Download Greece Versus the Eurozone: Game of Chicken Enters Round

May 2012
Greece Versus the Eurozone: Game of Chicken Enters Round Three
By: SEI Investment Management Unit
Greece’s experience as a member of the single currency eurozone (also known as the Economic and Monetary Union, or
EMU) has hit yet another rough patch. Investor reaction to the current showdown - rushing out of risky assets in favour of
perceived safe havens - is identical to the reaction seen in earlier episodes.
• While SEI’s funds have little or no direct exposure to Greece, a disorderly breakup of the EMU would rile global
markets.
• Since its fiscal shortcomings came to light, Greece has engaged in two intensive rounds of negotiations with the troika
of the European Commission, European Union (E.U.) and International Monetary Fund (IMF).
• In return for accepting severe, depression-inducing austerity measures, Greece has received significant financial
assistance and experienced a major restructuring of its debt.
• However, Greece’s progress in implementing promised reforms has been slow and recent national elections have
thrown this fragile state of affairs into turmoil.
• As a result, European leaders have finally started to publicly entertain the possibility of a Greek exit from the
eurozone, which for some time we have viewed as inevitable.
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• When and how it occurs is still anyone’s guess, however we doubt it will occur prior to the 17 June election.
In the meantime, we expect the political drama in Europe to remain elevated
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On 6 May the New Democracy (conservatives) and
PASOK (socialists) political parties that had shared
power in Greece for over forty years were trounced by
more radical alternatives on both the right and left, as
voters overwhelmingly favoured anti-austerity platforms
over establishment candidates (a sentiment that echoed
the recent election of Socialist President Francois
Hollande in France and the rise of nationalist parties in
several other E.U. nations). Attempts to form a national
government failed and a new round of elections, which
anti-austerity leftist party Syriza looks likely to win, is
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scheduled for 17 June.
This latest turmoil has finally spurred European leaders
to acknowledge the risk of Greece departing the
eurozone and markets seem to be placing a much
higher probability on it. Speculation is now rampant as to
when such an event could occur. However, as much as
we believe that Greece (possibly along with a small
number of other countries) will eventually depart the
currency union, it is not clear at all that an exit is
imminent or even desired by the Greek public.
Should We Stay or Should We Go?
According to recent polls, an overwhelming majority of
Greeks - upwards of 80% - want the country to remain in
the euro club. But as recent election results show, they
are also strongly opposed to the austerity measures
needed to remedy structural imbalances between
Greece and the rest of the eurozone. As a result, it
seems unlikely that Greece will choose to exit voluntarily
and judging by the rhetoric of its newly ascendant
political parties, that option is not receiving serious
consideration. If anything, the Greek electorate has
managed to raise the stakes in an ongoing game of
chicken, in which it seeks to remain in the eurozone by
obtaining fiscal support from the troika, while avoiding
the worst of the rebalancing measures. For example, in
rounds one and two of this game, liberalisation
measures such as slashing public payrolls and selling
state assets were promised in return for financial
assistance and debt restructuring. However, on both
counts and in the area of tax collections, the Greek
government appears to have fallen well short. Of course,
the game has not come without severe costs, such as
plummeting gross domestic product (GDP), worsening
competitiveness
and
productivity
and
youth
unemployment above 50%. But in the minds of most
citizens and politicians, the status quo may be preferable
to what could be a messy return to the Greek drachma.
To make things even more interesting, there is no legal
mechanism in the treaties governing the EMU that allow
a country to be forced out. In the end, Greece must
choose to exit. The troika (or errors by Greece’s new
political leadership) could conceivably make things
painful enough for this to happen, but to change the
minds of 80% of the Greek public would entail some
nasty market and economic effects that would likely
spread beyond just Greece.
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It is also important to keep Germany’s national economic
policies, which favour exports, in mind. The currency
union has been a boon to Germany’s economy and
exporters. If Greece and other countries were to depart,
Germany would be negatively impacted. Dissolution of
the eurozone would be a worst-case outcome for
Germany.
All of that said, it does appear that contingency plans for
an eventual exit by Greece - and more importantly,
strengthening of the firewall around Italy and Spain - are
being taken even more seriously by policymakers.
Parsing the Scenarios
More important than speculating on whether and when
Greece might exit is to consider the broader possibilities
and how they could impact financial markets. We
continue to believe that the status quo is unsustainable
and that the situation is quite binary - the ultimate
outcome could be extremely positive or negative.
As we said in our Fourth Quarter 2011 Economic
Outlook (“A Pivotal Year Ahead”):
…the situation [in Europe] is binary - things could
improve dramatically or become far worse. If Greece
opts out of the eurozone, there will be a painful
period of uncertainty as investors work through all
the implications and costs of debt default and
banking system distress.
In a way, the European debt crisis is analogous to a
white-knuckle drive along a treacherous high-mountain
road. At some point, you either arrive at your desired
destination or you plummet into the gorge. Until such
time, it promises to be a rough and sometimes
frightening ride.
In the best-case scenario, Europe would move full speed
ahead toward closer fiscal integration and a more
optimal framework for sovereign budget deficits based
on economic outcomes (as opposed to the somewhat
arbitrary and rarely adhered to 3% deficit limit under the
Maastricht Treaty). Barring this, policymakers could get
creative with existing or new forms of rescue facilities.
