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Jyske Markets 24.05.2012

The parliamentary elections have changed the political landscape and the risk of a chaotic Greek euro exit has risen markedly. If that happens, the Greek economy will be paralysed with resultant spill-overs on the rest of the euro zone. The euro zone will be able to handle the direct losses incurred in relation to Greek euro exit but the risk of the problem spreading is much disturbing. Hence, the authorities must be ready to intervene swiftly and consistently. The ECB will again play an important role but also a joint European deposit guarantee may contribute to dampening a run on the banks.

Strong risk of Greek euro exit

still be the best thing for Greece to stay with the euro. The big left-wing party Syriza won about 17% of the votes at the elections in May, and the opinion polls indicate that the party is in for further progress. As a result, Greece may have a government headed by Syriza. The party wants Greece to stay with the euro (which 80% of the population does), yet at the same time Syriza rejects the conditions of the rescue package. And these two viewpoints are mutually contradictory. And indeed, the other euro countries have several times emphasised that Greece should stay with the euro, but also for this to happen, the conditions should be met.

Publisher: Jyske Markets Vestergade 8 -16 DK - 8600 Silkeborg Senior macro-economic analyst: Tina Winther Frandsen +45 89 89 71 70 twf@jyskebank.dk Translation: Translation Services

Our main scenario is still that Greece will remain in the euro since the alternative to the current austerity measures is even worse. But the risk of an irrational outcome with the politicians giving up after the new elections despite the country then being thrown into chaos and deep recession has increased drastically. Even if Greece will be able to weather the storm initially, the problems remain so huge that an exit in the 2 to 3-year term may take place.

Euro exit will not be voluntary

We still assess that Greece will fight to stay in the euro cooperation and that a possible exit will take place as a result of pressure from the rest of the euro zone. There is, however, no legal basis for excluding a country from the euro cooperation. Yet, as appears from the box, it may take place via the ECB, which can block access to liquidity and Target2, which in actual fact will exclude a country from the euro. Such a far-reaching decision will, of course, not be made by the ECB alone, but rather at the very highest political level.

Political chaos and new elections on 17 June

The parliamentary elections on 6 May changed the political landscape in Greece. The left-wing parities and the ultra-nationalists on the right wing, who all reject the conditions of the rescue package from the EU and the IMF, saw strong progress. And following unsuccessful attempts to form a coalition government, new elections were called to be held on 17 June. We have for quite some time assessed the probability of Greece exiting the euro as moderate as, after all, the adjustment could be easier under than outside the EUs auspices. However, the progress for the political extreme wings changed this significantly, and we now think there is a strong risk that Greece will leave the euro. Even if, from a rational point of view, it would

Hypothetical scenario for a Greek exit

If the outcome of the elections is a government headed by Syriza, which takes a tough stance and rejects the conditions of the rescue package, the EU and the IMF may very well stop disbursements of funds. This would force Greece to stop paying off its debt and nationalise the banks. The depositors will withdraw their funds from the banks, and as the ECB will no longer accept Greek government bonds as security, the banks will find it impossible to handle the run on them. Therefore the Greek central bank will no longer be able to supply the banks with liquidity from the ECB, and also Greeces access to Target2 (the euro zones interbank payment system) will be closed. In actual fact, this would preclude Greece from the euro cooperation. And the government will therefore have to introduce capital control and a new currency.

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Even though it is easy to imagine such a scenario, there are also some reservations. Particularly the fact that even a government headed by Syriza would not want to leave the euro, and also the other euro countries would still want Greece to stay in the club. Simply because the costs of a chaotic Greek euro exit would still be too high. And therefore the big issue is whether it will be possible to renegotiate the conditions and reach a solution that is acceptable for both parties. We assess that both parties would be willing to compromise even though the EU would undoubtedly maintain the basic structure of the debt agreement. And indeed, proposals for growth initiatives have already been presented to Greece. Therefore a government headed by Syriza will not necessarily mean that Greece will leave the euro even though there is a high risk. currency will be a problem. At the same time the legal repercussions relating to contracts and redenomination from the euro will go on for years, and also confidence in the new currency will be limited. This may lead to import restrictions, which may have severe effects, for instance in respect of medicine and food, and for a period we may see hoarding. A significant currency depreciation may also lead to inflation, and a number of companies will have to default on their euro loans. This would very soon overshadow the advantages of a weak currency and an independent monetary policy. Moreover, it is also important to bear in mind that the cause of the poor competitiveness is not the currency but rather a miserable business climate and a most regulated and inefficient economy. It is not likely that the steep depreciation will quickly invigorate the economy as, historically, the Greek unions have been able to protect real wages despite a high unemployment rate, and also it can be doubted whether a new and presumably unstable government will implement the necessary economic reforms. Leaving the euro may also entail leaving the EU, and that would indeed have a severe impact on Greece, as each year the country receives transfers from the EU of up to 3.5% of GDP. Therefore we asses that a quick and chaotic exit would have the result that Greece will slide into an even deeper recession. The economy way contract by further 5-10% , which will bring the total contraction to 2530% from the peak.

