Greece – The Market’s Odyssey by Toby Nangle, Columbia Threadneedle Investments

  • The events of the past few weeks underscore the linkage between domestic political willingness to service debts and the likelihood of capital controls and/or eurozone exit.
  • Greece’s negotiations with its creditors provide lessons on eurozone creditor reaction functions, which will inform the market’s pricing of risk.
  • The jury is out as to whether business and consumer confidence across the region will be impacted by the spectacle, but we estimate that the impact will be limited.

The Greek economy is relatively small. Following the decision to bail out private creditors and replace their exposures with official credit, the country’s connectivity with the private financial system is extremely limited. But market participants have followed the twists and turns of the country’s negotiations with creditors with great interest, and for good reason — these negotiations provide lessons that will be generalized for the future. These lessons are not the morality tales peddled by pundits, but rather an understanding of eurozone creditor reaction functions, which will inform the market’s pricing of risk.

In 2012, eurozone leaders committed to the principle that domestic eurozone banking system integrity should not be compromised by concerns of domestic sovereign creditworthiness per se, and vice versa. The direct supervision of large banks was transferred from local regulators to the European Central Bank (ECB), and the regular Asset Quality Review process was set in motion. This move was made in reaction to the incipient financial Balkanization of the eurozone and the prospectively self-fulfilling eurozone financial crises of 2011–12.

Markets remained skeptical of eurozone leaders’ resolve to separate issues of sovereign creditworthiness and domestic banking integrity, suspecting that the negotiating leverage that could be mobilized on creditors’ behalf by binding both issues together would be too tempting for eurozone leaders to resist when it would advance their collective interests.

In declaring itself unwilling to continue to service its official sector debts, the Greek government has served as a test case for this de facto principle for the eurozone. Swiftly following this declaration of unwillingness to pay, capital controls were put in place that threatened the integrity of the already fragile banking system. The principle of separation between sovereign creditworthiness and banking system integrity proved as illusory as markets had anticipated, and media footage of cashless ATMs and distressed pensioners beamed across the world as proof.

From a market perspective there is little difference between the “bad outcomes” of a eurozone country implementing protracted capital controls and that same country leaving the eurozone. Both are associated with an initially significant negative economic shock, the requirement to write down bank equity meaningfully, the likelihood of senior creditor bail-in, and chaotic or unfunctioning domestic financial markets. With the second of the 19 eurozone countries going down the path of capital controls, efforts by eurozone policymakers to cast developments as unique will prove fruitless.

And so the experience of recent weeks serves to strengthen the market’s understanding of the linkage between domestic political willingness to service debts and the likelihood of capital controls, and/or eurozone exit. This lesson is independent of Greece’s continued membership of the eurozone: the market’s “bad outcome” has already been realized. Greece’s fate from here matters to us as citizens but less so as market participants.

How should markets now price eurozone financial assets? The unedifying political omnishambles that we have witnessed in Europe speaks poorly of the strength and coherence of its institutions. And the jury is out as to whether business and consumer confidence across the region will be impacted by the spectacle, but we estimate that the impact will be limited.

What remains is a “jump risk” that markets will struggle to price. The additional risk premia that investors require in order to insure against the prospect of a “bad outcome” of capital controls or exit is related to the joint probability of falling into an EU program and falling out with creditors. This is likely to be extremely small until it is extremely large. It is akin to going short an out-of-the-money put option with every purchase of a eurozone financial asset, with the option struck where domestic politics collides with creditor politics. Where this joint probability is minuscule, so will the risk premium demanded by investors.

It is worth recalling that the linkage between compliant politics and the risk that a banking system is turned off is a peculiarly European phenomenon. It is a product of political choices made in Brussels and Frankfurt. Choices made on the other side of the Atlantic have led to no such de facto linkage being in place in the United States. The contemporaneous debt default by the Puerto Rican government was not accompanied by the collapse of the Puerto Rican banking system and limits on cash withdrawals from ATMs. Similarly, the bankruptcy of Detroit did not lead to the suspension of Ford stock. In his July press conference, ECB President Draghi expressed unhappiness over the choices made, appealing for the completion of a banking union and the introduction of a pan-European depositor insurance scheme. If he is to have his wish, we could soon see the end of the rolling eurozone monetary crises that we have witnessed for the past several years.

Greece