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Article / 29 June 2015 at 15:15 GMT

What happens after the Grexit and what to watch out for

Blogger / MoreLiver's Daily
Finland
  • Greece will remain locked for a long time
  • ECB will allow some contagion – but not too much 
  • Loss-handling is the only major open question

By Juhani Huopainen

In my two earlier articles I pointed out that Greece’s default would not be a fiscal or economical disaster to the euro area and that the risk of serious contagion or political risk is minimal – but the long-term path to a full monetary and economic union has become hopeless. I now turn my attention to how a post-Grexit world would look like and what to watch.

Greece will have capital controls for a long time

Greece has definitely moved toward exiting the monetary union. On its way, it is now in a limbo of initial capital controls and technical defaults, and the end game could end with either Greece introducing stricter capital controls or someone caving in and finding another can-kicking solution.

A bank holiday with deposit withdrawal limits is now in place for at least this week, and similar cases in the past suggest it will be extended. 

The capital controls in Cyprus were implemented in March 2013, but were only fully lifted in April 2015. In Iceland they were implemented in November 2008 and in June 2015 it was announced they would be lifted.

Iceland - Blue Lagoon
Iceland has a long history of capital controls. Also, it tourism is an important sector. Maybe Greece can find lessons to learn there. Photo: iStock

Remember, Greece has to fight both a traditional bank run of people withdrawing their deposits, but also a bank run in the interbank markets. If Greece moves toward a default and possibly an exit from the monetary union, it will need to introduce a parallel currency and force people and institutions to use it. 

With an automatic preference for euros, the only way to do that is through legislation and capital controls.

The ECB will allow limited contagion...

The European Central Bank (ECB) will do ‘whatever it takes’ its utmost to control contagion. The monetary union could survive by pretending that Greece is a special case, but it will require two things. 

Firstly, no other country can ever think that Syriza-like demands of debt forgiveness or an exit from the monetary union are plausible options. 

Secondly, all institutions must treat everyone in a consistent manner and support everyone equally.

A small contagion effect, for example a rise in sovereign bond yield spreads over Germany, will be allowed. It will provide a signal to a country which is moving to the “wrong” direction. The wrong direction could be lack of reforms, high deficit spending, rising support for populist parties in the polls or statements from politicians that are deemed undesirable.

These small spread increases will be inconvenient and wake up the national media and politicians and remind them who calls the shots, and what the red lines are.

…but serious contagion capped with OMT and loss of sovereignty. 

If the spread increases would prove large enough, despite the ECB’s sovereign bond purchase programme, the ECB would politely remind the country that requesting additional targeted support via the Outright Monetary Transactions-programme would be possible, but it would be conditional on applying for at least a precautionary credit line from the euro area's rescue fund and signing a Memorandum of Understanding. It would mean giving up sovereignty to the European institutions.

While this is not as good as a transparent and rules-based federal union, it is better than nothing. Unfortunately, it also increases the chances of public quarrelling and lousy compromises.

Handling of the losses provides an opportunity for the federalists

I believe eventual losses from the Greece’s debt are a matter of fact. Only the timing is open for debate. We do not know how the euro area’s institutions would handle the losses. 

The ECB would probably require member states to provide more capital so that the ECB’s capital would not become negative, and such capital would have to be scraped from national budgets. 

The European Financial Stability Facility (EFSF) would also require capital, and the bilateral loans from other euro area countries would have to be marked down to zero.

Either the European institutions accept that this was a one-time hit and go easy on the European Semester process, which monitors the adherence to debt- and deficit limits. Alternatively, they could use this opportunity to tighten their control over the member countries.

This is the only open question in my opinion, and possibly dictates how the euro area will end. If control is tightened by too much, there will be more Syriza-like trouble later down the road, as the impossibility of a monetary union without asymmetrical shock-fighting transfers becomes clearer.

On the other hand, if control is tightened too little, the creditor countries’ voters who realize they’ve been had would lose faith in closer integration. This would lead to the long-term doom of the euro area, as I outlined in my two earlier articles. 

Bull & Bear
Ready for a bullfight? Photo: iStock 

Market implications: the devil takes the hindmost

After the initial short-term panic of weaker EUR and weaker stock markets has now been seen, markets are already returning to the underlying fundamentals of slowly but surely improving economy and easy monetary policy. 

The bond yield spreads should begin to tighten and stock prices continue moving higher. EUR is additionally supported by the huge current account surplus, and the US rate hikes are too far away to get too much focus for now.

Post Weekend

Source: Saxo Bank. Create your own charts with Saxo Trader click here to learn more



Take a look at my two earlier articles on Greece here:

Worst-case Greece scenario is tolerable, so be bullish
While there is cautious optimism about a deal being made to resolve the Greek debt crisis, make no mistake – there will be losses at some point. But a quick look of the worst possible outcome suggests that they might not be that bad. So did the stock market get scared into a big correction, just before it makes a big rally?

Contagion from Greece: don't worry - yet
There will be no contagion from Greece. The euro area's leaders have blocked every channel that could cause harm. The only remaining contagion channel is themselves, as they will now be unable to complete the monetary union as a result of their actions over Greece.

– Edited by Clemens Bomsdorf


Juhani Huopainen is a blogger and a macro analyst at MoreLiver’s Daily. Follow Juhani or post your comment below to engage with Saxo Bank's social trading platform.

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