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Greece: Thinking the unthinkable

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Sunday’s referendum has pushed Greece closer to euro-area exit. A Greek departure would plunge the region into uncharted waters, with unpredictable consequences. But policymakers have powerful tools to combat contagion and prevent a Greek accident sending the rest of the region back into recession, says Darren Williams (pictured) – Senior Economist, Europe, AllianceBernstein…

Greece has taken another big step towards euro-area exit following a decisive “no” vote in yesterday’s bailout referendum. While the referendum was not a formal vote on Greece’s membership of the euro area, it was a huge rejection of the fiscal discipline and reforms that go with it. 
This means it will now be even more difficult (if not impossible) for Greece to reach a deal with its euro-area partners. In fact, it’s hard to see how Greece will avoid default on the European Central Bank (ECB) on July 20—if its banking system lasts that long.

It’s still possible that Greece’s creditors will “blink”, but they’ve shown no sign of doing so thus far. In our view, they’re now likely to start working on a plan “B” to protect the rest of the region if/when Greece ends up leaving the euro.

There are three main channels through which a Greek exit could impact other countries: direct trade links; financial links; and contagion. The impact via the first two channels is likely to be limited. Greece accounts for just 1.8% of euro-area output and 0.5% of the exports of other euro-area countries. And most of the financial exposure has been transferred out of private sector hands into the safer hands of official creditors (other euro-area governments, the ECB and the International Monetary Fund (IMF). Foreign bank exposure to Greece has fallen sharply in recent years (Display). 

The main threat to other euro-area countries is therefore likely to come through the third channel: contagion. In recent years, other vulnerable countries in the euro area have taken important steps to differentiate themselves from Greece, particularly with respect to their commitment to reform. Nonetheless, the recent volatility of peripheral bond markets shows that developments in Greece can still have important knock-on effects elsewhere. 

If Greece actually leaves the euro, these knock-on effects will intensify. That’s because the departure of any country from the euro area would shatter the myth that membership is irrevocable. This, in turn, would lead to a higher risk premium in other countries. Much of the time, this premium for “redenomination” risk might be quite small. But it could rise significantly – and act as a dangerous accelerant—at times of economic or financial-market stress. Fortunately, the ECB is aware of this. 

Over the last three years, the ECB has gone to great lengths to ensure that its monetary policy is being transmitted properly to the periphery. Recent evidence suggests that these efforts are starting to bear fruit (Display). So, while we don’t think the ECB has any hard and fast targets for bond yields in the periphery, we doubt that it would stand back and let the actions of the Greek government undo all its good work—especially with the spectre of deflation still lurking in the background. 

The ECB’s tolerance for rising bond yields is therefore likely to be limited. And it has the tools, in our view, to prevent contagion from spiraling out of control. In the first instance, it could alter the speed and composition of its current sovereign-bond purchase program (ie by tilting its near-term purchases more towards the likes of Italy and Spain). In extremis, it could deploy its Outright Monetary Transactions program – or some variant thereof.

In light of this, we think any increase in peripheral bond yields following a Greek exit would be much less severe than during earlier phases of the crisis. So, while we are mindful that the euro area would be sailing into uncharted waters, we are hopeful that the economic impact would be manageable. That’s probably also the assessment of other euro-area governments. And it helps explain why they may now be willing to let it go.

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