One such idea is for the European Stability Mechanism
(ESM) to obtain a banking license which would allow it to
borrow from the European Central Bank (ECB) in order
to increase its lending firepower to eurozone
governments. The proof of the pudding will be in the
details. For example, while the ECB’s recent long-term
refinancing operations bought some time, they have
proven - perhaps sooner than most people expected - to
be a less than permanent solution. A durable solution
will have to include some sort of mechanism for the
appropriate creation of unencumbered financial assets,
as occurs in monetarily sovereign and fiscally integrated
countries such as Canada, Japan, the U.K. or the U.S. A
system that relies solely on central bank and private
credit will inevitably experience systemic fragility, as
Europe’s recurring crises clearly demonstrate.
In the worst-case, a disorderly default and exit by
Greece could lead to contagion within the global banking
system and cascading uncertainty in financial markets.
Credit spreads would blow out and there would be a
massive rush into safe havens, with certain sovereign
yields plummeting even further than they have in recent
weeks. The euro would fall sharply, as could sterling
given the close integration of the British and European
economies. Spain has already nationalised one bank,
and other European countries (perhaps even France,
which is looking increasingly like a periphery country
rather than a healthy core economy) could follow in its
footsteps. Recession in the eurozone would intensify
and if coordinated, counter-cyclical measures are not
implemented in short order, recession or even
depression could unfold across China, Europe, the U.S.,
and most of the world.
Our View
In a December 2011 commentary (“The European
Union’s Fiscal Compact More of the Same”), we wrote:
We continue to expect that Greece will eventually
exit the eurozone…Such news could cause market
dislocation, at least in the short-term, but we do not
believe it would spell the end of the euro. Instead,
we expect the eurozone to remain intact as long as
a majority of the citizens [in EMU nations (and
aspiring EMU members)] believe it is in their interest
to do so and are willing to pay the price. We would
become more concerned for the euro if Italy or Spain
started to seriously entertain the possibility of
exiting, but at this point, there is no sign of that and
the latest agreement is clearly intended to prevent
that from happening. It is also important to keep the
ECB’s mandate of price stability in mind - while it is
deeply reluctant to backstop governments and
financial institutions, it is likely to become more
active if a slowing eurozone economy is reflected in
falling price levels. While a deep recession and
ongoing policy errors pose clear risks to the euro’s
future, they are also likely to stimulate additional
summits and perhaps more forceful ECB
interventions.
Unsurprisingly, we are already seeing those additional
summits and while these have largely been can kicking
exercises, Europe may slowly and haltingly grope its
way toward a solution, even as it buys ever shorter
periods of time. For example, while closer fiscal
integration through Eurobond issuance was rejected by
Germany this week, European stock markets rose the
following day. The ECB has not eased its current policy
stance, but recession should give it room to do so.
Meanwhile, a weakening euro should help the eurozone
economy at the margin.
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It is also instructive to look at past episodes of
contagion, such as the Asian Flu of 1997 and Russian
default and Long-Term Capital Management debacle of
1998. If this type of panic unfolds, it will present an
attractive opportunity to investors for whom risk is
appropriate. If we see concerted movement toward a
truly durable solution, such as Eurobond issuance or
conversion of the ESM to a specialised banking
institution, we would be inclined to put additional risk on
(for example, in U.S. and emerging markets equities).
We do not believe there is a meaningful probability of
Greece exiting the euro until after the June elections.
Even then, the status quo could continue for a time.
However, we continue to believe that an eventual exit is
unavoidable and that Greece could be joined by Portugal
and possibly Ireland. How these departures unfold, and
how policymakers manage the fallout, will determine
what kinds of effects they have on financial markets.
For equity investors, the higher probability of a disorderly
exit by Greece has resulted in increased market volatility
and weakness. Banks have been especially hard hit, as
the worries over Greece have compounded strains
already being felt due to the looming implementation of
tighter capital requirements as well as tight lending
standards and moribund loan demand.
For fixed income investors, while we continue to believe
that tighter capital requirements are a bullish long-term
story for bank creditors, worries over Greece are
exacting a toll in terms of credit spreads and contagion
fears. It is still important to note that many banks are
better capitalised than when they carried AAA credit
ratings and the banking industry remains attractive in our
view. However, the ride could be bumpy, especially
during periods of market distress.
Our Funds
Our equity funds have little direct exposure to Greece
and are underweight the country relative to their
benchmarks. In our fixed income Funds, we are roughly
even to the benchmark’s exposure.
As shown in Exhibit 1, our funds also have limited
exposure to the Financials sector and are generally
underweight (or neutral) relative to their benchmarks:.
Exhibit 1: Fund Exposure to Financials Sector
Fund
Weight
(%)
SGMF Global
Credit Fixed
Income
14.92
SGMF Global
Opportunistic
Fixed Income
14.92
SGMF
European (ex11.54
UK) Equity
SGMF Pan
European Small 11.16
Cap
SGMF Global
Developed
14.22
Markets Equity
SGMF Global
Managed
8.30
Volatility
Sources: BlackRock, SEI
Weights as of 30 April 2012
Weight
(%)
Difference
15.18
-0.26
15.18
-0.26
MSCI Europe
(ex-UK) Index
18.62
-7.08
MSCI Europe
Small Cap
Index
18.97
-7.81
MSCI World
Index
18.67
-4.45
MSCI World
Index
18.67
-10.37
Benchmark
Barclays
Global
Aggregate exTreasury Index
Barclays
Global
Aggregate exTreasury Index
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