The situation in Greece remains very fluid. Unwilling to implement certain proposed austerity measures, the Greek government has rejected the proposal for an extension of the financial bailout package by its official creditors. That said, it is not a foregone conclusion that this will lead to a significant debt default or Greece’s exit from the eurozone.
Nevertheless, the possibility of both events has increased, leading to greater caution among investors and a flight to safer, more liquid financial assets. The next week is an important one and we will continue to monitor events closely. According to media reports, a last-ditch effort to broker a deal between the Greek government and its creditors may be underway.
At present, there are many unknowns and volatility is likely to remain elevated in the near term as policymakers across Europe react to the latest development. However, it is important to remember that flare-ups like this are usually temporary in nature and rarely cause lasting damage in financial markets.
What Just Happened?
- On Friday, June 26, the Greek government rejected a proposal that would have allowed for an extension of the financial aid program provided by the European Union (EU), the European Central Bank (ECB) and the International Monetary Fund (IMF).
- The Greek government took the unusual step of calling for a referendum on Sunday, July 5, on the proposal from the official creditor group. Investors were unnerved by this decision.
- Complicating matters, Greece also announced that banks and the stock market will remain closed until July 7 to restrict the flight of capital. Citizens will be allowed to withdraw only nominal amounts from ATMs.
- Late on Monday, June 29, the Greek government said it will be in arrears on a €1.5 billion payment to the IMF due on June 30. However, IMF rules allow for some leeway in negotiating the payment and the terms with Greece while it is in arrears. The next crucial deadline is July 20, when payments are due to the ECB.
- The ECB has capped the level of support provided to Greek banks via the Emergency Liquidity Assistance (ELA) program at €89 billion, and promised to work with Greece and other governments to avoid financial contagion.
- U.S. officials called on European leaders to avoid an exit of Greece from the eurozone.
Safe-Haven Assets Get Renewed Interest
- Equity, bond and currency markets experienced volatility in the wake of the events of the weekend. Greater caution among investors led to a rally in some assets traditionally regarded as “safe havens,” including U.S. Treasuries, the Japanese yen and Swiss franc. The euro depreciated against many currencies, but remained fairly stable against the U.S. dollar.
What Happens Next?
- There is no clear-cut answer on how the situation will unfold. The government recommends a “No” vote in rejection of the creditors’ proposal. However, Greek polls suggest a significant majority may favor a “Yes” to the proposal, in line with the popular support for remaining in the EU and retaining the euro. A “No” vote would increase the risk of a Greek exit from both the euro and the EU — an event that is without precedent and likely to take some time to implement fully.
- IMF rules give the agency some leeway in negotiations with a borrower in arrears. This could provide sufficient time to negotiate a new deal and avert default.
- Given the small size of Greece’s economy, developments there should have a limited direct economic impact on the eurozone and elsewhere.
Policymakers Have Several Tools At Their Disposal
- The ECB has a number of tools at its disposal and has pledged to do whatever it takes to avoid contagion to other southern European countries such as Portugal, Spain and Italy, and it may tilt its bond purchases to those countries. The central bank is likely to be more focused on disruption in the bond markets rather than equity markets as a trigger for any actions.
- Market volatility is likely to remain high as negotiations continue among European policymakers, creditors and Greek officials.
- Most Greek debt is held by official-sector institutions, and exposure to Greek debt among private-sector banks in Europe is relatively limited. It should also be noted that, generally, European banks are relatively well capitalized. Consequently, the impact on the global financial system is expected to be limited.
- Elevated volatility among Greek bonds and stocks is likely, with the Greek banking sector under particular pressure amid recession, rising nonperforming loans and deposit outflows. Greek banks have been supported by the central bank’s ELA program since February 2015.
- Greece remains a source of near-term volatility for eurozone bond and stock markets, as well as the euro. Over time, the ECB’s commitment to buy up to €1.1 trillion of eurozone bonds via its quantitative easing program should be supportive of European growth and market stability.
- Federal Reserve officials hinted at the possibility that an interest rate hike could be postponed further if market sentiment remains fragile.