Euro exit would paralyse Greek economy

The costs for Greece in the event the country leaves the euro soon would be very high as such an exit would take place in a chaotic manner. The fiscal consolidation would be even larger outside the euro than with the currency, and without external financing from the EU and the IMF, Greece would be forced immediately to eliminate the deficit on the primary budget balance (was at 2.4% of GDP in 2011.

Greek bank deposits plunge

How will an exit affect the euro zone?

As mentioned above, a chaotic Greek euro exit will prompt a default with the Greek state, banks and a number of Greek businesses. And this will, of course, affect the euro zone as well, although we believe that the effect will, after all, be more limited than it would have been e.g. two years ago. But it may reduce euro zone growth by up to two percentage

The run on the banks will accelerate; the banks will be nationalised; and also the logistics relating to the introduction of a new

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points compared with our current forecast (GDP decline of 0.2% in 2012). The Greek debt has already been restructured and only about 1/4 of the debt is now in private hands against previously 2/3. Hence, the public sector has the greatest exposure to Greece. Given the loans from the EU rescue fund, the ECBs acquisition of Greek government bonds and the Target2 outstanding amounts, the public sector has an exposure to Greece of approx. EUR 300bn. Assessing a recovery rate of 20%-50%, the loss (or the involuntary transfer) with the euro zone countries amounts to approx. EUR 150bn-240bn. This corresponds to 1.5%-2.5% of euro zone GDP. should exit the euro. Accordingly, it is disturbing that politicians so far have constantly been lagging behind in the attempt to solve the crisis. The ECB will therefore once again play an important role given the ECBs possibility of swift intervention. As a minimum, the ECB must only inject unlimited liquidity for an unlimited period of time and preferably subject to more relaxed requirements with respect to collateral than seen so far. The ECB also has the possibility of lowering the interest rate, and the purchases of government bonds from the vulnerable countries may be resumed. Additionally, political intervention will be needed. Especially a joint cross-border deposit guarantee in the euro countries may contribute to dampening the run on the banks. For the slightly longer term, a joint European financial supervisory authority and common guidelines for reconstruction of banks may be a possibility and the idea of jointly issued euro bonds has certainly not been abandoned either.

Great contagion risk

If the concerns were exclusively related to this direct effect of a Greek exit, it should be handled without any major problems. But the really serious risk i.e. the contagion to other vulnerable countries in the region - is more indirect. This may be both in the form of increased pressure against the countries and their banks. The financial markets have already turned the spotlight on Spain given the countrys vast budget overruns, a collapse in the housing market and vulnerable banks. Hence, the 10year yield has risen to 6.2%, and should the Spanish situation deteriorate, this will inevitably hurt Italy as well. This would be an entirely different and disturbing development since Italy and Spain are the third and fourth largest economies of the euro zone. It is therefore very much a matter of containing the problems to Greece. This also applies to the banks in the vulnerable countries since there is a risk that the run on Greek banks will spread to other countries. So far, the public statistics only show moderate falls in bank deposits in the other Southern European countries but this may easily change if distrust starts spreading.

The authorities may lose initiative

There is a risk of increased pressure already prior to the elections, resulting in the authorities losing the initiative. If the run on Greek banks accelerates, the ECB may be forced to further increase exposure to Greece although there is no certainty that the rescue package from the EU and the IMF will continue after the elections. However, we do not expect the ECB to cut off Greek banks from financing in the ECB before the elections, although rising exposure to Greece will undoubtedly arouse concern with both the ECB and the politicians.

Still strong political will in the EU

It is important to bear in mind that there is still very strong political will to sustain the euro cooperation which builds on the tentative European integration in the years after World War II; also towards Greece, although the country has repeatedly offended against the rules. The EU is certainly not interested in a chaotic Greek euro exit developing into a

What can the authorities do?

The authorities must intervene swiftly and consistently to contain the crisis if Greece

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powder keg in the EU backyard. But there is of course limits to the EUs willingness.

What if Greece stays?

Although Greece should succeed in preventing a chaotic euro exit this time, considerable risks persist. First of all, there is a risk of bending the rules so much that it will undermine the credibility of the actual euro construction. Hence, the concept of conditionality (conditions) stands the risk of losing its importance given lack of political will to introduce sanctions. The development in Greece in the coming weeks will show whether this is in fact the case. If Greece succeeds in negotiating major concessions this will inevitably inspire Portugal and Ireland to demand similar concessions. Secondly, the situation in Greece remains very difficult, although a quick euro exit is prevented in the short term. If the poor ability to reach the targets in connection with the rescue packages from the EU and the IMF continues, it may, in the somewhat longer term, prevent further payments. And if it is assessed that the safety net at that time is sufficiently well-developed to prevent other countries from being drawn into the fall, and that the other vulnerable countries are significantly further ahead in the reform process, a Greek exit may otherwise materialise in the 2 to 3-year term.

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