Grexit or Greccident?

There is no longer a need to read into the tea leaves to ponder about Greece's near future: as the IMF is heading back to Washington DC after having left the negotiation tables, not to mention the stark warning of the President of the EU stating that Greece's poker game is over, there is a very high likelihood that Greece will default - ultimately resulting in a Grexit/ Greccident. As we speak, for the sake of keeping up appearances, only the EU Commission remains on speaking terms with Athens - but that is merely for the sake of saving political face.

Source: Trading Economics

Standard & Poor's has recently downgraded Greece's credit rating 1 notch further into junk territory. And, Greece's 5 yr CDS now stands at 3,020 bps compared to 639 bps early 2015. However, it is now a known fact that CDS are not really an efficient indicator for an upcoming default.

However, while Greek 10-year yields rose 52 basis points to 11.82 percent (and two-year note yields added 137 basis points to 26.03 percent), yields are still relatively speaking very low when compared to end January 2012 (@ 36.59%).

Source: Investing.com

Last but not least, and as a sign of times, Greece has decided to postpone the euro 300 million due on June 5th and regroup all June payments ($1.7 billion) till the end of the month as cash is running short. IMF rules allow borrowers to combine payments of principal due in a calendar month, but the provision has been used only once before - by Zambia in the mid-1980s.

So, since we can all agree about the upcoming default, the question is whether the exit of Greece from the EMU will be in orderly fashion ('Grexit') or in a chaotic manner ('Greccident')?

• If a Grexit takes place, a loss of 15-20% can be expected, meaning that Greek sovereign bonds need to be written off for roughly 80-85%.
• If a Greccident take place, then the write off would be equal to 95% (or 5% recovery).
• Obviously, there is also a third option, namely where theEU would agree on a voluntarily basis to write off 75%of Greece's outstanding debt.

Clearly, politically speaking, several EU ministers and commissioners explicitly stated that it is no longer mandatory to keep Greece at all costs within the EMU/EU, reason why the mysterious plan Z has been unearthed (aka a blueprint for what a Greek exit might look like). The adamant position of these EU officials is supported by the fact that  the monetary-policy stance and the instruments that have been deployed by the ECB are a very important factor in keeping contagion risks relatively low, and hence political spirits are cynically high. But that might be wishful thinking ...

So, what would be the consequences that investors and markets should take into account? At the end of the day - as already mentioned - , it all depends whether the Grexit would be in an orderly fashion or not.

• A euro exit would necessitate leaving the EU as well. Indeed, while a Member State may be free to denounce its EU participation and repudiate its treaty obligations in their entirety, it would not be free to go back on its decision to join EMU without breaching a binding obligation, under the EC Treaty, unless it were also to withdraw from the EU.
• The main risk from a Greek exit would remain the contagion impact on the periphery, in particular Italy. The effects on the wider economy and sovereign borrowing costs remain key for European banks. As we speak, Greece's 5 yr CDS is at 3,020 bps compared to 639 bps early 2015, the contagion effect - through the CDS channel - seems to be under control as Italy's 5 year CDS is - as we speak - only at 110bps, Portugal's @ 168 bps, and Spain's @ 84 bps (while France is only @ 29 bps).
• While a Grexit would have deer consequences for the EMU, the ECB has sufficient weapons to deal with a contagion risk. Indeed, the ECB has enough instruments at this point of time, the OMT (bond-buying plan), QE, and so on, which though designed for other purposes could certainly be used in a crisis if needed. In effect, the ECB now has the license to act as a full lender-of-last-resort and mop up the bond markets of Portugal, Spain, or Italy, preventing yields from rising.
• An exit from the EMU would immediately result in the come back of the drachma. The euro would be effectively abandoned, and Greece would return to the drachma, its previous currency (it might take a new name). The drachma would likely tumble in value against the euro as soon as it was issued, and how much the government could print quickly would be a big issue.
• It would have to be fast, with capital controls as the establishment of a switchover date to drachmas would without any doubts result in a massive capital outflow. Indeed, there would be people trying to pull their money out of Greece's banks en masse. The Greek government would have to make that illegal pretty quickly. The European Central Bank drew up Grexit plans in 2012, and might be dusting them off now.
• European states would have to write off future claims against Greece totaling euro 304 billion. Euro-Area governments (including ESM) hold 62% of the Greek debt, followed by the IMF (10%), ECB (7%), the private sector (17%) and the Central Bank of Greece (through repos - 3%). The write-off would socialite between 75-95% depending on the scenario.
• Obviously, liquidity for Greek bonds (linked to trading activity) is now only a trickle hurting equally the recovery value of these bonds. Reason being is that Greece is too binary to get involved in, since bonds will either rally sharply if an agreement with creditors is reached or plunge if Greece defaults. And, with trading so thin, the price of Greece’s debt can swing wildly, as experienced in recent weeks. Bonds maturing in July 2017 fell from 87 cents on the euro in January to as low as 61 European cents in April, only to rebound to 74 cents mid-May 2015. At the end of the day, if the market is extremely volatile, you cannot expect the same level of commitment from banks as when markets are liquid and orderly,

