Greek Referendum: Consequences on financial markets

Greeks have decided to give their support to the Government and give the capacity to negotiate a better deal with the creditors

With a percentage of voters at more than 61%, the “No” vote finally won. This paper is aimed at presenting the new stakes, the different scenarios and the impacts on financial markets and asset allocation.

Lessons from the vote and from the current context
Eight questions are key at this stage:
What are the key messages? First, even if the Greeks do want to stay within the EU and EMU, they have rejected the referendum, and that gives additional bargaining power to the Tsipras government. Second, it is crucial at this stage to closely monitor the German and French positions. The Germans want to avoid any moral hazard while the French recommend a quickly-approved agreement, without humiliating Greece (some references to the Versailles Treaty have been mentioned). The third key point deals with the possibility creditors accept debt restructuring or debt relief into the agreement. It would make a big difference in terms of long-term solvency. Fourth, during the negotiation period, the attitude of the ECB (Greek banks, QE…) will be a key factor in financial stress. Last but not least, no doubt financial markets will be highly sensitive to the speed of any agreement. The sooner the better.

Will negotiations start again following the referendum? The answer is yes. A few days before the referendum, the chairman of the Eurogroup warned Greeks that negotiations might be impossible following a “No” vote. Angela Merkel mentioned she did not want to manage any negotiations before the vote, while François Hollande tried to put the pressure for an emergency agreement. On the other hand, Greeks reiterated they do not want to exit the EU or EMU, but they do want to secure a (good) deal. The situation was confusing, and even blocked: neither creditors nor the Greek government want (can) take the responsibility for a breakdown in talks. We already pointed out that it would be risky to consider a “No” vote as the end of negotiations and a “Yes” vote as the end of the problems. Following the referendum, the major change will deal with the bargaining power. A “No” vote is definitely a plus for the Greek government, while a “Yes” vote is a plus for creditors. But at the end, all actors should plead for an agreement. The question of timing is crucial due to the deadline regarding the ECB: the Greeks will owe €3.5bln on Greek Referendum: Consequences on financial markets and asset allocation July 20, and in the absence of any payment, financial markets will bet on the end of ELA programme, i.e. the bankruptcy of the banking system and of the country … unless Europeans are able to promote a transitory set-up to avid such a drama.

Is a “No” vote the worst-case scenario? Not necessarily. It is more complex. Of course, if creditors stop negotiating, it would be the worst-case scenario. Will creditors take that risk? Probably not. Europeans want their money back and to save the union. What is clear, however, is that Tsipras obtains a plus in terms of bargaining power, and the Greek government do want a debt restructuring / cut to be part of the deal, which would also include structural reforms, and a bail-out plan. If creditors accept such a deal, this scenario is at the end positive for financial markets, including for mid and long-term perspectives. In the short term, a “No” vote will be badly perceived by the financial markets.

Will the potential deal take into account a debt renegotiation? This question is massively important for the mid-term perspectives. If yes, the deal will be perceived as a long-term and sustainable one. If not, Greek problems (insolvency, debt burden…) will resurface soon, with the possibility of entering new phases of stress and chaos. However, in the short-term, no doubt financials markets will be pleased with any deal aimed at solving the current political crisis. As a reminder, Greece owes money to several countries and organisations, due to two different bailouts (2010 and 2012). The bailout funds totalled €220bln, most of which has not been paid back. Greece owes around €56bln to Germany, €42bln to France, €37bln to Italy, €25bln to Spain, €12bln to Netherlands, €6bln to Austria, €7bln to Belgium, and €4bln to Finland. The Greek government owes Greek private investors around €39bln, and €120bln to institutions including Greek banks. Greece’s debt mountain is 180% of its GDP.

How long can Greek banks stay shut? This issue is not debated much, which could be a mistake.
According to the government, Greek banks are supposed to reopen the day following the referendum, which seems to be overly optimistic in the absence of a deal/bailout … The only way to reopen banks might be to reinforce capital controls. Will banks stay shut for long without major damage and without street protests and/or any additional downgrade from rating agencies? We doubt it. A rapid deal between creditors and Greece is necessary.

