Wilson Mizner is credited with the advice to be nice to people on your way up because you will meet them on your way down. This may apply to us as individuals, but not to countries. We are struck by the fact that creditor nations are acting like creditors and debtor nations are acting like debtors, no matter their history. The picture to the left is from the 1950s. The Greek finance minister is signing off on a 50% reduction of German debt.

  1. Why is Greece, whose economy less than 2% of Europe, dominating the headlines and investors’ attention?

The end of the global credit cycle in 2008 first hit Greece in 2010.  Europe was ill-prepared from an institutional point of view to cope with the crisis.  After Greece sought aid, several other European countries needed assistance, including Ireland, Portugal and Cyprus.  Spain received assistance for its banking sector.  The Greek economy has contracted by more than a quarter.  Unemployment has soared.  In exchange for assistance, Greece committed to various austerity and reform measures.  Due to the failure to implement the program, assistance was cut off in the middle of last year.  This led to elections and victory for a coalition of two extreme parties in Greece’s political spectrum, led by the leftist Syriza Party.  It campaigned on a pledge to resist austerity but stay within the monetary union.  It is struggling to achieve both pledges.

  1. Why did the Greek government call for a referendum for July 5? 

The Syriza-led coalition received about 40% of the popular vote the late -January election.  To form a stable government, the party with the most votes gets an extra 50 seats in parliament.  However, Prime Minister Tsipras argues that he did not have a sufficiently strong mandate to make such a momentous decision as rejecting the last offer of the official creditors (EU, ECB, and IMF).   The reality is much more complicated.  On one hand, Tsipras had rejected the government’s call for a referendum on the first of two aid packages in 2011.  That referendum was canceled, and that government collapsed.  On the other hand, Tsipras is likely using the referendum as an instrument in the negotiating process.

  1. What does the referendum entail, and will it lead to a Greek exit from the monetary union? 

The precise wording of the referendum is still being hammered out.  A yes vote will be to accept the official creditors terms.  Although the second assistance program expires today, a yes vote would likely trigger the fall of the Syriza government.  A cross party government would likely be formed ahead of a new set of elections.  It would  resume negotiations with the official creditors.   A no vote would be to resist the creditors demands.  There is some fear that this would lead to a Greek exit from monetary union but it need not.  It is important that the German finance minister, who has been a vocal critic of the Syriza government has said the same thing.  Prior to the past week, we had subjectively attributed a 20-25% chance of a Grexit, but recognize the risks have increased.  We would now estimate the odds at 40%.  The rating agency S&P put the odds at 50% yesterday.  Throughout the crisis, we have argued that market participants are under-estimating the political forces, like geo-strategic considerations, that are pulling Europe together even if economic issues are pushing it apart.

  1. Why did Greece institute capital controls and declare a bank holiday?  How long will it last? 

Due to the fractious negotiations the ECB has refused to accept Greek government bonds or Greek government guaranteed bonds as collateral for Greek banks loans since February.  Instead Greek banks have been allowed to borrow from the Greek central bank, with the ECB’s approval.   Under this facility (ELA or Emergency Liquidity Assistance) there is a more lenient view of collateral though it comes at a higher interest rate.  The ECB has gradually increased the amount of ELA borrowing it permits, until this past weekend.   The call for the referendum meant that the current aid program would end, and this was the condition on which the ECB was granting an increase in ELA.  The ELA was primarily a way to offset the flight of deposits out of the Greek banking system.

With deposit flight accelerating as Greeks anticipated capital controls, with knowledge that Cyprus depositors were bailed in (took losses when the banks were recapitalized), and no increase in ELA, the Greek government had little choice but to implement capital controls.  The capital controls put severe limits on withdrawals from the banks and ATMs.  In order to make it effective, the government declared a bank holiday and shut the stock market.  The bank holiday and closure of the stock market are expected to continue to early next week.    Although there is some hope that they will re-open on July 6, following the referendum, it is not a sure thing.

  1. If Greece misses the IMF payment, why isn’t this a credit event, triggering credit-default swaps?  

The rating agencies have indicated that a default is when a debt payment to the private sector is missed. Missing an IMF payment does not qualify.  Under the IMF’s procedures, a missed payment is regarded as falling into arrears.  If European officials wanted, they could exercise a clause in its loans to Greece that could force expedited repayments.  We do not expect this discretion to be exercised.    The next private debt obligation is a JPY20 bln Samurai bond (~140 mln euros) that matures in the middle of July.  It has a chunky payment (~3bln+ euros) to the ECB a week later.

  1. Will what happens in Greece cause much contagion in the capital markets? 

The ECB has various tools at its disposal to minimize the knock-on effect emanating from Greece.  The European Court of Justice recently recognized the Outright Market Transactions (OMT) facility under which the ECB could support sovereign bonds of a member that sought official assistance.  The ECB is already engaged in quantitative easing (QE) under which it is buying sovereign bonds.  Due to the earlier crises, there are backstops in place, such as the European Stabilization Mechanism (ESM), that can also be drawn upon if necessary.

Our concern about contagion is not about the short-term, but the medium and longer-term if Greece is pushed out of monetary union.  Monetary union would no longer be irreversible.  A banking or credit crisis in the future may quickly turn into an existential crisis as investors would not to consider the risk that another country leaves the union.

  1. What are the implications for the euro?   

In the medium and longer-term, we expect that the divergence between the trajectory of Federal Reserve and ECB policy to push the euro lower.  The Federal Reserve is expected to raise rates before the end of the year (the market has this almost fully discounted, looking at the pricing of the Fed funds futures).  The ECB’s bond buying program (QE) is expected to continue through September 2016.    After a sharp downtrend in H2 14 through most of Q1 15, the euro has been in a broad trading range between about $1.08 and $1.15.

In the short-term, risk of a broader disruption in EMU, appears to have spurred demand for euros as a precaution to secure funding.  In essence, many businesses and investors have borrowed euros.  A sharp crisis would risk the ability to service the euro-denominated obligations.  The purchases of euro denominated assets by sterling, yen or dollar based investors has frequently been financed by euro funding (borrowings).

There have been a few days over the last few months where Greek developments had a material impact on the direction of the euro, but this seemed to be short-lived.  The euro recorded a 12-year low in mid-March near $1.0460.  The recent high was recorded two months later near $1.1470. The 100-day moving average comes in near $1.1050.

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