Fra Deutsche Bank
What if we are wrong? Grexit scenarios
We believe that ultimately, even at the cost of capital controls, Grexit will be avoided. But what if we are wrong? With the risk of Grexit, in our view the highest since the crisis began in late 2009 and European patience wearing thin, we engage in some “what if” analysis on the short and long-term consequences of Grexit under three scenarios.
Back in January we have looked at (i) channels of contagion, (ii) peripherals’ vulnerabilities and (ii) ex-post tools to contain contagion11. There we highlighted that in a Grexit scenario, direct channels are not the main source of concern. Indeed, the private sector direct exposure to Greece has been scaled down dramatically. It is the indirect channels that are by far more material.
Grexit Scenario 1: no contagion
In the first scenario, Grexit occurs but has no contagion effects thanks to the QE firewell and the perception that Grexit is due to an idiosyncratic event mainly caused by the Greek government. No contagion implies that the shortterm implications for the stability of the euro-area are benign.
However, despite the benign short term impact, we think that the stability of the euro-area would be weakened in the medium to long term because membership of the euro area could no longer be considered permanent. A political accident could occur again.
Investors would have to assign a non-zero probability to redenomination risk for other weaker counties too. This is not necessarily something the market prices immediately. But the next time the euro area faces a (tough) recession or a member state suffers a shock or its politics turns more populist, risk premia would likely rise more quickly than if Grexit had not happened. In short, the euro area could be rendered systemically more vulnerable by Grexit.
Back in January, to quantify the impact of redenomination risk, we look at a representative country with public debt of 115% of GDP, 3% nominal growth and an average cost of debt of 3.5%. This government would need a primary surplus of about 0.5% of GDP to stabilize its public debt.
Figure 7 provides a number of probability-depreciation combinations. The depreciation of the new Greek drachma would be taken as a reference point. We think that a 50% nominal exchange rate depreciation is a reasonable starting point. Were investors to assign a 5% probability to a 50% depreciation within one year, the debt-stabilising primary surplus would jump to about 4%. Such a primary surplus is proving political undeliverable in Greece and in general tends to be achievable only in a strong recovery.
Grexit Scenario 2: contagion
Markets have proven benign around the stress points during the Greek saga probably expecting a noisy journey but ultimately a compromise.
Still, Grexit could create some modest contagion. In our Scenario 2, therefore, following Grexit there would be an increase in volatility and a negative market reaction, including a widening of peripheral government spreads, a flight to quality in the bond market, weaker equities and weak risk markets in general.
However, we also believe current buffers and backstops will catch markets before a self-sustaining negative feedback loop takes. This may require some demonstration of the capacities of the euro crisis firewall, for example, an accelerated pace of QE, easier access to the TLTRO liquidity, revised terms and conditions on the official loan programmes, etc.
Still, under Scenario 2 as under Scenario 1, we think the euro area would be more vulnerable post-Grexit when the next crisis materializes: the precedent of exit will have been created by Greece and the euro area will be systemically more susceptible to loses of confidence in weak member states as a result.
Grexit Scenario 3: a stronger monetary union
In Scenario 3 euro area leaders understand that Grexit destroys the argument that membership in the euro area must be considered permanent. Investors will no longer be able to assign a zero probability that a similar political mistake will not happen again during the next crisis. The rise of populist parties across the euro area reinforces the risk.
Euro area leaders might be tempted to make an example of Greece – shutting out the country from the EU and making its exit as painful as possible. Even Bedsides geopolitical considerations, we do not think this is the best option. In “The Prince”, Machiavelli never wrote that the end justifies the means. His message was that a kingdom founded on fear is intrinsically unstable.
In Scenario 3, euro area leaders, conscious of threat to lasting stability, decide to take a major leap forward in the integration of the euro-area regardless of the short-term degree of contagion. This could take the form of stronger macro-economic coordination – i.e., surrendering more national sovereignty – in exchange of greater federal funding via issuance of euro-area federal bonds.
Such a major leap in integration would strengthen the stability of the monetary union. EMU membership would bring fiscal advantages as long as rules are respected. The Greek example and the greater coordination would make easier to motivate structural reforms. EMU could then become less imperfect.
Conclusions from our “what if” Grexit scenarios
Of the three scenarios, the most efficient ex-post response from euro-area partners is the one in Scenario 3 – further integration. Indeed, were this intention to be signaled unambiguously before Grexit, it would credibly confirm that the euro-area partners are not bluffing in their unwillingness to incur any costs to avoid Grexit. An excessive compromise with SYRIZA, above all in terms of structural reforms, will not be accepted. This would, in turn, increase both the ex-ante credibility of the Eurogroup’s message to Greece and the benefits of remaining in the euro-area while following its rules. Hence, ultimately, the forward-looking implementation of Scenario 3 would reduce the likelihood of Grexit.
Unfortunately, we think that Scenario 3 is the least likely. It is potentially feasible only if market pressure increases exponentially, that is, if the current backstops including QE comprehensively fail. Even then, the rise in populism throughout the euro area, in the core as well as the periphery, questions whether a consensus could be reached on closer integration.
Whether Scenario 1 (no contagion) or 2 (contagion) is most likely depends on market perceptions of two factors:
- Politics: The more the market views a Greek exit as an idiosyncratic event related to Greek specific issues, the less likely will be contagion. Rising populism in the periphery could gives rise to a channel for contagion.
- ECB: The less the ECB is concerned about moral hazard, the better. The lack of opposition from the ECJ Advocate General to OMT and the capacity of the ECB to deliver a QE policy above elevated expectations increased market confidence in the central bank. To protect the independence of ECB policy, it is imperative that the fiscal/non-fiscal policy coordination framework operates. For the framework to be binding there needs to be political will to enforce policy recommendations. This can be questioned.
Overall, there is a good chance that Grexit would be seen as idiosyncratic. We recently reviewed the political situation within the other peripherals holding elections over the next year. It is possible that the perception of Syriza’s policy success or failure in Greece damages support for anti-austerity and populist parties elsewhere. The good news is that we think it is extremely unlikely that Podemos will obtain an outright majority even if helped by small parties, although by taking a large block of votes increases the challenge of creating a stable government. In Portugal and Ireland, anti-austerity rhetoric is audible, but we expect broad policy continuity.
