Investment - Articles - Stephanie Flanders at JPM Asset Management looks at Greece

 The Greek stand-off has worsened in the past two weeks, with the growing rancour in the negotiations now also infecting asset markets. It’s possible that policy makers will come up with a last-minute proposal to break the impasse in the next few days. But there’s not much sign of that kind of ‘hallelulah’ moment right now. As a result, we believe there is now a roughly 75% probability on some kind of Greek default – up from 50% a month ago. However, we would not put the chance of Greek exit from the Euro higher than 30%.

  

 Depending on the way any default is handled, the situation could get very messy indeed for Greece, but not all of these dark scenarios would end in Greece leaving the single currency area. A majority of Greeks still want to stay in, even if it means accepting the austerity and structural reforms that Syriza was elected to prevent. For that reason we think a change of government in Greece is more likely, now, than a change of currency. But either – or both – of these now looks eminently possible in Greece.

  

 There have been more signs of contagion in European markets in recent days, but in general the reaction of investors to this deteriorating situation has been muted – and, arguably, a little complacent. Banks are much less exposed to Greek debt than they were in 2012. It’s also true that the European Central Bank has weapons such as OMT available to protect other Eurozone countries from the fallout from Greece – at least in theory.

  

 But if Greece does descend into deeper political and economic chaos it’s difficult to believe that European financial markets will be completely unmoved.

  

 The market reaction so far:

 The impact on European bond prices is more difficult to judge, since these markets have been buffeted by many conflicting forces in recent weeks. But periphery bond yields have lately shown some renewed correlation with Greek ones while there are also some signs of safe haven flows into bunds.

  

 The Swiss National bank today maintained its interest rate on sight deposits at minus 0.75%. The hyper aggressive policy is clearly aimed at reducing the level of the Swiss Franc which the Bank again referred to in today’s statement as “significantly overvalued”. Despite the attempts to weaken the currency it continues to remain attractive given the systemic stability concerns emanating from Greece. Another safe haven, Gold, is also catching a bid for the same reasons and is up around 2% today at time of writing.

  

 The road ahead

 In the absence of a breakthrough in the European finance ministers’ meeting, the focus shifts to the European Union leaders’ Summit on the 25th and 26th of June. But by then, many believe it will be too late to release funding in time for Greece to meet its 30 June repayment to the IMF. To be feasible, a deal also has to have a chance of being ratified by the German parliament, and it must have full IMF support. This points in the direction of an emergency meeting of the key European policy makers before the EU leaders meeting, but this is a situation very much in flux.

  

 The uncertainty has led to accelerating flows of deposits out of the Greek banking system. Deposits in Greek banks fell 17 per cent in the first 4 months of 2015, after Syriza was elected. Since then, the outflows are said to have escalated, with outflows as high as E400m in a single day. Total deposits are the lowest in a decade, and at least 40% lower than in 2010.

  

 There is talk of capital controls to prevent further mass withdrawals of Greek banking deposits and limit damage to domestic banking institutions. We have seen capital controls work reasonably smoothly in Cyprus, who enforced capital controls in 2013 while in the process of negotiating a bank rescue programme with European creditors. But there the negotiations centred only on the banking system, and the capital controls could only be imposed with the sign-off of other EU members.

  

 The situation in Greece is very different from Cyprus, and the impact on foreign investors would depend on the exact details. But one clear lesson of experience is that once imposed – even for temporary emergencies - they are difficult to remove: they remained for 2 years in Cyprus and they are only now starting to be lifted in Iceland, nearly 7 years after they were imposed. If controls are introduced without any deal in prospect, the effect on the domestic economy and broader market confidence could be quite significant.

  

 What happens if Greece defaults?

 Against this backdrop, some form of Greek default looks more and more likely – and would largely involve default on official institutions and other governments. But as we outlined in our previous market bulletin on Greece, there is no straight line between default and Grexit.

  

 Greece can potentially default on certain obligations and still be part of the Eurozone, if that is what the Eurozone ultimately decides – and we should remember that the Greek people have a say in all this as well. A default could even strengthen domestic political support for staying in the Eurozone, if it gives Greek voters a taste of what a messy exit from the single currency would feel like. But
 
 This week for the first time we saw a pro-euro rally on the streets of Athens. A recent survey by Proto Thema asked that if Greece should choose between the creditors proposal or a “Grexit”, 50% of respondents said they should accept the creditors proposal, with only 27% opting for a Greek exit being the best option for the country.

  

 As described in our earlier note, the European Central Bank has a key role to play here, because Greece has little chance of remaining in the Euro without continued ECB funding for Greek banks. ECB officials have said all along that the bank is a “rule-based” institution, and beyond that, the key decisions about Greece need to be taken by politicians. But that is going to be a difficult line to sustain in an environment in which the interpretation of those rules is deeply political.

  

 As expected, the ECB maintained Greek banks’ access to its Emergency Liquidity Assistance, despite the lack of progress in negotiations with creditors – it even raised the ELA limit by €1.1bn, to €84.1bn. But ECB officials have also continued to warn that the central bank can only support solvent banks. The question they are less willing to answer is whether the Greek banking system would be deemed solvent, if the sovereign defaulted on all or some of its debt. But the question of the reality is that the solvency of the Greek banking system is utterly dependent on the stance of the ECB. The banks are solvent as long as Greece remains in the Euro, and as long as they continue to have support from the ECB.