IN BRIEF

We know what Greek voters have rejected. We don't know what they have voted for, exactly—and neither does anyone else. The surprisingly emphatic victory for the "no" camp in Sunday's special referendum in Greece has strengthened Syriza's domestic political standing—and also made negotiations with the country's European creditors over a new support package for Greece a lot more difficult.

There are plenty of potential scenarios from here, not all of which include a Greek exit from the euro. But the 1 in 4—or 1 in 3—chance we have ascribed to that outcome in previous notes was based on an expectation that Greeks were likely to vote "yes". With this "no" vote we have moved firmly onto the Grexit side of the decision tree, with a messy Greek exit now more likely than not.

We can expect this to cause volatility and sell-offs in European markets and potentially very serious long-term political implications for Europe. However, assuming that policymakers respond reasonably decisively to signs of contagion, we do not currently believe the result poses a broader risk to European investors or the European recovery.

 

Immediate market reaction

The markets are down pretty heavily this morning, but the sell-offs are not of a different order of magnitude than we saw after the referendum was called.

  • The Stoxx 600 is down close to 2%, led by heavy selling in peripheral markets such as Spain and Italy, which are down nearly 3% today. On a sector level, financials and banks are down by nearly 3%.
  • Greek equity markets remain closed due to the bank holiday, which has been in place for over a week. Unsurprisingly, Greek 10-year debt yields jumped 235 basis points (bps) over the weekend to 16.4%.
  • Elsewhere in Europe, there has been a flight to safety, with German and Swiss yields falling slightly. German 10 year yields have fallen to 0.74%. Investors are also selling other peripheral debt, with Italian, Spain and Portuguese 10-year yields having increased by around 10 bps. The euro has strengthened by around 0.4% against the US dollar since the announcement.

What to watch now

The Greek prime minister, Alexis Tsipras, insists he still wants to do everything to keep the country in the single currency area. That is what 60-80% of Greeks have also said they want in recent opinion polls. Whether it turns out to be possible will depend on how the European Central Bank (ECB) and other eurozone leaders respond to the referendum result when they have held various emergency meetings today.

The ECB will meet first to decide what to do about Greek banks’ access to Emergency Liquidity Assistance (ELA), which has been capped at EUR 89 billion since the referendum was called at the end of last month.

The Greek central bank was in contact with domestic banks overnight to establish exactly what their cash positions were, but estimates suggest that domestic banks went into the weekend with less than EUR 1 billion in reserves.

The ECB could terminate access to ELA altogether, but that would immediately bankrupt most of the banking system and push Greece many steps closer to Grexit. Mario Draghi will not want to take such a step without extensive preparations and plenty of implied political approval. The most likely scenario is that the central bank will maintain the ceiling at the current level. This could be on slightly tougher terms—which some banks won’t be able to meet—but given how close the banks are to the ceiling, it imposes a tough squeeze on the banking system even if the ECB leaves the terms unchanged.

The second key meeting to watch is a special summit between German chancellor Angela Merkel and French president Francois Hollande later today. In that discussion, the leaders need to decide whether they are formally viewing this referendum result as a vote against remaining in the euro. They must also decide whether the Eurosystem is still offering Greece a new bailout—and if so, on what terms. This, in turn, will set the terms for the summit of eurozone leaders on 7 July.

The Greek government is trying to produce a more positive outcome from these meetings, with the resignation of its controversial finance minister, Yanis Varoufakis.

The Greek government is trying to produce a more positive outcome from these meetings, with the resignation of its controversial finance minister, Yanis Varoufakis. Tsipras has also talked about a broader Greek negotiating team going to Brussels, including representatives of other parties. But the initial mood music coming out of Berlin has not been very encouraging. As the International Monetary Fund (IMF) highlighted in a recently released paper on Greece’s financial situation1, the deterioration in the Greek economy since the start of the year means the fiscal hole is now much larger than it was when Syriza was elected. In that sense, the financial obstacles to a new agreement have grown along with the political ones.

The support programme that Greek voters were asked to vote on was allowed to expire on 30 June, but Tsipras has promised to go to Brussels immediately to restart negotiations over a new arrangement under the European Stability Mechanism (ESM). He requested an ESM programme last week, but the request didn’t get far—partly because of the referendum, but also because he appeared to denounce his would-be benefactors as blackmailers only a few hours later.

Even if his European creditors decided to go ahead with negotiations, there would be bureaucratic hurdles to cross—in Germany for example, the Bundestag has to be consulted formally before the finance minister can be officially involved in discussions about a new deal for Greece.

It seems unlikely that this process could proceed very far before 20 July, when Greece is supposed to make a key EUR 3.5 billion repayment to the ECB. But the state of the Greek banking system could bring things to a head before then, if banks do not obtain further support from the ECB. By that point, the government might well have had to resort to issuing IOUs to cover day-to-day obligations, which would be another step on the way to a parallel currency and an exit from the euro.

Economic and investment implications

Whatever happens, the road from here is going to be extraordinarily costly for Greece’s people and its economy. Exhibit 1 shows how consensus forecasts for the Greek economy this year have tumbled as relations between Greece and its creditors have deteriorated. On average, 59 Greek businesses have gone bust every day since the start of 2015. That number will have soared with the closure of the banks, and the timing could not be worse for Greece’s main industry—tourism—as foreigners are already rushing to cancel family holidays in Greece.

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However, the same chart also shows that Europe’s economy has not been seriously affected by the Greek crisis so far. We can say the same for European financial markets.

There has been a "risk-off" mood in markets since the referendum was called, but as Exhibit 2 shows, the spread between periphery and core sovereign borrowing costs is still far below previous peaks and has not been hugely affected by the crisis. Meanwhile, the Libor-OIS spread—which has spiked in previous crisis periods—has not moved at all.

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A Greek exit from the Euro would be costly to Europe’s taxpayers – and legally very messy to the extent that it is likely to involve heavy losses for the ECB. It would also have important long-term consequences for the Eurosystem and the future risk premium on Eurozone assets and also raise more immediate geopolitical concerns if Greek membership of NATO or the European Union was brought into question. These risks are literally incalculable, but they can hardly be ignored.

All that said, however, we do not believe the crisis poses major immediate risks to peripheral economies, the European financial markets or the eurozone recovery, all of which are now much less exposed to and better equipped to deal with Greek contagion than they were in 2011 and 2012. As we have noted previously, in theory, at least, the ECB also has much more effective tools available now to deal with any tightening of financial conditions that results from the Greek vote. Policymakers have signalled previously that they stand ready to make use of those tools, should market conditions warrant it.

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