The financial crisis in Greece is once again in the headlines, as a loan of about $1.6 billion from the International Monetary Fund (IMF) comes due on June 30. While negotiations over the weekend have resulted in some progress toward a deal, it is still quite possible that a breakdown could occur, resulting in a default on Greek debt and a possible exit from the euro currency.
Predicting the likelihood of a so-called “Grexit” has become a blood sport among commentators and strategists in the financial media. Experts are all over the map regarding the likelihood of Greece exiting the euro and, importantly, what the fallout might be across global financial markets. Although in economic terms Greece is about the same size as San Diego, the impact on the confidence in the “eurozone experiment” may be severe. We have no unique insight as to the probability of such an outcome, but as risk managers, we must consider the potential impact on client portfolios under a worst-case scenario.
Greece’s creditors (largely the ECB, the IMF, and other entities backed by other European governments) are insisting on more austerity (through higher taxes and additional pension cuts) in order to bring Greece’s fiscal deficit under control. Th e Greek government, on the other hand, believes that any further austerity will bring undue economic hardship to the Greek citizens and is resisting any further cuts.
Concern over the Greek situation has led to large outfl ows of euro deposits (totaling 100Bn euros since 2009) from Greek banks. Outfl ows have accelerated in recent days as the crisis has escalated. The great fear is that continuing deposit outfl ows from Greek banks will cause the country to impose capital controls which would limit or bar additional withdrawals and/or wiring of funds abroad, thus crippling the Greek economy.
In the event that Greece does default and exits the euro, the impact on the Greek economy would be swift and severe. The IMF predicted in 2012 that the reintroduction of the drachma as Greece’s currency would result in a 50% plunge against the euro, an infl ation rate of 35%, and a drop in Greece’s already anemic GDP by 8%. For these reasons, the Greek population remains overwhelmingly in favor of staying with the euro.
Beyond Greece itself, the potential fallout from a Grexit on the global economy is harder to predict. In the event of a default, here are some possible financial market implications:
- Short-term financial market instability, particularly in Europe, as concern spreads about the wider implications
- Slowing growth in Europe, including the possibility of a recession
- Declining interest rates in Northern European countries (e.g., Germany, Switzerland), with higher rates in the peripheral countries
- Destabilization in the European Union, including the heightened risk of a larger country following suit, and concerns that other eurozone countries may turn to Russia for support
- Capital controls in Greece coupled with a sharply devalued Greek currency and much higher infl ation
- Higher taxes in European countries to rebuild reserves among central banks stung by losses on their Greek debt
- Possible flight to quality, resulting in inflow to U.S. dollar-based assets, lower interest rates in the U.S., and strength in the USD
- Delay in the FOMC’s timing for raising interest rates in the U.S., as they seek to calm nervous markets
If Greece reaches a deal with its creditors, the most likely outcome is simply to postpone the timing of the next crisis. Without a significant increase in Greece’s economic growth rate, it is unlikely they will ever be able to grow their way out of their debt problem.
From an investment strategy standpoint, we have remained significantly underweight in European equities in part because of the possibility of a Greek default. We continue to believe that is a prudent approach, despite a likely short-term rally if a deal is reached. If the talks collapse, we would expect a “risk-off ” environment to benefit our investment-grade taxable and-tax exempt bond holdings. In the anticipation of increased volatility in financial markets should a default occur, we have increased our allocation to liquid securities in both our domestic and international fixed income portfolios and are holding above-average cash allocations in both equity and fixed income strategies.
Importantly, we view any market disruption caused by a potential Grexit to be relatively short-lived and not the trigger for some broader global financial crisis. As a result, we hope to take advantage of any market weakness by opportunistic purchases in selected asset classes.
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