The Greek leader of the Radical Left (Syriza) coalition, Alexis Tsipras, arrives at parliament in Athens on May 8, 2012, the future of the EU may be in his hands – Image credit: AFP/Getty Images via @daylife
With the tide turning against a Greek unity government that will respect prior agreements with the troika, the possibility of a Eurozone breakup is no longer just an academic possibility. The consensus is gradually accepting a Greek exit as a likely scenario: external funding could dry up, severely constraining the supply of euros and leading to the adoption of a new currency. According to Nomura, these neo-drachmas would face a 50% to 60% depreciation, while the euro would tank, falling to 1.15 to 1.20 against the U.S. dollar. This is why it could happen, and how it would go down.
The cards are stacked against the least dangerous scenario, Greek permanence in the European Monetary Union. Rising Greek political star Alexis Tsipras, head of the far-left Syriza party, has walked out on talks to form a unity government with the more moderate PASOK and New Democracy parties.
The looming prospect of a new round of elections suggest the left could take over, forming a coalition government, headed by Syriza, which would seek to renegotiate what Tsipras has called the “barbaric” bailout agreement. Recent polls, cited by both Dennis Gartman and Nomura’s Jens Nordvig, indicate a rising possibility of this. Nordvig explains the repercussions of this:
In our opinion, there is little desire within the Troika (ECB, EC and the IMF) to renegotiate. Certain symbolic concessions are feasible, but that is probably it. As such, it will be hard to reach a compromise, and we could see a breakdown in cooperation between Greece and its European/international partners in the months following the second round of the election.
In practical terms, this means Greece would run out of money in a few months. On the one hand, the Greek government would lose access to EFSF and IMF funding, making it difficult to meet debt payments. At the same time, the Greek banking system would find itself euro-strapped as the Greek National Bank halts its special liquidity program (ELA assistance, approved by the ECB). The implications of this latter point are massive:
Terminating this special liquidity support may sound like a technicality, but it is not. Turning off such assistance would imply that Greek banks would lose access to much-needed euro funding, which would leave them no longer able to provide euro liquidity to the general public domestically. This type of separation of balances in Greek banks from balances within other eurozone banks would lead ‘Greek euros’ to trade at a discount to ‘normal euros’ and would effectively amount to the adoption of a new national currency.
If indeed negotiations breakdown and Greece stops cooperating with the troika, then this scenario would play out around July or August, when the next quarterly disbursement is set to be made. Capital flight and domestic bank runs would probably ensue, as the government moves to pass new laws formalizing the redenomination of contracts. “New notes and coins would have to be created and introduced to formalize the shift from euros into a new Greek currency for cash transactions,” noted Nordvig, adding that it would be a speedy process as households hoard euros, which would then become more of a store of value than a currency used for daily transactions.
What does this mean for Greece? A simplistic analysis (based on a metric of current overvaluation of national real exchange rates and a measure of future inflation risk in Greece) suggest the new-drachmas would depreciate about 50% to 60%, according to Nordvig. The banking system will probably collapse, according to data from UBS, as funding costs surge, and companies become unable to finance daily operations. Initially, Greece would be mired in chaos, much like Argentina was once it broke the U.S. dollar peg in late 2001.
The Hellenic Republic will most probably default on various debt obligations (“primarily toward official creditors”), having significant spillover effects, both internally and across the monetary union. While Germany has been active lately trying to assure markets the EU can handle a Greek exit, the shock waves would definitely rattle the foundations of the financial system. Instability would push up the current, elevated, risk premium on Eurozone assets, causing “additional deterioration in external capital flows.”
One could assume that the U.S. dollar would be favored by a Greek euro exit, as investors flock to safety. While Nomura’s current Q3 estimate for the euro sits at $1.25, a breakup scenario could push that down to the 1.15 to 1.20 range. Gold, which should benefit from safe haven flows, would have to face a higher dollar, though, making its move uncertain.
Risk-sensitive currencies and assets would probably take a hit; U.S. equities have taken a hit since the European sovereign debt crisis flared up again. Companies like McDonald’s, with a substantial exposure to Europe, have seen sales in the Old Continent slow, while Caterpillar indicated the European economy remains depressed; Coca-Colanoted a “volatile macroeconomic environment.”
The situation in Europe is dire indeed, with Greece teetering on the edge of default and Spain falling prey to the dreaded bond vigilantes. Germany has managed to keep the monetary union alive, but might have to deal with the first casualty over the next few months. No matter what happens, investors should be prepared for extreme market tension in the EU going forward.
