An unsteady first step

Derry Pickford, Macro Analyst at Ashburton Investments.

The new Greek government and the Troika have successfully cleared the first and easiest hurdle to Greece remaining within the Eurozone. There are unfortunately several more difficult obstacles yet to overcome. While we believe both sides wish to avoid “Grexit”, the chance of a policy mistake remains: we put the probability of an exit from EMU within the next two years at around 25%. Despite these risks, however, the benefits to the Eurozone flowing from the very significant easing in financial conditions that the QE announced in January has unleashed should not be underestimated. On a currency hedged basis the Eurozone still provides some very attractive opportunities for investors.

What victory?

Alexis Tspiras, Greece’s Prime Minister, has declared that Greece had won the battle but not yet won the war. However, the opposite would be a fairer assessment. Greece has won very few concessions. Some are purely cosmetic – the Troika, a toxic concept to the Greek electorate, is now referred to as the “three institutions”. More substantively, the primary surplus target for 2015 “will take economic circumstances into account”. An acknowledgement of the economic reality that Greece won’t achieve its previous 3% target because of a shortfall in fiscal revenues cannot really be seen as a big concession. In return Greece has agreed to “refrain from any rollback of measures and unilateral changes to the policies and structural reforms”. In other words the Troika’s programme remains intact.

Some analysts have suggested that by conceding so much the SYRIZA leadership has acknowledged that they will do anything to avoid being forced out of the Eurozone and so have weakened their hand. The negotiations are like a game of poker and, if you know what the “payoffs” of your opponent are, then you have a good strategic position.

By the end of April the Greek government and the “Eurogroup” (which is made up of the finance/economy ministers of the Eurozone member states, with Mario Draghi attending in an observational capacity) will have to agree to fiscal targets and structural reform measures. If Greece has weakened negotiating power then it could be forced to accept the terms dictated by the Eurogroup. However, the Eurogroup hawks believe they may be overestimating the strength of their hand. This risks a dangerous miscalculation of the actual payoffs from the game.

Greece eventually bowed to pressure at the end of last week because there was a growing possibility that the ECB would cut off Greek banks’ access to emergency funding at the weekend and force the imposition of capital controls. By agreeing to continue the programme Greece has bought itself time. The fact that the deal was concluded within relatively civilised time by the standards of European bargains, suggests that the Greek government didn’t want to go too close to the wire for now. However, the payoffs from the game may be being miscalculated by the Eurogroup hawks. Although Greece doesn’t want to leave the Eurozone, walking away from a substantial part of its debt burden would soften the blow. Furthermore, unless SYRIZA is able to walk away with some prize, the current administration will likely crumble. SYRIZA won an election on the basis of being prepared to leave the Euro if they couldn’t get a better deal. The payoffs for SYRIZA politicians may not therefore match the payoffs for the Greek people.

Could the deal unravel?

So how much time has Friday’s agreement bought? The standard view is to the end of April 2015 when the new targets have to be agreed. However, there are risks that the situation could unravel before then. The first obstacle is that we still have to get ratification of the deal through several European parliaments. Given how much the Greeks have conceded this shouldn’t in theory be an issue. However, anything that undermines trust in the deal, such as vitriolic pronouncements from Athens may create an upset. Countries with parliamentary elections later in the year, like Finland, have to be more responsive to sceptical public opinion and may prove more of a danger than Germany when it comes to ratification.

An even bigger hurdle will be holding the current Greek coalition together. One prominent Syriza MEP has already apologised to the Greek people for the “illusion” of an improved deal. Their right wing coalition partner has little incentive to remain, particularly as the chance of new elections later in the year rises and they risk being outflanked by the extreme right-wing party, Golden Dawn. Finally, maintaining confidence that Greece will remain in the Euro will be essential. Last week alone, according to JP Morgan €3 billion of deposits left the Greek banking system. The more deposits leave, the more funding will be reliant on the Emergency Liquidity Assistance (ELA) window. Although theoretically the Greek National Central Bank have to refund the rest of the European Monetary System any losses resulting from ELA, the chances of that happening under a forced Grexit scenario are slim. If capital flight continues the ECB may judge that access to ELA funding is not sustainable.

All doom and gloom?

Although there are risks, our base case remains that a deal will be done. Greece will get more fiscal flexibility in return for honouring its debts and it will remain part of the Eurozone.

We shouldn’t underestimate the huge easing in financial conditions that the ECB’s €1.1 trillion of asset purchases has already created and will continue to deliver.

Deutsche Bank estimates that over the period of the programme these purchases will represent over 189% of net sovereign issuance. This will be supportive not only for fixed income markets but should help all risk assets as investors facing very low rates are forced into reaching for yield. Low rates will continue to put pressure on the euro but this should be helpful to exporters and other corporates with high levels of overseas earnings.

Even if Greece was to leave EMU we believe the consequences for financial markets will not be nearly as severe as if this event had occurred in 2012. Exposure to Greek financial assets by foreign banks is down according to BIS figures to below €65 billion (from nearly €300 billion in 2010). The strong firewalls that have been put in place over the last couple of years (including the €450 billion European Stability Mechanism, and unlimited long-term repos for banks) mean that the risks of contagion are much lower than they have been. If Greece was to leave we also believe there would be further measures to increase confidence in other country’s membership being maintained. We therefore believe that despite the risks, European assets, on a currency hedged basis, remain very attractive to investors.

1In game theory “payoffs” are numeric representations how well each player does in a game.