What Greece's mire really means

Greek Prime Minister Alexis Tsipras has called for a referendum to decide whether or not to accept the terms and conditions of a bailout agreement with its international creditors.

"What a default implies for Greece's ongoing euro area membership is not clear."
Tom Kenny and Brian Martin, Senior International Economist and Head of Global Economics

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Not surprisingly, the series of events has resulted in overwhelming uncertainty over Greece's future in the euro zone. Reactions to the referendum have been mixed.

The implications are widespread, including heightened uncertainty and volatility in markets and the delay of the expected return to Federal Reserve interest rate normalisation. Here's how the situation could play out.

NO CLARITY ON DEBT DEAL

It is not clear exactly what is on the table at the moment as negotiations are not finalised. The President of the European Commission (EC) Jean-Claude Juncker has said the ECB's is different to that of the Greek government.

As such, the structure of the referendum question is neither well designed nor reasonable. Indeed, the question appears structured to be about the need for more austerity and thus is set up to be rejected. If this happens Greece will be cut off from receiving much-needed funding and would almost certainly lead to default.

There is also no guarantee the 'deal' discussed last week between Greece and its creditors will still be available now Greece has missed its debt payment to the IMF.

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Photo: Yiorgos GR / Shutterstock.com

UNCERTAINTY OVER GREECE'S FUTURE IN EUROPE

European official commentary has suggested a Greek default is not necessarily a trigger for exit. Tsipras has said a 'no' vote will not mean an exit from the euro area.

However, what a default implies for Greece's ongoing euro area membership is not clear. At a minimum, trust between the creditors and the Syriza government will be seriously eroded and the government's position may not be tenable in such an event.

What we do know is the majority of Greeks are in favour of remaining in the euro area and are prepared to accept reform if that is the cost. Whether or not this is how they view the referendum is unclear.

In the coming days we expect the referendum question will be reworked and the choice made clearer for the people of Greece.

Financial stability for Greece and the broader European area is the utmost priority now. The European Central Bank will continue to support Greek banks with its emergency liquidity assistance (ELA) by maintaining the current level of liquidity support. However, that decision is subject to review. There is no guarantee this mechanism will remain in place now the Greek government has missed its payment to the IMF.

The ECB will review its decision on whether or not the Greek government and banks are solvent as the ELA is only available if the institution receiving support is deemed solvent.

On safeguarding the euro area more generally, we expect the ECB to support liquidity in the inter-bank market and guard against any possible contagion risks on euro-area assets.

The ECB can limit a sell-off in periphery bonds through its (as yet unused) outright monetary transmission (OMT) facility and by front-loading its existing QE program.

It helps that the ECB has made considerable progress in enhancing the financial stability of the region with banks significantly recapitalised. The region is in much better shape than in 2012, when fears over a Grexit first surfaced.

RISK OF GLOBAL CONTAGION

If strains were to arise in funding markets we expect global central banks to act strongly to counter these by providing liquidity. The US Federal Reserve already has in place an arrangement with other central banks to combat strains in US dollar funding markets should they emerge.

That said, we are of the view the risks of global contagion seem limited for the following reasons:

• The vast majority of Greek debt is held by official creditors and the remainder by Greek banks and other financial institutions (pension funds, insurance companies). At the end of 2014, about 5-10 per cent of Greek debt was estimated to be held by private investors.

• Foreign bank exposure to Greece is limited. According to the latest BIS data for end 2014, the net claims of European banks on Greece are $US32.9 billion, and has probably been run down. In terms of largest foreign bank exposure to Greece, these are: Germany: $US13.3 billion; UK: $US12.2 billion; and the US: $US12.7 billion.
  
  

Thus, the immediate direct implications for the private sector seem limited.

However, there is little doubt uncertainty and volatility will be heightened in the short term. Fears of contagion to periphery bond markets will be the primary concern, but we find assurance in knowing the ECB will do what it can to preserve the euro and will act in the strongest possible way to minimise contagion.

IMPLICATIONS ON FINANCIAL MARKETS

Heightened uncertainty and volatility will drive a flight to safe haven. Typical beneficiaries of this are the Japanese yen, Swiss franc and pound sterling in Europe.

We have already seen the yen performing strongly on most crosses (with the exception of the USD), equity markets fall, key sovereign bonds bid and spread widening of European peripheral bonds and credit. Although the market has responded to this risk-off event in a traditional manner, the moves so far have been limited.

Expectations of UD Federal Reserve interest rate normalisation are likely to be pushed back, and obviously the messier and more protracted the Greek crisis is the more they will be.

Brian Martin is Head of Global Economics and Tom Kenny is a Senior International Economist at ANZ.