Eric Chaney Chef Economiste du Groupe AXA (2008 - 2016)

Rough Ride for Greece in 2015 but No Significant Impact on Euro Area

1 janv. 2015

A systemic worst case scenario is very unlikely but can't be totally ruled out

- The early Greek general elections on January 25 are likely to yield a government led by the anti-bailout leftist party Syriza, which has publicly called for a restructuring of the Greek government debt, including loans by other euro area members (OSI).
- Our baseline scenario: the new cabinet and international lenders agree on alleviating the weight of Greece's national debt, on completing and ending the bailout program and help Greece to regain access to the markets thanks to an emergency credit line.
- A non-cooperative scenario would unfold if negotiations prove lengthier than expected and postpone an eventual agreement beyond mid-2015. Bad for Greece, this scenario implies some spillover effect on other euro area financial markets, not on real economies.
- A very remote worst case scenario, consequence of unforeseen dramatic political events could led to Greece defaulting on bonds due to the ECB and eventually leaving the euro. Preventing contagion and self-fulfilling consequences would then be in the hands of euro area governments and the ECB.

PM Samaras' attempt to buy time in order to complete the reforms pledged by Greece and get the last tranches of the loans promised by the ESM (€1.8bn due in 2014 but postponed) and the IMF (7.1bn) has backfired. Early General Elections will take place on January 25 and they are likely to give a majority to the leftist party Syriza or a coalition led by this party, although polls suggest the situation remains fluid.

Financial markets have immediately reacted to the news, with a 10% fall of the Greek equity market and a more than 100bps rise on 10Y Greek government bond yields, which are now close to 10%. Sovereign credit default swaps are implicitly pricing a 20% probability of default in the next 12 months and 52% in the next five years, assuming a recovery rate of 20% (that is, close to the 21.5% that resulted from the 2012 PSI). Italian government bond yields have marginally increased.

Syriza's leaders have publicly expressed their rejection of the conditions -fiscal in particular- associated with international rescue loans and pre-announced that they will seek a restructuring of the Greek debt (€330bn or 180% of GDP), of which 71% is due to public lenders, itself split into IMF (10%) and euro area institutions (61%) that is, euro area taxpayers. We try in this note to explore what could happen next.

Because EU lenders have already rescheduled the amortization of their loans, the most critical part of Greece's relationship with its lenders will take place in 2015. In short, debt coming due in 2015 amounts to €29bn, of which 6.7bn to the ECB or euro area central banks (maturing bonds bought under the SMP program) and €8.6bn to the IMF. The next big chunk due in 2015 is T-Bills, mostly held by international private investors. On the funding side, the expected primary surplus (the government's cash balance before interest payments) of 2 to 3bn will not bridge the gap. Provided that Greece eventually fulfils its commitment in terms of reforms, the ESM will disburse the tranche due in 4Q 2014 (1.8bn) and the IMF its very last tranche (7.1bn). Even if this condition was met, Greece would still have a large funding need, of around €10bn.

In our baseline and our'non-cooperative' scenarios, we assume that the Greek government will honour its debt due to the ECB and the IMF and will rollover T-Bills. Only in the worst-case scenario, which we think has a very low probability, do we assume that Greece would default on its debt due to the ECB.

Baseline scenario: some fear, not much harm

Negotiations with international lenders start soon after the general elections. At the outset, the Greek government rhetoric is quite radical, asking for debt forgiveness and refusing conditions. Since most of the debt is due after 2020, it appears quickly that the real stake is 2015. EU lenders are open to restructuring -again- the loans extended to Greece in the bailout programs, under the condition that Greece completes its reform program and pays debt due to the ECB. After much bickering, including a postponement of EU and IMF disbursements and a significant rise in T-Bills rates, it is agreed to soften the reimbursement conditions of the first bailout program (the EU part of the Greek Loan Facility), which is less politically sensitive that the second, which involves the ESFSF/ESM and thus its rating quality. In addition, Greece gets an emergency short term loan (ECCL or Enhanced conditions credit line) from the ESM, which will buy time to return to market funding. The Greek side claims this'OSI' (for Official Sector Involvement) is a national victory while lenders conceal a sigh of relief. Actually, a key factor has made Greek leaders more conciliatory: the announcement by the ECB of a large sovereign bonds purchase program (call it QE), which includes Greek government bonds and therefore makes Greece's funding gap easier to finance and helps Greece come to the market at non-exorbitant rates.

