From Goldman Sachs:
Our central case that a deal will come only after (or thanks to) the introduction of capital controls, a technical default on the IMF and issuance of IOUs/and a further build-up of arreas. The logic is that it is only when the cash constraint is fully binding and associated economic and financial stresses escalate that the Greek authorities would be able return to the negotiating table and compromise with official creditors. With many precedents to point to, we recognize that going into Monday’s policy meetings risks are skewed in favour of a last minute appeasement. This would allow a partial disbursement of funds withheld under Greece’s 5th review upon the passage of new measures, avert a credit event on the IMF and the ECB and buy time for more strategic discussions, i.e. push the problems to a future date. Should this not occur, and the base case be realized, risk would flip in the direction of outright Grexit.
Mapping Market Response to Three Possible Scenarios
To start, it is important to recognize that the financial risk emanating from developments in Greece is very specific. An increase in the correlation between Greek public debt securities and those of other EMU peripherals has not given way to a decline in asset prices of the proportions seen during 2011-12. There are good reasons for this. The majority of Greece’s public sector exposure is now with the foreign official sector (the roughly EUR 40bn of government bonds held in private hands are for the most part marked-to-market). As tensions have increased since the new Greek government took power, private claims against Greek banks (deposits and credit lines) have declined, with the ECB filling the void. Finally, the ECB has also been active in the secondary government bond market, and is expected to absorb between 40 and 80% of the gross supply of Euro area government bonds this year. The main effect of Greece thus far has been on volumes, and market liquidity. This is particularly evident in fixed income, especially in Euro area corporate credit. In our view, Greek risk would materialize on broader asset prices in much more prominent way if the chances of Grexit were to increase.
Our market stance since the start of the second quarter has called for higher core rates and wider, more volatile peripheral spreads as the July bond redemptions approached. Here we map the three possible scenarios mentioned above to market responses, using the average spread between 10-yr Italian and Spanish government bonds to their German counterparts as a gauge (for brevity, we refer to this differential as the ‘bond spread’ henceforth).
The ‘base case’:Should the imposition of capital controls and the introduction of IOUs prove to be the only way to reach a compromise, we would expect the bond spread to drift wider from the current 150bp to eventually as much as 200-250bp.To be sure, a ‘default’ and ‘capital controls’ are now consensus (going by our client interactions, we would say that at least 2-in-3 investors expect these joint events to occur). But by the same token, those anticipating Grexit remain a minority, as most point to opinion polls suggesting that the Greek population still wants to stay in the single currency. The reasons we are more pessimistic are twofold. Capital controls in Cyprus were an integral part of a negotiated package designed to restructure an insolvent banking sector.
On the reverse, in the case of Greece, they would come because efforts to agree on a plan have repeatedly failed. Once cash is blocked and state payments are in other means than the EUR, the distinction between being part of the Euro system and not could start becoming more blurred. Also, the political and social reaction in Greece to a failure to find a compromise is unpredictable. After all, Europe has so far not offered a ‘growth strategy’ for its member states and too frequently remains a synonym for myopic austerity.As the base case unfolds, we think the market would adjust upwards the probability of Grexit.
The ‘accommodation’:Probably spurred by news of a gathering at the highest political level, investors have started to hope that an appeasement is in sight. After all, this would conform to the pattern of Euro area negotiations seen in the past. A compromise could be centred around the structure contained in the 5th program review (e.g., higher direct taxes, some changes to access to pensions, etc) and -conditional on the Greek government passing measures in Parliament – unlock just enough financial resources to allow the government to make payments to official sector creditors during the Summer months and pay wages and pensions. This would probably lead to more strategic discussions over the second half of the year, with no major concessions until after the Spanish election booths are closed. The market would likely salute another ‘kick to the can’ with a relief rally. This could take the bond spread 20-30bp tighter to the 120-130 area, as hedges are covered and quick gains are sought. German Bunds in this scenario would still stay in the 80-90bp range. But without indications on what the strategy for Greece entails, however, we doubt that intra-EMU capital flows and market liquidity would materially improve. The Greek government would still operate on a very tight cash constraints, deposits might continue to decline, and the economic contraction extend.
ECB President Draghi stated at a press conference on 03 June that a ‘strong agreement’ for Greece should have four characteristics: ‘produce growth’, have ‘social fairness’, be ‘fiscally sustainable’ and ‘address the remaining sources or factors of financial instability in the financial sector’. The order in which Mr Draghi chose to order these elements is significant. What, in our view, would meet the criteria for a strong deal is (i) an emphasis on deep structural adjustments and their timely implementation, (ii) realistic growth and primary balance targets and (iii) an explicit re-profiling of public debt, possibly going beyond the promises made to Greece in November 2012. Realistically, seeing this happen on Monday is far fetched, but a move in this direction in coming months could see the bond spread returning below 100bp by the end of the third quarter.
The Road to ‘Grexit’: As discussed previously there is a myriad of possible interim currency arrangements, including dual currency circulation, which would qualify Greece still being formally ‘in’ but de facto having a foot out the door. In the extreme event of Greece introducing a new currency and defaulting on its exposures vs the ECB and the other Euro area member countries, we have stated that the bond spread could widen to 350-400bp, involving yields on BTPs and Bonos of around 4.00%.
A widespread assumption is that if we were to head this way, the ECB would intervene to stem financial contagion in other EMU members. An effective way of doing so would be, for example, instructing national central banks in the core countries to purchase bonds issued by peripheral member states, signalling cross-country risk transfers (currently, each central bank is buying its own debt so that credit risk is not mutualized).
Provided they are pre-emptive, policy countermeasures of this sort would support financial asset prices. But the damage resulting from a breaking of the integrity of the Euro would not be fixed by monetary policy alone, in our view. For all its specificities, the failure to keep Greece in the Euro would highlight the limitations of the growth and fiscal arrangements of the current Euro area policy framework, offer a precedent to other governments (and their oppositions), and crystallize the convertibility risk on all Euro area securities. Institutional upgrades to the economic and monetary union, along the lines of those included in the Four Presidents Report which European leaders are to discuss at the end of this month, would be required to overcome the ‘shock’. A key dimension over which these upgrades would be judged is the degree of ex ante risk sharing among Member States they involve. Examples include Euro area-wide bank deposit guarantees or an embryonic Euro area Treasury.