Source: The Wall Street Journal

• European life support for Greek banks would be withdrawn (currently some $100 billion). Greek banks can currently access emergency liquidity assistance from the ECB, which would be removed if Greece left the euro. In that case, the Greek banking system would be nationalized.
• European banks have reduced their exposure towards Greece down to some euro 21 billion. Indeed, Europe’s biggest banks have limited risk tied to Greece after selling local units and cutting holdings of the country’s bonds. Six banks in Germany and France have about 15 billion euros of credit to Greek clients. HSBC has some $6 billion and RBS some $0.6 billion.
• Non-European banks have some $40 billion of exposure against the Greek economy based on data from the Bank for International Settlements (BIS), which monitors cross-border lending. U.S. banks have $11 billion (Citigroup last year sold its consumer banking operations in Greece, although it kept its corporate and institutional banking business there).
• From a currency perspective, a Greek exit from the Eurozone is already priced in. What could however surprise the markets is if something is actually settled and the uncertainty is removed from trader’s minds. In short, in either scenario, the current risk-off trade in the euro could unwind once the markets can discern a glimpse of the future for Greece. Funds will flow out of the dollar and back into risk-on currencies.
• While there would be a grace period of six weeks before the IMF board declared Greece to be in technical default, the process could spin out of control at various stages. 
• A redenomination would mean for Greece that it would be immediately secluded from international capital markets, and as such Athens would not be able to issue a globally traded currency.  With senior liabilities outstanding, Greece's seclusion from international capital markets would not just hold for the Greek government. It is likely that the implications touch the Greek private sector too, with Greek exporters and importers not being able to rely on letters of credit provided by Greek institutions.
• For the OTC market, there are $400 trillion in OTC derivatives contracts which reference the euro. They’re all called into question if the currency changes. A Grexit won’t do good things to liquidity globally. Remember, the situation in Greece boils down to the single most important issue for the finacial system, namely collateral. A derivatives implosion might get international minds focused on the whisper issue.
• When analysing derivatives documentation for potential effects of a Grexit consider: (i) Jurisdiction; (ii) Governing law; (iii) Currency of payment provisions; (iv) Place of payment; (v) Illegality Termination Event, Events of Default and other documentary provisions.
• One of the challenges with analysing a Grexit is that the manner and legal basis upon which Greece might leave the euro area would substantially affect the analysis. There are a number of ways in which it is possible to imagine exit occurring. These range from a European Union (EU) approved withdrawal from the EU and the euro area or an approved withdrawal from the euro area but not the EU (although there is no mechanism in the EU Treaties for the latter), to a unilateral withdrawal by Greece (from one or both) on a nonconsensual basis (but which could itself subsequently be approved by EU action). It is also likely that, in such circumstances, Greece would seek to impose deposit withdrawal restrictions, capital and/or exchange controls. Accordingly, a complicated set of legal considerations arises. Moreover, the conflicts of law position would further complicate matters, as would the approach to redenomination adopted in any domestic monetary legislation in Greece.
• While debt forgiveness is said to be a major trigger point of the unregulated derivatives that are connected throughout the European region, the likely solution to avoid a bloody outcome could be located in an extension of loan terms. Elongating the term of Greece’s debt to become a 70 year loan could be one solution. But transferring term structure from shorter five, ten or thirty year durations would be considered in this circumstance to be a haircut. Such terms, at historically low interest rates, would severely harm those who previously purchased the bonds. But most importantly, elongating loan terms might not be considered a technical default of the derivatives. No one knows for sure, because the dangerous derivatives in question are non transparent.
• The primary issue with the derivatives underlying the Greek economy is transparency. Greece has a little wildcard called unregulated derivatives default. The extent of the damage a Greek derivatives default is unknown to key market participants and regulators, as is the resulting defaults in other European countries and debitor nations.
• A Grexit will result in more unrest and disorder as this sudden economic collapse would aggravate social unrest, and notes that historically similar moves have caused a 45-85% devaluation of the currency. 
• In retaliation against Brussels, Greece would for sure open the gates to massive immigration flooding the EU with huge numbers of migrants from the Middle East, Africa, and South Asia. In turn, this will lead to a rise in nationalism and populism among the European public opinion.
• Greece would resume economic policymaking. Greece's central bank would probably start doing its own QE programme, and the government would likely return to running deficits, no longer restrained by bailout rules (though investors would probably want large returns, given the risk of another default).
• Inflation would spike immediately, but that should be temporary. It might look a bit like Russia this year — with the new currency in freefall until it finds its level against the euro, prices inside Greece would rise at dramatic speed. The inflation might be temporary, however, because with unemployment above 20%, Greece has plenty of spare labour slack to produce more.
• A return to the drachma and the devaluation of the currency would, even without this assistance, have the advantage that Greece would stop buying foreign agricultural products. The majority of consumers would turn to domestic producers, who would in turn see a boost in production and be able to generate jobs. Greece could develop its agricultural sector with the same level of success already achieved by Israel, which exports products all over Europe.

