With party leaders failing to set aside their differences, Greece is set to hold another general election on June 17. The outcome is hard to predict, but one thing is clear: a Greek exit from the euro area is now a possibility that investors need to take very seriously.
There are three broad scenarios that might play out. The first is the election of a government that continues to support the terms of the bailout provided by the European Union (EU) and International Monetary Fund (IMF). This would provide a period of respite, but would not alter the fact that the Greek program is failing.
The second scenario is that parties hostile to the bailout—notably the left-wing Syriza—gain a majority of seats and reject the EU/IMF program. In this case, financing from other euro-area governments and the European Central Bank (ECB) would probably dry up, forcing Greece to leave the euro.
The third scenario is stalemate, which makes it impossible to form a government. In this case, the ECB and the other euro-area governments would probably continue to provide some support, but there would be no new money to cover the primary budget or current account deficits. This would make the consequences of euro-area exit very clear to the Greek electorate and a third election might then become an explicit referendum on euro-area membership.
Against this backdrop, euro-area exit is now a real possibility. Nonetheless, we do not believe it is inevitable, as some observers seem to think it is. So far in the sovereign-debt crisis, difficult decisions of this nature have invariably been avoided or deferred. Kicking the can down the road may not solve very much, but it may still be the path of least resistance.
Potential Impact of a Greek Departure
What happens if Greece does leave the euro? In recent weeks, many policymakers have argued that the region is now better equipped than previously to handle the aftermath. In a narrow sense, this is probably correct. Indeed, the exposure of private investors to the Greek government is significantly lower than it was a couple of years ago, mainly because most of it has been transferred to the IMF, the ECB and other euro-area governments. In a worst-case scenario, we estimate that the total exposure of euro-area governments to the Greek government is about €280 billion.
But the indirect costs of a Greek exit are potentially much higher. A Greek exit would destroy the myth that exchange rates between euro-area countries have been irrevocably fixed, and this would have ramifications well beyond Greece’s borders.
Last year, when euro-area policymakers decided to force private investors in Greek government debt to accept large losses, they thought investors would recognize that Greece was different and not use it as a template for the rest of the euro area. This proved to be wrong. The results were a fundamental change in the risk characteristics of euro-area sovereign debt and a significant escalation in the crisis.
If Greece were to leave the euro, there would be a similar change in the risk characteristics of bank deposits in the euro area, and this could lead to significant outflows from the Italian and Spanish banking systems. The ECB has the tools to deal with this, but, in the process, huge chunks of the euro-area banking system would become utterly dependent on central bank funds, and the exposure of the core countries to the periphery would explode.
We are not convinced that the region’s governments have enough firepower to counter a run on euro-area sovereigns. This means the onus would again fall on the ECB. And we would expect the central bank to step in if market pressure starts to approach melting point, just as it has done throughout the crisis. In the near term, investors should brace themselves for further volatility.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Darren Williams is Senior European Economist at AllianceBernstein.