SH: What if Greece leaves the euro?

The lack of conclusive election in Greece has left the consensus – including us – expecting Greece to exit the euro. We try to address some of the key questions facing investors.

Spanish bond yields are trading at 6.25% after starting the year at just over 5%, and there has been a sharp sell off in a broad range of risk assets following Greece’s failure to form a government.

What will happen to Greece after it leaves the euro?

We would expect the new drachma to depreciate by anywhere from 30-70%. It is also possible that the authorities would peg the exchange rate at a set rate to the euro.

It is likely that capital controls will be imposed to put an end to the flow of money out of the country. This is against the rules of the European Union and therefore the ountry may have to leave the Union, either temporarily or permanently.

The day that Argentina allowed its currency to devalue at the end of 2001 marked the start of that country’s recovery. This is likely to prove true in Greece too. Exports of goods and services account for a quarter of annual output and would be significantly boosted by the currency depreciation. However, the initial outlook is uncertain as the political situation is extremely unpredictable, with none of the parties that have ruled in the past maintaining any credibility and none of the alternatives offering a convincing alternative.

If Greece goes, what can be done to avoid contagion?

A credible commitment to a common bond market would be the ultimate solution. However, this requires referendums across the euro area so will not provide an immediate support.

Additional financial support to the periphery countries that have followed through on reform is possible. However, this involves handing over more money at a time when the papers will be full of stories of how much money was given to Greece and will never be recovered.

A commitment from the European Central Bank to buy sovereign bonds, perhaps capping interest rates at a rate that markets would consider sustainable (somewhere below 6%) would be effective if the bank followed through and sustained this cap. This would be similar to the move by Switzerland to peg their currency to the euro by standing willing to print as much money as is necessary to cap the exchange rate. However, there are no signs that the ECB is willing to do this.

A further injection of money into the banking sector through a third tranche of the long-term refinancing operation is also possible. This would provide banks in Spain and Italy with funds to buy their domestic government bonds.

In conclusion, there are a number of measures that could be taken to provide liquidity to the stressed sovereigns and banks in peripheral Europe. However, most measures would only address the immediate liquidity crisis rather than addressing the underlying solvency problems.

Will anyone else leave?

With 17 countries involved, the number of permutations is obviously huge. However, we do not expect any other country to leave. It remains likely that we will see more debt write-downs for peripheral countries, notably including Spain. For the euro to survive, we will need to see restructuring in the periphery and German acceptance of both higher inflation and on-going financial support for their euro neighbours. The current agenda of fiscal austerity will test the political resolve of the periphery nations. Donor fatigue from the core is also a threat. A complete break-up cannot be discounted.

What would the impact be on economic activity?

The most relevant recent example of the dissolution of a currency union is the break-up of Czechoslovakia into the Czech and Slovak Republics in January 1993. This precipitated a 20% fall in trade between the two countries. Alarmingly, the Eurozone is on a quite different scale, being 17 countries and one of the world’s largest trading locs. We have to accept that a Eurozone breakup will see a significant fall in trading activity – the mechanisms simply are not in place to maintain Eurozone trade at today’s levels – without the euro. However, history also shows us that economies do eventually recover.

What does a euro breakup mean for UK?

A deepening recession, with all that means for employment. A disorderly euro area breakdown may even be enough to trigger global recession because of the impact on the banking sector. UK banks have huge exposure to Europe, as do US banks. The likelihood is that UK banks may need further recapitalisation from the government.

How would it impact markets?

The overall immediate impact will be deflationary. Shares will fall. Cash and UK government bonds will be relative safe havens. Recessions also hit property prices but central London could continue to defy gravity due to its appeal as a safe haven. Interest rates will remain pinned to the floor. The pound will be weaker against the dollar and nor will it be the strongest currency in Europe – that will be the Deutschemark if we go back to where we started – but it will certainly not be the weakest.

European equities are cheap. Is it time to buy?

Equities in the euro area have lagged their near neighbours over the last decade. When investors look back in five years’ time, it is highly likely that a break-up in the currency union will have marked a reversal in this trend. But a break-up has certainly not been fully priced in to equity markets and the level at which this reversal take laces is almost certainly well below the current prices, both in absolute and relative terms.

What is the bottom line?

Paul Krugman puts it succinctly. “Germany has a choice. Accept huge indirect public claims on Italy and Spain, plus a drastic revision of strategy — basically, to give Spain in particular any hope you need both guarantees on its debt to hold borrowing costs down and a higher eurozone inflation target to make relative price adjustment possible; or end the euro”.

We do not know what the outcome will be. Our baseline scenario is that Greece exits the euro but other countries remain within the single currency. Our expectation is that the current period of stress will trigger at least one more round of measures aimed at keeping the euro together in the form of another burst of liquidity. The money flowing out of the banking systems of Greece, Spain and very possibly beyond means that the authorities need to act fast. Whether sufficient liquidity is provided to calm the markets remains unclear. Our current policy is not based on a view that we can predict the outcome of the current crisis. Instead, we must accept that the outcome is impossible to predict and construct our portfolios in such a way as to avoid disaster for our investors even if the authorities in Europe cannot do the same for their populations.