What’s the ‘Grexit’ strategy of Europe’s common currency?
In a now famous 2012 speech that vowed to do whatever it took to put a floor under the single currency, stocks and bonds, European Central Bank president Mario Draghi said that “the euro is irreversible.”
Fast forward three years and that pledge is in doubt. After a dizzying and dramatic weekend of headlines, the odds of Greece leaving the euro have shot up, putting the common currency under renewed selling pressure.
When it comes to the euro’s future, there are two key questions. Will Greece indeed leave the ‘irreversible’ common currency? If it does, what could it mean for the euro’s value and viability?
“…The insurance from European institutions will continue to work as an effective backstop for other vulnerable countries, as long as there is no political contagion.”
On the question of a possible ‘Grexit’, most economists and strategists agree that the Greek referendum on July 5 on Europe’s bailout proposal, is—for all intents and purposes—a vote by the Greek population on whether they choose to remain part of the euro zone.
Citigroup economists, led by Willem Buiter, predict the situation will get worse: He thinks Greece will miss its Tuesday payment owed to the International Monetary Fund and will be further restricted by the ECB to access emergency liquidity assistance.
Eventually, the country will be forced to impose tighter capital controls. However, they do not expect a Grexit, a word first coined by Buiter.
“We expect the referendum to result in a comfortable majority for the ‘yes’ camp and expect no Grexit this year and a lower risk of Grexit in subsequent years.” he wrote in a research note on Sunday.
A ‘no’ vote, however, Citigroup economists say would make a departure from the 12-nation currency area “very likely.”
“We maintain our probability of 60 percent that ultimately a semi-stable agreement will be reached, allowing Greece to remain in the euro, but it will be a lengthy process. We now see a 40 percent chance of [a] Grexit,” economists at Societe Generale wrote Sunday.
What if Greece votes ‘no’?
What if the Greeks vote no to a deal that their own Prime Minister Alexis Tsipras opposes, and has called a “blackmailing ultimatum… strict and humiliating austerity without end?”
Credit Suisse says it “would be viewed as raising the risk of a descent into a much more negative scenario,” analysts wrote, giving that scenario a 33 percent probability.
A “reject” vote at the referendum would likely mark a first step towards relinquishing the euro, as “there is no indication that the Troika stands ready to offer Greece a better deal,” according to the Societe Generale economics team.
While not the base case of many Wall Street firms, if the Greeks vote ‘no’ to the bailout, the chances of Greece exiting the euro rise substantially. The opinion polls leading up to next weekend will be key.
European politicians and central bankers have declared repeatedly throughout the euro’s brief 16-year-old life that it is unbreakable or “irreversible.”
So what if it isn’t?
That’s why some doomsayers have compared a Grexit to Europe’s ‘Lehman Moment,’ recalling the failure of the once storied Wall Street bank whose collapse helped catalyze the 2008 financial pandemic.
Any Greek exit from the euro would set a dangerous precedent that the euro membership is indeed reversible, and therefore could raise the risk of an exit by other weaker members such as Spain and Italy. Contagion fears could also drive up borrowing costs in the periphery.
“The key will be if contagion effects to peripheral markets are significant (leading to a break in bond spreads observed this year),” writes Jens Nordvig, managing director of currency research at Nomura.
However he, like many economists and strategists, remain optimistic that the crisis won’t spiral out of control.
“The key point here is that the political situation in the rest of the periphery is fundamentally different from that of Greece,” Nordvig said.
“Hence the insurance from European institutions will continue to work as an effective backstop for other vulnerable countries, as long as there is no political contagion,” he said
Can Europe stem the tide?
Further, the ECB has proven it is an effective crisis fighter and has the tools to calm the markets by buying bonds through quantitative easing (QE), verbal intervention and other liquidity programs like long-term refinancing operations (LTROs).
“The governing council is closely monitoring the situation in financial markets…The governing council is determined to use all the instruments available within its mandate,” the central bank said in a statement on Sunday, when announcing the Emerging Liquidity Assistance caps for Greek banks.
Wall Street seems to think European authorities have enough tools in their arsenal to stave off a full-fledged panic.
“In a very practical sense, so long as the ECB is engaged in QE, there is a rather clear limit to how much damage markets will inflict on other sovereigns,” wrote Erik Nielsen, Chief Global Economist at Unicredit Sunday. “Once the QE is phased out, we have the OMT [outright monetary transactions].”
He was optimistic the Eurozone would emerge stronger if Greece votes to leave.
“The odds favor better European policies after a Greek exit. Keep in mind the Greek government has managed to unite the rest of Europe in its opposition to its voodoo economics to an extent rarely seen before,” Nielsen added.
“This is fundamentally a crisis generated by the Greek government,” he said. In Nielsen’s thinking, should Greece leave, it will have been the population’s decision, and doesn’t mean Europe will have thrown Greece out of the currency.
In the near term, there may be a period of uncertainty and that may weigh on the euro. In Asia trading on Sunday, the single currency tumbled by more than a cent.
“Our base line is an initial move towards 1.10. But no major follow through from there, and perhaps a reversal if contagion effects turn out to be manageable without ECB intervention beyond the soft verbal intervention we already received Sunday,” Nomura’s Nordvig said.
No matter how the Greek referendum ends up, it could create waves of risk aversion on uncertainty and uncharted territory.
Ultimately, however, Wall Street thinks the political commitment to the common currency, combined with the support of a determined central bank, should pave the way for a stronger, more united euro—with or without Greece.