Grexit-- Not A Game Of Liar’s Poker, Either We All Win Or All Lose

Yesterday we asked if the bell is tolling for Greece or for the E.U. We should have waited and had all our questions answered. One of the big Wall Street firms sent out an investor advisory to their clients. The Dow was down 350 points Monday, nearly 2% so... some investors may be nervous, although Puerto Rico's debt problems are probably adding fuel to the Greek fire. And now you can read that advisory... without even being an investor.

As we indicated on Friday, the collapse of the weekend’s negotiations has resulted in the introduction of capital controls in Greece effective today. We did not predict that Greece’s government would call a referendum on 5 July as technically such a referendum does not make sense given that the current bailout programme expires on 30 June. Yet, the referendum will give the Greek government (Syriza-led or technical or any other), a powerful mandate to act and resolve Greece’s issues.

Greece will hold a referendum on 5 July to decide whether the government should accept the proposal made by “the Institutions” on 25 June, including VAT changes, pensions cuts etc. The actual question asked in the referendum is still subject to change, but we assume that the referendum will be a choice between saying YES or NO to tough reforms demanded by Greece’s creditors and there will be no explicit reference that voting in favour of reforms means staying in the euro zone, whereas saying NO to the reform package results in the introduction of the drachma. We would like to present our scenarios for that event:

1. Resuming the negotiations before 30 June and signing the sweeter deal for Greece

Some European leaders proposed the idea of resuming the negotiations immediately, but we consider that scenario the least likely given the lack of trust between the Syriza-led government and its EU partners. It would be extremely positive news for stock markets.

2. Referendum outcome: YES to the reforms

We believe it is likely that a “YES to the reforms” vote will gain an overwhelming majority, which may result in Greece staying in the euro zone, but it could also lead to uncontrolled Grexit. (Un)surprisingly, Greece’s government is officially against accepting the reform package. Initially, stock markets would react in relief, rally, but then other factors would have to be taken into account.

In our view the sequence of the events would be as follows:

• ECB keeps the ELA support for Greek banks unchanged (€89bn for now) and effectively keeps Greece in the euro zone.
• The Syriza-led government resigns (they were supporting the NO vote) and Greece faces a snap election; a technical government is also an option.
• Resumption of negotiations with the new government.
• Third bailout for Greece-- a compromise based on conditions similar to the previous one, with some debt relief options.

The risks of this scenario lie in the calendar. A new election in Greece, negotiation of a third bailout programme and then its approval by national parliaments-- this would all take time, whereas Greece does not have it. On 20 July Greece will have to repay its debt to the ECB and defaulting on those obligations could be dangerous as it would be extremely difficult for the ECB to justify the ELA lifeline for Greek banks in that case. As we indicated on Friday-- the music really stops for Greece when the ECB pulls the plug on the ELA. Then Grexit is the only option.

In case of YES to the reforms, it would be very volatile days ahead for stock markets as each milestone (e.g. snap election or each vote in national parliament) bears the risk that the whole process will collapse.

3. Referendum outcome: NO to reforms

We consider that such an outcome would lead to severe sell-off on stock markets, resembling the times of the Lehman Brothers collapse. In this case we would expect the following sequence of events:

• The ECB stops supporting Greek banks via the ELA facility and Greece has to introduce a bank holiday (no withdrawals from ATMs).
• Syriza stays in power, unpredictable geopolitical consequences (financial help from Russia?).
• Grexit begins.
• Greece defaults on its external obligations (IMF, ECB, ESM etc.).
• Greece enters severe recession, while the European economic recovery slows (but no recession).
• Introduction of IOUs for domestic obligations such as pensions or public sector salaries.
• Dual-currency regime: euro cash is in circulation, IOUs are also in circulation, but are “traded” at a significant discount in everyday life (e.g. morning coffee for €1 or 4 IOUs) and then “bad money drives out good money”.
• IOUs are converted into new drachma.

We believe that European banking and financial systems are not as exposed to the Grexit as in 2012. Foreign institutions have been reducing their exposure to Greece (and preparing Grexit contingency plans) since then. We think that the improving economies of Italy and Spain reduce the risk of bank runs in those countries. Moreover, European businesses (companies) are not very exposed to Greece (or they have been reducing their exposure for a long time) and Greece is a small economy if we take all of Europe into account; hence Grexit would not be something that could derail European recovery if the ECB ensures that this is an isolated case.

The ECB’s (and broader-- the public institutions’) exposure to Greece is a completely different story. The ECB would have to deal with a massive loss on Greece due to its €38bn Greek bonds holding, its €89bn ELA facility and unclear liabilities related to Greece in the Target2 system (Bank of Greece carried €107 liabilities in January 2015, now the amount is unknown).

How could the ECB handle the loss related to Greece given that the Eurosystem has combined reserves of just €86bn?The ECB can simply monetise it (=inflation) or ask for more capital from the governments (=new taxes).

If the ECB decides to monetise Greece's debts, this would result in higher CPI in Euroland (desirable to some extent), and pave the way for broad intervention on the financial market by the ECB in order to stabilise it. Now the ECB can buy bonds under the QE programme, but it can do more if necessary (remember Draghi's "whatever it takes"?). In our view, contagion risk in the euro zone is manageable and the common currency could remain, with just one less member in that case (Greece would use euro in a similar way to Kosovo or Montenegro).

About €195bn of Greek public debt is in ESM hands or tied up in bilateral loans with EU governments-- this money is lost in case of Grexit.

As Mr Juncker said: “This is not a game of liar’s poker, either we all win or all lose.”