Grexit contagion risk greater than expected, say managers

The impact of a “Grexit” could be more serious than the market is pricing in, due to a contagion risk that would destabilise the political fabric of other eurozone nations, say investors and commentators based in London.

Some argue an exit would be suicidal for both sides, resulting in a Greek humanitarian crisis, severe recession, near-hyperinflation, potential military intervention and even a political lurch towards Russia. The stakes are high and US president Barack Obama has urged both sides to reach a compromise deal.

But in advance of the latest European Union crisis summit yesterday, portfolio managers, strategists and economists in London rated a Greek exit as more likely than not, with a probability ranging from 50% to 85%.

“There is an economic reality that you can’t escape,” said Mike Cirami, co-director of global fixed income at Eaton Vance. “Greece is bankrupt and unsuitable for monetary union.” His only surprise was that it had taken so long to get to this point.

The big pending deadline is July 20, when Greece is required to repay a 3.5 billion euros to the European Central Bank (ECB). Failing to do so could mean the ECB could cut off any liquidity Greece has had, hastening its eurozone exit.

Asked whether it was in Europe’s best interests to keep Greece in, Azad Zangana, senior European economist and strategist at Schroders, said he was beginning to question that.

“We are seeing populist parties such as Podemos rising in Spain,” he observed. “The big question is, do you want to hold on to Greece and risk Spain getting into the same situation, or are you willing to let Greece go to safeguard Spain? There is a clear relationship between the success of Syriza and Podemos.”

While Cirami noted that Greece accounted for less than 2% of eurozone GDP, he said the impact of its exit mattered due to its potential contagion effect on Spain, Portugal and Italy. “The rise of Syriza is not a Greek phenomenon. We are seeing it everywhere,” he said.

He noted the driver for this was not dissatisfaction with austerity, but with the whole economic system. “It is not austerity that is creating 50% youth unemployment in some of these countries,” he added.

Marino Valensise, head of the multi-asset group at Barings Asset Management, said you needed a crystal ball to understand what would happen next, as the behaviour of some participants was "irrational".

He cited as an example the Greek government showing up to a critical European summit without a written plan. “There are times when I think maybe [Syriza] just wants to exit,” he said. “But I can’t believe that’s the case because it would be so painful for their people and they would hate them. I don’t think they [Syriza] really appreciate how close we are to the end.”

He noted the emergency liquidity agreement (ELA) could not be extended for more than a week. “On Monday [today], if there is no agreement the ECB will step back and stop ELA. That is going to be the end of the Greek banking system. At that point the Greek central bank will have to print IOUs.”

He said a Greek default would amount to about 500 billion euros, of which public debt made up 350 billion euros, with the remainder in liabilities to other central banks in Europe. “If they default the ECB will probably need to be recapitalised, the IMF will lose a substantial part of its firepower and the European Stability Mechanism will lose a lot of its capital.”

As Sunday's negotiations played out, however, it appeared more likely than ever that Greece will be forced out. At the emergency meeting in Brussels, German chancellor Angela Merkel and French president François Hollande presented Greece’s prime minister Alexis Tsipras with a list of austerity measures amounting to a surrender of fiscal sovereignty as the price of avoiding financial collapse and being ejected from the euro bloc.

Valensise argued it was important to find a solution as eurozone leaders need to show they can deal with populist political forces. “If not, the next time a rebel party gains power in one of the peripherals, is it going to be Greece all over again?" he questioned.

But his base case remains that the two sides agree a bridging loan of up to 10 billion euros, to enable Greece to meet its July 20 ECB obligations.

“I can’t believe they won’t reach some sort of compromise, because it will be suicidal for both parties otherwise,” he said, placing faith in the instinct for self preservation. “A bridging loan would mean they can take time to discuss a longer-term agreement. I can’t see why this would not happen.”

Valensise said the key question for the eurozone surrounded the pooling of liabilities and whether the strongest nations were prepared to underpin the weakest.

Zangana, too, noted the monetary union was not set up with an agreement of rich countries financing poor, but only an agreement for small transfers linked to structural reforms. “The monetary union never set up to be a fiscal union,” he stressed.

He was among those to argue the eurozone would be stronger without Greece. “There will be a clear understanding for other member states that if you don’t look after yourself the safety net is not always there. It removes moral hazard and hopefully forces governments to be more responsible with finances.”

He suggested Greece would likely suffer a severe recession, making what happens to the country’s social fabric difficult to predict. “History suggests the military usually ends up taking over,” he observed.

He said he was less concerned about the reintroduction of the drachma than the possibility that Greece would lean towards Russia for support. “A large contingency of Syriza is very pro-Russia and has pro-communist tendencies. Europe does not want Russian military bases on its borders. That would be the cost of help from Russia.”

Cirami suggested the idea of Russian military bases was far-fetched, but admitted a humanitarian crisis was a risk. He suggested the best way to approach the crisis was to allow Greece to exit and to devalue its currency. “It has to be the drachma. It needs to be redenominated and revalued. That is not the solution, but that will create an environment where reforms can be done.”

He noted that Eaton Vance carried out an analysis five years ago that found that several eurozone states were closer to African nations in terms of business measures, competitiveness and educational indices. “Yet they are crammed into a monetary union with the likes of Germany, so it doesn’t work.”

He suggested that the eurozone would eventually see the completion of banking union, with a regulator and bailout funds in place. “The next stage would be to have some common deposit guarantee so you no longer relied on governments to bail out banks. That removes contagion between governments and the banking system. Thereafter they can move on to fiscal union, but we are a long way from that.”

He added that Greece needed to be allowed to default and introduce a scrip that could turn into drachmas. “That [scrip] could be the currency employees are paid with and they could leave it to the private sector to decide whether they want a contract in euros or drachmas. I don’t see why you could not have two currencies circulating side by side in an economy.”