With the tide turning against a Greek unity government that will respect prior agreements with the troika, the possibility of a Eurozone breakup is no longer just an academic possibility. The consensus is gradually accepting a Greek exit as a likely scenario: external funding could dry up, severely constraining the supply of euros and leading to the adoption of a new currency. According to Nomura, these neo-drachmas would face a 50% to 60% depreciation, while the euro would tank, falling to 1.15 to 1.20 against the U.S. dollar. This is why it could happen, and how it would go down.
The cards are stacked against the least dangerous scenario, Greek permanence in the European Monetary Union. Rising Greek political star Alexis Tsipras, head of the far-left Syriza party, has walked out on talks to form a unity government with the more moderate PASOK and New Democracy parties.
The looming prospect of a new round of elections suggest the left could take over, forming a coalition government, headed by Syriza, which would seek to renegotiate what Tsipras has called the “barbaric” bailout agreement. Recent polls, cited by both Dennis Gartman and Nomura’s Jens Nordvig, indicate a rising possibility of this. Nordvig explains the repercussions of this:
In our opinion, there is little desire within the Troika (ECB, EC and the IMF) to renegotiate. Certain symbolic concessions are feasible, but that is probably it. As such, it will be hard to reach a compromise, and we could see a breakdown in cooperation between Greece and its European/international partners in the months following the second round of the election.
In practical terms, this means Greece would run out of money in a few months. On the one hand, the Greek government would lose access to EFSF and IMF funding, making it difficult to meet debt payments. At the same time, the Greek banking system would find itself euro-strapped as the Greek National Bank halts its special liquidity program (ELA assistance, approved by the ECB). The implications of this latter point are massive:
Terminating this special liquidity support may sound like a technicality, but it is not. Turning off such assistance would imply that Greek banks would lose access to much-needed euro funding, which would leave them no longer able to provide euro liquidity to the general public domestically. This type of separation of balances in Greek banks from balances within other eurozone banks would lead ‘Greek euros’ to trade at a discount to ‘normal euros’ and would effectively amount to the adoption of a new national currency.
If indeed negotiations breakdown and Greece stops cooperating with the troika, then this scenario would play out around July or August, when the next quarterly disbursement is set to be made. Capital flight and domestic bank runs would probably ensue, as the government moves to pass new laws formalizing the redenomination of contracts. “New notes and coins would have to be created and introduced to formalize the shift from euros into a new Greek currency for cash transactions,” noted Nordvig, adding that it would be a speedy process as households hoard euros, which would then become more of a store of value than a currency used for daily transactions.
What does this mean for Greece? A simplistic analysis (based on a metric of current overvaluation of national real exchange rates and a measure of future inflation risk in Greece) suggest the new-drachmas would depreciate about 50% to 60%, according to Nordvig. The banking system will probably collapse, according to data from UBS, as funding costs surge, and companies become unable to finance daily operations. Initially, Greece would be mired in chaos, much like Argentina was once it broke the U.S. dollar peg in late 2001.
The Hellenic Republic will most probably default on various debt obligations (“primarily toward official creditors”), having significant spillover effects, both internally and across the monetary union. While Germany has been active lately trying to assure markets the EU can handle a Greek exit, the shock waves would definitely rattle the foundations of the financial system. Instability would push up the current, elevated, risk premium on Eurozone assets, causing “additional deterioration in external capital flows.”
One could assume that the U.S. dollar would be favored by a Greek euro exit, as investors flock to safety. While Nomura’s current Q3 estimate for the euro sits at $1.25, a breakup scenario could push that down to the 1.15 to 1.20 range. Gold, which should benefit from safe haven flows, would have to face a higher dollar, though, making its move uncertain.
Risk-sensitive currencies and assets would probably take a hit; U.S. equities have taken a hit since the European sovereign debt crisis flared up again. Companies like McDonald’s, with a substantial exposure to Europe, have seen sales in the Old Continent slow, while Caterpillar indicated the European economy remains depressed; Coca-Colanoted a “volatile macroeconomic environment.”
The situation in Europe is dire indeed, with Greece teetering on the edge of default and Spain falling prey to the dreaded bond vigilantes. Germany has managed to keep the monetary union alive, but might have to deal with the first casualty over the next few months. No matter what happens, investors should be prepared for extreme market tension in the EU going forward.