Yet, economic and financial uncertainties caused by the negotiations with international lenders choke the nascent recovery of the Greek economy, which resumes only by the end of the year or in 2016. There is no material impact on the rest of the euro area.

Impact on markets: in the heat of the negotiations, risk aversion and'risk-off' positions may hurt equity markets but, apart from the Greek government bond market, there is no significant spill-over effects on other euro area sovereign markets, because markets know that the ECB is ready to act.

Non cooperative variant: more harmful but baseline only postponed

The new Greek government refuses to abide with troika conditions but honours its debt to the ECB and the IMF by issuing more (and ever more costly) short term debt and drawing on all cash cows at its disposal including the non-used bank buffer designed to recapitalize Greek banks, and which is already in the books of the central bank. This short term fix leads to ever higher borrowing costs, including for short term funding. Eventually, the Greek government takes a more conciliatory stance and negotiations start again, with a lag, following the script of the baseline scenario. Note that, in the absence of a QE program by the ECB, this scenario might have a higher probability.

The Greek economy is more severely impacted than in the cooperative scenario, with a relapse into recession, a further fall in equity markets, capital flight and a retrenchment of both consumers and companies. The recovery does not resume before 2016. Despite the bad news for the Greek economy and risk assets, the real impact on the rest of the euro area remains marginal.

Impact on markets: the fear factor is significantly stronger than in the baseline scenario, with global equity markets experiencing a significant correction, which eventually appears as a buying opportunity. Sovereign spreads become much more volatile but do not rise enough to trigger a demand by Italy (the most fragile sovereign market in the euro area) for ECB's intervention (OMTs).

A very low probability worst case scenario: euro at risk

An unexpected and dramatic political event occurs during the negotiations -such as violent riots causing human casualties-, the new government loses the control of the situation, the Troika suspends negotiations and the government is unable to fill its funding needs in the markets. Maturing bonds due to the ECB are not paid and the government announces a unilateral haircut on its debt due to official and private lenders. Greece is excluded from any QE program and Greek banks have no more access to ECB liquidity. Greece unilaterally decides to leave the Monetary Union so that the Bank of Greece is able to print money. A 40% devaluation of the new Drachma follows and Greece turn into another Argentine case. Italian bond yields rise abruptly and Italy calls for ECB intervention. A memorandum of understanding, including a stronger commitment to labour market reform, is negotiated, followed by ECB's intervention. After a large widening, sovereign spreads shrink again.

Impact on markets: global equity markets take the brunt of the rise of the fear factor and contagion spreads across the weakest members of the euro area, starting with Italy, possibly Spain, Portugal and France. Only after the activation of a OMT program do markets retrace their previous losses. Note that if for any reason, the ECB is not able to activate OMTs, a full-blown sovereign crisis would happen. Outcomes such as those that were priced with a significant probability by the bond markets in 2011 would be, again, debated. A break-up of the euro area or a fast track toward more radical reforms of the governance of the euro area as well as structural reforms in Italy and France are polar potential outcomes.

In conclusion and barring dramatic political events which could lead to our worst case scenario, political changes in Greece are likely to be negative for the Greek economy in the short term and neutral in the longer term. Contagion to other euro area markets is likely to be too limited to be material but the uncertainty caused by negotiations between Greece and international lenders is likely to take its toll on risk assets, in the euro area at least. We believe that this uncertainty should not last very long and that the broad lines of an agreement should emerge before June. Since the biggest debt repayments due by Greece are in July-August, a longer period of uncertainty could shift the odds from the baseline scenario to the non-cooperative one.