Will the ECB continue to support Greek banks through the emergency liquidity assistance? Suppose they do not: in such a scenario, banks would be short liquidity and would default. So to say that the Greek economy would fall down, as Iceland did in 2008. ECB officials recently stated the institution is not a political one, and as long as a solution is debated between both parties, Greeks and creditors cannot take responsibility to interrupt it. But the ECB has its own statutes and mission: if Greece does not pay what it owes to the ECB and/or if the solvency of banks deteriorate further, then the central bank will be forced to amend the current assistance to the Greeks banks. Last week, S&P agqin downgraded the 4 big Greek banks (Alpha Bank, Eurobank Ergasias, National Bank of Greece and Piraeus Bank); their rating is now one notch above selective default. Nevertheless, the ECB has decided to keep its support for the Greek banking system unchanged (same amount of liquidity, without any haircuts). No doubt that some members, who already voted against the increase in the ELA ceiling for Greek banks on June 28, firmly disagree. However, in the absence of any additional downgrade of Greek banks, it is reasonable to consider the ECB will continue to accept them in the ELA programme, without haircuts. This should remain the case … at least until July 20. Missing the ECB payment due on July 20 would be highly critical.
This would probably freeze the ECB emergency liquidity programme for Greek banks. Note the Greece’s banking system is being kept alive by this emergency money (nearly €89bln since June 28). Note also the ECB already increased the ELA ceiling for Greek banks 4 times in a row in 2015: on Feb. 12 (€60bln), Feb. 18 (€68bln), April 22 (€75.5bln) and June 19 (€84bln). Any good deal between Greeks and creditors would eliminate these risks.

Is the anti-contagion set-up solid and credible? The answer is clearly yes. Beyond the ELA programme (which guarantees access to liquidity for banks), the ECB can enlarge and speed up the QE programme (which maintains rates and yields at low levels and protect peripheral countries’ debt) and activate OMTs (recently approved by the European Court of Justice). Last but not least, the ECB might also start buying corporate bonds. In other words, Greece is not a systemic risk, and the anti-contagion set-up is highly credible.

Financial markets: what is at stake now? Following the referendum, 3 options:

• An agreement between creditors and Greece or not,
• A large agreement including the public debt or not,
• A quickly-approved deal or not.

A deal forcing Greece to implement new reforms, including a bail-out plan (with banking system recapitalisation) and debt restructuring would definitely calm worries. A deal excluding debt restructuring would also please financial markets. If quickly approved, any deal would be better due to the coming deadlines:

• July 8: Greece to sell 26 week bills.
• July 10: Greece needs to refinance €2bln in T-Bills.
• July 13: IMF loan repayment totalling about €450m due. Eurogroup meeting.
• July 14: Greece needs to repay JPY 11.7bln in yen loans.
• July 16: ECB Governing Council monetary policy meeting.
• July 17: Greece needs to pay €71m in interest on 3yr bonds sold in 2014.
• July 20: Redemption of €3.5bln in bonds held by the ECB.
• July 31: Moody’s to review Greece’s sovereign debt.
• August 1: Interest on IMF loans (payment due August 5), totalling about €175m.
• August 5: ECB Governing Council non-monetary policy meeting. Greece to sell 26 week bills.
• August 7: Greece needs to refinance €1bln in T-bills.
• August 14: Greece needs to refinance €1.4bln in T-bills.
• August 20: Greece needs to repay €3.2bln in bond redemptions held by the ECB.

Scenarios, probabilities and impacts
4 scenarios have been identified. Probabilities that are totally subjective and scenarios depending exclusively on political developments …

Scenario #1 creditors and Greeks are unable to close a deal.

