What's Next For Greece?

HOW DID GREECE GET TO THIS POINT?

After five years of bailouts, budget battles, and forced austerity, the Greek population has voted to reject stringent European Union (EU) bailout demands. As a result, Greece is now at risk of becoming the first country to leave the eurozone.

While the escalation to this point has been many years in the making, the seeming culmination came on June 28. With the Greek government, the EU, and the International Monetary Fund (IMF) unable to reach an agreement on a financial assistance package, the Greek Prime Minister Alexis Tsipras, in a surprise move, announced a referendum on a new bailout deal to be held on July 5. Greece subsequently missed a €1.5bn payment to the IMF on June 30, becoming the first developed world economy ever to default on an IMF loan.

Meanwhile, given the uncertain and unpredictable environment, deposit outflows from Greek banks increased dramatically, forcing the government to introduce capital controls to prevent a run on Greek banks. Measures including the closure of all banks and a daily withdrawal limit of €60 from Greek ATMs were quickly imposed—and remain in place—effectively freezing the country’s financial system.

In turn, on Sunday, July 5, the Greek public voted in no uncertain terms, electing by large majority to reject the European austerity demands that would have ensured further financial relief for Greece. In essence, Greece has voted to implement austerity on its own terms, rather than have those terms dictated by European institutions.

Clearly, the Greek government has been given a powerful mandate to take a firmer line with Greece’s creditors. These creditors, however, will only accept so much, heightening the possibility of Greece exiting the eurozone— an event that could have far-reaching ramifications for Europe and global financial markets.

While the resounding referendum outcome is a glowing endorsement of the current Greek government, Prime Minister Tsipras now faces the difficult task of negotiating the country through the next phase, potentially without any further financial support from the EU—support that Greece has depended upon heavily in recent years. The most immediate example of the difficulties the government faces involves its banks. Greek banks are now completely reliant on the provision of liquidity from the European Central Bank (ECB). Should the ECB decide to pull the plug on this funding, Greek banks would almost certainly collapse.

WHERE CAN GREECE GO FROM HERE?

The outlook for Greece remains unclear. Negotiations with EU partners and Greece’s creditors continue, and with so many uncertainties and potential outcomes, we are unlikely to have any clarity for some time. Given the short time since the referendum result announcement, and with the situation evolving rapidly, we will continue to monitor events closely.

That said, the immediate reaction from global financial markets provides us with some early guidance, at least in terms of investor sentiment. Indeed, the response from bond markets has been reasonably calm, with peripheral spreads moving marginally higher in early Monday trading (following Sunday’s referendum). What’s more, peripheral spreads remain below the peaks reached in mid-June.

In our view, the subdued reaction from bond markets reflects a couple of possible factors. First, it likely suggests that investors were conservatively positioned ahead of the referendum vote. Heightened bond and foreign exchange markets volatility in recent weeks may have already prompted some risk reduction, which is suggestive of the more muted post-referendum response. Secondly, it also suggests that the market still expects the ECB to intervene should financial market stress become elevated, increasing its purchases of eurozone government bonds if necessary in order to keep peripheral spread widening contained.

FOCUS POINTS IN THE NEAR TERM

The key events to watch over the coming weeks will be Greek domestic politics and the response from Europe. Regarding the former, markets are hoping for a more conciliatory approach to negotiations from new Finance Minister Euclid Tsakalotos following the post-vote resignation of Yanis Varoufakis, the confrontational former finance chief.

Meanwhile, all eyes will also be focused on what new proposals the government can come up with in order to secure some debt relief. Greece is due to pay €3.5bn to the ECB on July 20, and missing this payment could have severe implications for Greek banks in particular, given the ECB is currently keeping them afloat. In terms of the response from European officials, we will have to wait to see what position they take toward Greece, what their expectations are, and how willing, if at all, they will be to accept the compromises offered by Greece. As yet, all of these considerations remain critical unknowns.

In our view, we now see the likelihood of a Grexit as a roughly 50% probability, which is below that of the general market consensus. Even if such an event did come to fruition, we do not think it would be a quick departure, as the unwinding of Greece’s membership is likely to take time. Many commentators do not seem to appreciate just how difficult such an exit would be to transact due to the detailed legalities and technical considerations, not least of which is the creation/printing of a new currency.

As such, it would likely take several months for Greece to fully exit, in our view. Turning to the general consensus view, it appears that a Grexit is now fairly widely anticipated, with opinion ranging from a 60% to 80%¹ probability. What this means is that market participants are positioned rather defensively. Therefore, the market implications of a Greek exit, should it come to pass, are likely to be less severe than might have been previously anticipated.

From the T. Rowe Price perspective, we are looking to selectively add European risk in appropriate strategies, as we believe that significant value has been restored to European fixed income markets over the past few months.

In summary, we do not anticipate a major financial crisis should Greece be forced to exit the eurozone. The European banking system’s exposure to Greek assets is certainly far less than was the case a few years ago. Trade channels between Greece and the rest of the eurozone are also limited, as Greece is a relatively closed economy. That said, such an outcome could prove damaging for the eurozone, raising niggling doubts about its long-term integrity and viability.

¹ Source: Bloomberg, July 5, 2015.

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