Euro Watch – Greece referendum: what next?

by: Nick Kounis , Han de Jong

Euro-Watch_Greece-referendum_what-next_28-June-2015.pdf (204 KB)
  • We look at the implications of the calling of a Greek referendum
  • The government will miss its IMF payment, while capital and deposit controls are likely
  • There will be grave consequences for the already battered Greek economy
  • Some damage to eurozone, but this is not 2011-2012, and economy should recover quickly
  • Risk of Greek euro exit has risen, though it is not our base case
  • Economic and financial damage could well push Greece back to the negotiating table

Tsipras drops a bombshell

Greek Prime Minister Alexis Tsipras dramatically called a referendum on Friday night. It is planned to be held on 5 July and will ask the public whether they agree with the bail-out plan that creditors are proposing to the Greek government. He and other members of his government have made it clear they will be campaigning for a rejection of the plan. So Mr Tsipras is asking the Greek people for their permission for him to refuse the plan and accept the consequences, which would at the least mean default.  Here is how we currently assess the situation:

  • There still is time to go back to the negotiation table before the current bailout programme runs out this Tuesday.
  • If that does not happen, Greece will miss its IMF repayment and head for default.
  • The pace of cash withdrawal from Greek banks will accelerate, it is becoming a bank run.
  • The ECB may restrict the Greek central bank’s liquidity support for Greek banks, which will initiate a banking crisis.
  • Opinion polls suggest a majority of Greeks may support a Yes vote. How this develops is unpredictable, but financial chaos during the next few days may persuade the electorate to vote in favour of the bailout.
  • New elections may become inevitable.
  • The ECB and the other policymakers will do what they can to guarantee financial stability in the eurozone. They now have a significant arsenal of tools at their disposal.
  • The initial reaction on financial markets may likely be very negative. We think that the authorities will be able to restore calm relatively quickly.
  • Some economic damage will occur as confidence is negatively affected, but the eurozone economy should regain its footing relatively quickly. This is not 2011/2012 when the first Greek crisis pushed the eurozone into a recession.
  • The risk of a Greek exit from the euro has risen, though a large majority of Greeks want to remain part of the euro. The period of stress could still push Greece back to the negotiating table at some point.

Consequences of the referendum call

We see five direct consequences from the Greek government’s decision to stop the negotiations, call a referendum and campaign for a No vote.

1.     Greece will run out of cash

The current Greek bailout programme ends on 30 June, when Greece is also scheduled to pay the IMF. So ironically, by 5 July the new bailout plan the Greek people would be asked to vote for would technically no longer be on the table in any case. The Greek government asked the Eurogroup for an extension of a month. Without any further commitment from the Greek government, the Eurogroup denied this.

Given the lack of an external financing programme, the Greek government will be unable to pay its debts in coming days and weeks. First up is the IMF payment on 30 June. Missing an IMF payment is not technically defined as a default by credit rating agencies. Furthermore, under normal IMF conditions a missed IMF payment is not registered as such for a while.  However, Managing Director Lagarde has so far taken a tough approach and has said Greece would be declared to have missed the payment on 1 July. The next major payment is on 20 July when government bonds held by the ECB are due. Failure to pay back the capital would be seen as a default. The government may also struggle to meet its domestic payments.

2.     ECB may end liquidity support; deposit and capital controls look inevitable, a bank holiday likely

Given the escalation of fears of default and Greek euro exit, it seems very likely that deposit withdrawal will accelerate to a rapid pace with a major risk of a bank run. So far, the Greek central bank has been providing emergency liquidity assistance (ELA) to Greek banks to accommodate these cash withdrawals. When the current bailout programme runs out and is not replaced by a new one, the ECB may judge that Greek banks are no longer solvent due to the Greek government bonds they hold. As a result, the ECB may pull the plug on Greek banks and end the ELA liquidity support. This would imply significant financial instability with grave consequences for an already battered economy.

Even if the ECB were to allow the Bank of Greece to continue its ELA support, deposit and capital controls will most likely be necessary to stem deposit flight and the Greek authorities may close the banks for a couple of days. Deposit flight eased during the course of last week, but there were long lines at many ATMs in Greece on Saturday following the announcement of the referendum.

3.     New government may be necessary to get process back on track

There still is time for all parties involved to get back to the negotiating table before the Tuesday deadline expires. It must be said that mutual trust between Greece and the institutions has sunk to a new low following the Greek government’s decision to end the negotiations, call for a referendum and commit to campaign for a No vote. On their part, the Greek government feels that the institutions were not flexible enough.

The first opinion polls suggest that a majority of the Greek population want the government to sign the deal, while an overwhelming majority are saying they want Greece to stay in the euro. Mr Tsipras has vowed that he will respect the outcome of the referendum, but he will, presumably, call for new elections should he lose the referendum.

4.     ECB needs to ready the OMT

Financial markets will most likely react badly to the developments over the weekend. There is a risk that peripheral government bond spreads surge to stress levels. The ECB needs to be ready to activate its OMT programme to restore calm if necessary.  The Eurogroup put a lot of emphasis on the firewall the authorities have built over recent years in its statement on Saturday asserting that ‘euro area member states intend to make full use of all the instruments available to preserve the integrity and stability of the euro area. This will complement any actions the European Central Bank may take in full independence and in line with its mandate. EFSF and ESM remain the strong instruments with our full backing that they have always been’.

The ECB could decide to step up QE. However, QE is skewed toward core government bonds, while the OMT could focus on ‘unlimited’ purchases of peripheral government bonds. To qualify for the OMT, member states need to be in an ESM programme. However, this includes a precautionary credit line, which has very limited conditions. The ECB needs to make the plans necessary so that it can use the OMT quickly if market tensions escalate.

5.     Risk of Greek euro exit has risen

The scenario where Greece eventually initiates a process to exit the eurozone has become more likely, though it is not our base case. The economic and financial deterioration could push Greece  back to the negotiating table, possibly even with a new government eventually or after an in-out euro referendum. However, a euro exit scenario could instead materialise if the economic pain of staying in the euro without financing for the government and the banks was judged to be too much by the Greek authorities and public. They may feel they could not accept the necessary conditions for a new programme.

A euro exit would not be good for Greece. In the first year at least it would mean an even more severe economic crash. The weakness in the economy, banking stress and fiscal tightening would be ‘complemented’ by a collapse in the value of the new currency. Inflation would soar. The experience from countries that have exited currency boards is that eventually, the economy would adjust and rebound. However, in the meantime, social hardship would become severe and there would be a risk of serious political instability.

For the rest of the eurozone, there would most likely be more financial stress, with peripheral government bonds and other Southern European assets leading the decline. During the previous Greek debt crisis in 2011/2012 the combination of deteriorating confidence and spiking borrowing costs in a number of countries pushed the eurozone economy into a new recession. The consequences this time around will be much less severe. First, the Greek exposures of the rest of the eurozone are much less than in the past. In addition, as discussed above, policymakers would intervene. There are signs that confidence in the eurozone is being affected by the Greek crisis and some economic damage is likely. However, we are assuming that calm will be restored relatively quickly. If that is the case, the economy should eventually regain its footing.

How the eurozone might develop after an exit by Greece is unclear. Investors may price in higher risk premiums for weaker eurozone countries. But we have to keep in mind that the project of European integration stumbles from crisis to crisis only to get more solid with every step.