Clearly, the short-term effects would be painful and fast, but Greece might be better off leaving the Eurozone in the long term. A well-managed exit could even end up as a favourable economic development for both Greece and the rest of the euro-zone.

And for the rest of Europe and the world, the effects may be manageable. Indeed, obligations to “official” creditors such as the IMF, the ECB and the governments of other European economies account for the vast majority of Greece’s euro 300 billion worth of external debt, so these institutions would bear the brunt of foreign losses from a Greek default. Foreign bank exposure to Greece totals only $46 billion, which is widely dispersed among countries, so the direct effects of Grexit on the private sector in other countries should be manageable, at least in theory. Of course, financial markets may react negatively if Greece were indeed to leave the Eurozone, and we worry that contagion could spread to other European countries.

Where the danger comes in is when events come, they start to affect confidence and you get illiquidity moments. At the end of the day, if Athens drops out, the core question will actually not be Greece, it's Spain, Portugal and Italy (and potentially even France).

A probable Greek exit would also affect confidence in the banking sector beyond that country. Already, the rating agencies downgraded 26 Italian banks and 21 financial institutions in recent months, despite the fact that officially speaking Europe's largest banks have relatively minor exposure towards Greece.

The exit of Greece and especially of any other big country would mean huge contagion through the banking channel: a lot of depositors will try to leave the country. Earlier this year, the International Institute of Finance (IIF) calculated the losses from a possible Greek default. The losses would be above 1 trillion euro, with credibility of other European states hard hit, according to the IIF. China, India and Brazil, big exporters to the eurozone, would also suffer, with China seeing exports shrink by 4%, and India and Brazil by 2% each.

In 2011 and 2012, Greece's fate seemed closely tied to the rest of Europe. Losing Greece would have signalled the first domino falling, followed by perhaps Portugal, perhaps Spain or Italy, unravelling the whole project. Right now, however, Greece looks like its own separate case, and very few people think that Grexit would force that chain reaction.

In spite of what the authorities of the EU/ECB as well as the IMF are officially stating (with the objective of maintaining overall confidence and trust), there is no exit mechanism in place for any country to leave the euro zone and/or this stress situation has never been tested before - it would be a first, and hence no one knows whether the contingency plans would suffice to stop the spreading of a domino effect.

Granted, the short-term impact of a Grexit on sovereign debt of other weak euro-zone countries, such as Portugal, Spain and Italy, is expected to be limited. Although in the early days of the European crisis (2010 to 2012) the yields of comparable debt of these three countries (indicating the extent of risk) were highly correlated with the yield of Greek debt, that is no longer the case. 

Yes, the currency union was badly flawed and the lack of an exit strategy for any country which didn’t adhere to the rules governing the European Monetary Union represented the height of technocratic hubris. But to suggest that a ‘Grexit” would be “manageable” or “orderly” as many in the Eurozone are now wishfully suggesting is nonsensical. Only the near future will tell ....