• This would be the worst-case scenario. Greece would not be able to pay its debt, and the ECB might be forced to stop the emergency liquidity programme to the banks, which would then go bankrupt. The Greek economy would also fall down (look at Iceland in 2008). Greece should be forced to print a parallel currency (to the euro) to pay public servants and pensions … this parallel currency would not have any international credibility (look at Cuba). Greece would still be part of the EMU de jure, but would have exited the EMU de facto. Long lasting conflicts would affect Greece and its creditors (look at Argentina following the end of currency board and default in 2001). Sooner or later, Greece might be inclined to ask for an official exit (see insert below).
• Probability: 20%
• Market impact: At first, European financial markets would be driven down: downfall of equities, and notably peripheral countries, widening of sovereign bond spreads and corporate bond spreads, decline in core bond European yields and US bond yields, increase in volatility indices, increase in gold prices … Later on, the ECB would certainly speed up its QE programme (and maybe OMTs), which would calm tensions in peripheral countries. The euro would certainly be weaker.

How to exit the European Union? Article #50, Lisbon Treaty mentions that “any Member State may decide to withdraw from the Union in accordance with its own constitutional requirements. A Member State which decides to withdraw shall notify the European Council of its intention. In the light of the guidelines provided by the European Council, the Union shall negotiate and conclude an agreement with that State, setting out the arrangements for its withdrawal, taking account of the framework for its future relationship with the Union”. This agreement “shall be concluded on behalf of the Union by the Council, acting by a qualified majority, after obtaining the consent of the European Parliament”.
“The Treaties shall cease to apply to the State in question from the date of entry into force of the withdrawal agreement or, failing that, two years after the notification, unless the European Council, in agreement with the Member State concerned, unanimously decides to extend this period”. For Greece to exit, the fist step is to ask for it. If so, European are working altogether to implement a specific set-up allowing Greece to create a new currency, the proper institutions … in other words to do reverse engineering of everything built in the past years / decades.
How to exit the EMU? A EU exit is planned in the Lisbon Treaty, a EMU exit is not planned. The exchange rate at which currencies are replaced by the euro is irrevocable (article 140, paragraph 3, Lisbon Treaty). In other words, entering the EMU is irreversible. Moreover, unless a specific treatment and derogation (as United Kingdom and Denmark have), any EU country member might have to accept EMU membership as soon as they respect the different criteria.
Are EMU members able to abandon the EMU and stay as EU members? We should refer to official statements for years, exiting the EU means existing the EMU. Legally, due to the absence of any legal framework, a country can ask for anEMU exit and ask to stay within the EU. However, technically, in regard to the institutions this seems impossible. Exiting the EMU means exiting the EU, at least for the moment.
European countries cannot push out one of the EU or EMU members. Of course, the EU can push out a country indirectly, through pressures or by forcing a country to adopt out of reach measures. This scenario surfaced in 2011-2012, in regard to Greece. Some observers thought that Europe and the ECB would stop supporting Greece, forcing the country to adopt the Grexit scenario.

Scenario #2 a deal before July 20, with a special mention on debt restructuring.

• To achieve this softer creditors and/or stronger bargaining power for Greece would be needed to allow a “perfect deal”: a bail-out plan + structural reforms + banks recapitalisation plan + debt restructuring (reduction). In such a case, banks’ activities restart, Greece is able to repay all its debts and no longer represents a risk in the coming years. The country would even be able to borrow money from capital markets. Politically, this scenario would also pave the way to a major step to federalism. This is by far the best-case scenario.
• Probability: 35%
• Market impact: The anti-contagion set-up and the “perfect deal” would guarantee stability and better conditions for European financial markets. In regard to the deal, the sooner the better. Equities would significantly go up, spreads (sovereign and corporate bonds) would further narrow, and the Euro should appreciate. Carry and duration trades would be at play.

Scenario #3 a deal before July 20, without any debt restructuring.

