close.

Conversely, a failure to keep Greece in the 19-member currency union would risk investor speculation that other nations could leave in the future, posing an existential threat to the euro project. Just as happened before Draghi’s speech in 2012, investors may demand higher yields to own countries’ bonds, threatening their economic recovery.

Marine Le Pen of the National Front party, a frontrunner in France’s 2017 presidential election, said Tuesday that she supports an orderly breakup of the common currency.

On the one hand, you have nationalist elements in France and Great Britain who want to leave the EU, and on the other, you have the far-left anti-austerity parties in Spain and Portugal who want to stay in the EU, but only if they can go back to the good old days of wildly overspending and forcing the rest of the eurozone to finance their welfare states.  

We saw what happened to Greece and Prime Minister Tsipras when that was tried.

Greece will be in technical default tomorrow when they can't pay the IMF the $1.6 billion.  But that's not quite the end for Greece.  We can expect another round of negotiations if the Greek people rise up next Sunday and accept the terms offered by the EU.  In that case, Tsipras will be forced to resign, with new elections held.  And the new government will have a mandate to negotiate another bailout package – almost certainly a lot more than the $7 billion or so left from the original bailout of $260 billion. 

This is dependent on the survival of the Greek banks.  And while the ECB is refusing today to increase the amount of euros it pumps into Greek banks every day in emergency liquidity loans, the bank may alter that policy if the referendum goes against Tsipras.  This would keep the banks afloat until a new government could come to an agreement with creditors.

So despite all the sturm und drang, there is a chance by the end of the summer that we will be back exactly where we were before Tsipras was elected: Greece on a tight fiscal leash, and the Greek debt can kicked a little farther down the road, delaying the moment when Greece must pay up or leave the EU.

The initial shock to global markets of the Greek banking crisis was extremely negative, as you can imagine.  Pre-market trading in the U.S. shows a 1.2% decline of the index.

As bad as the slump in stocks has gotten, it can get much worse.  That's because this is just phase 1 of the Grexit – the exit of Greece from the euro.  A total collapse of the Greek banks when they reopen next week might precipitate another sell-off and expose other European banks to large losses if they invested in Greek debt.  It's not as bad as in 2011 and 2012, when Spanish and Italian banks were teetering as a result of their possession of huge amounts of Greek sovereign debt and Greece was threatened with a default.  Since then, the European Central Bank (ECB) has shored up the banking system in those countries and others with emergency funding mechanisms and strict rules on reserves.

Today, the ECB acts as a credible backstop, both as a significant buyer of eurozone sovereign debt and also as a facilitator of low cost financing to banks. Money market rates have moved relatively little during the latest crisis – low interest rates remain an important stimulus for the real economy across the eurozone region, as evidenced by ongoing data trends. Moreover, the ECB has stated that it will use all tools available “within its mandate” to limit contagion and maintain financial market stability.

Another significant stabiliser is that European banks have less exposure to ‘toxic’ debt since the ECB’s Asset Quality Review and stress tests in 2014, which were widely accepted as robust and rigorous. Based on Bloomberg data at the end of 2014, our analysis of European banks’ exposure to total Greek debt is 8%, nearly all of it owned by Greece’s Eurobank, and to a lesser extent Piraeus. To place this in context, Barclay’s exposure is minimal at €1.29 million (or less than 0.01% of privately held Greek debt).

While the eurozone’s financing position is much stronger today than four years ago, broader market sentiment is not always predictable, and nor are the politics.  Greece is an economic problem requiring a political solution. It is not just an issue of the Greek electorate accepting the imposition of creditor demands, but on the other side a number of parliaments across the eurozone need to agree to Greek bailout measures.  European creditors, led by Germany, want to maintain the ‘moral hazard’ argument and not set a precedent for eurozone countries to renege on their financial commitments. There is a fear of emboldening the anti-austerity movements, especially as Spain and Portugal both have parliamentary elections later this year.

But there is one threat to the EU that can't be handled by the ECB or any other EU financial entity.  And that is the perception that the EU itself is indestructible and that membership is "irreversible."  A Grexit will almost certainly make a "Brexit" – the exit of Great Britain from the EU – more likely, although still a long shot.

To understand why Europe is investing so much time and effort on keeping Greece in the euro area, look no further than Mario Draghi’s celebrated speech three years ago.

At the height of the euro area’s sovereign-debt crisis in July 2012, the central bank president’s pledge to do whatever was needed to keep the region together underscored the principle at the heart of the currency bloc -- that membership is irreversible.

The risk of undermining that message may explain why a country that accounts for less than 2 percent of the bloc’s output has such a hold on policy makers and officials. It may also protect Greece, which has a population smaller than that of Ohio, from the risk of default and a euro-area exit.

“There’s a lot of political capital invested in the euro area to keep it whole,” said Elwin de Groot, a senior market economist at Rabobank International in Utrecht, Netherlands. “Indeed, when we allow Greece to get out of this, in a way it makes it clear to the market that the euro zone is no longer whole, it can be changed and is no longer irreversible.”

What’s at stake may also explain the relative lack of panic in financial markets even as talks on Greece’s future fail to make a decisive breakthrough. The euro was little changed against the dollar on Thursday and Italian and Spanish government bonds managed to eke out some gains by market close.

Conversely, a failure to keep Greece in the 19-member currency union would risk investor speculation that other nations could leave in the future, posing an existential threat to the euro project. Just as happened before Draghi’s speech in 2012, investors may demand higher yields to own countries’ bonds, threatening their economic recovery.

Marine Le Pen of the National Front party, a frontrunner in France’s 2017 presidential election, said Tuesday that she supports an orderly breakup of the common currency.

On the one hand, you have nationalist elements in France and Great Britain who want to leave the EU, and on the other, you have the far-left anti-austerity parties in Spain and Portugal who want to stay in the EU, but only if they can go back to the good old days of wildly overspending and forcing the rest of the eurozone to finance their welfare states.  

We saw what happened to Greece and Prime Minister Tsipras when that was tried.

Greece will be in technical default tomorrow when they can't pay the IMF the $1.6 billion.  But that's not quite the end for Greece.  We can expect another round of negotiations if the Greek people rise up next Sunday and accept the terms offered by the EU.  In that case, Tsipras will be forced to resign, with new elections held.  And the new government will have a mandate to negotiate another bailout package – almost certainly a lot more than the $7 billion or so left from the original bailout of $260 billion. 

This is dependent on the survival of the Greek banks.  And while the ECB is refusing today to increase the amount of euros it pumps into Greek banks every day in emergency liquidity loans, the bank may alter that policy if the referendum goes against Tsipras.  This would keep the banks afloat until a new government could come to an agreement with creditors.

So despite all the sturm und drang, there is a chance by the end of the summer that we will be back exactly where we were before Tsipras was elected: Greece on a tight fiscal leash, and the Greek debt can kicked a little farther down the road, delaying the moment when Greece must pay up or leave the EU.