• In such a scenario, Greeks would continue to carry their entire debt. The bail-out plan would nevertheless force them to implement structural reforms, fiscal rigour, primary surpluses … this would be good news for financial markets, but long-term problems would remain. Greece is not solvent long-term, and with this deal, it will not be solvent either… unless it experiments a very strong economic growth and huge fiscal surpluses and unless it is able to issue bonds … A “perfect market configuration” for Greece seems to be difficult to obtain without a “perfect deal”.
• Probability: 25%
• Market impact: it would not be very different in essence from scenario #2, but magnitude and duration should be weaker.

Scenario #4 a deal between Greeks and creditors, after July 20.

• Whatever the date, an agreement between both parties is good news for financial markets, but in this case, pressure and volatility would gain ground, as regard the numerous deadlines Greece has to face (see timetable above). Greece would not be able to honour its debt to the ECB, and we enter into new territories.
• Probability: 20%
• Market impact: Without temporary solutions or legal artefacts, all observers and investors may bet on the end of ELA programme to Greek banks and, at least temporarily, this scenario will look like the scenario #1. Once the deal is concluded, it will look like scenario #2 or scenario #3.

Conclusion
Scenarios #1 and #4 represent extreme risk scenarios, a “definitive” and “irreversible” one for scenario #1 (no agreement) and a “temporary” one should we refer to the scenario #4 (an agreement after July 20). Even if probabilities are not the highest, market impact might be dramatic, and protecting portfolios make sense.
In sum, despite the vote, the Greek problems are not solved: uncertainty has not disappeared yet, important reforms are still to come, public deficits and debt have to be contained further … in such conditions, do not exclude periods of tensions. Some key points have to be recalled, though:

• Sovereign bonds: QE maintains core countries’ bond yields at low levels and any crisis or contagion risk will give incentive to the ECB to speed-up or enlarge this programme. So to say, risk scenarios plead for lower yields.
• Peripheral countries bonds spreads: contagion will be limited due to several factors: i) Greece is not a systemic risk, ii) European banks exposure to Greece is limited at present (not the case in 2010 – 2011), iii) the ECB can speed up its QE programme and, iv) if needed activate OMTs.
• Corporate bonds spreads: until now, the corporate bond market is not part of European QEs, but things can be changed if needed, as ECB officials recently recalled. Note that weak liquidity in this segment gave incentives to reduce risk, essentially via equities (selling futures).
• Euro: the anti-contagion set-up of the ECB pushes down the European currency.
• Equities: all factors driving interest rates, bond yields and the euro down give incentive to invest in European equities. Beware tensions periods, where equities serve as macro-hedges (attractive role in terms of beta and liquidity).

All in all, no radical change in our asset allocation, already in favour of European assets, equities and carry
positions, and short euro. Some nuances must be mentioned:

• The Greek situation and the negotiations to come may provoke new periods of stress. As long as a deal is not concluded, tensions will not disappear.
• Liquidity constraints must not be underestimated: the decline in investment banks inventories, the consequences of regulation (Basel 3 and Solvency 2), forcing investors to buy big amounts of government bonds (as a buy and hold strategy), the reduction in market-making activities, the predominant role of central banks through QEs… are all factors which have shrunk liquidity on bond markets. As a consequence, to close positions or portfolios requires more time and patience. This constraint is a new determinant for portfolio construction.
• Greece remains one of the major worries, it is a fact, but some other factors are essential too. For example, any perspective of a Fed tightening has an impact on financial markets. There is no reason to consider the Fed will “normalise” its monetary policy, but rates hikes are now fully discounted. The question deals with the timing and the speed of tightening. The European QE will be pursued for a while, and this policy clearly pleads for widening spreads between the US and the euro zone, and for a weaker euro, two factors in favour of European risky assets.
• We continue to consider that being long gold and long USTreasuries represent the best hedges to the worst-case scenarios. Equities are quite good macro-hedge of corporate bond markets for those who do want to reduce risk in this segment. Note that hedging is not a question of probabilities of scenarios: even when the worst-case scenario has a low probability to occur, the outcome of such a scenario might be dramatic enough to reduce risk and adopt some hedging strategies.

Philippe Ithurbide – Global Head of Research, Strategy and Analysis – Amundi