Greece and its creditors arrived at a deal on Monday morning that outlines next steps towards providing €85 billion in additional bailout funds. While this is unambiguously good news for equities markets, the impact on business in Greece and the eurozone is less one-sided.
Procedural challenges to Greece’s bailout remain
Greece’s parliament must now pass into law and implement demanding bailout terms, which it is expected to do despite substantial political hurdles. However, even with a “finalized” bailout plan, the country’s financial system will remain in jeopardy at least for the next few months. Bridge financing must be arranged immediately to prop up the deteriorating Greek economy until the European Stability Mechanism can be unlocked, likely sometime in August. While there is political will to rush bridge financing, the immense amount of coordination necessary could result in an accidental bankruptcy of Greek banks, triggering their insolvency and possibly forcing an exit from the euro. In addition, recovery will require the recapitalization of Greece’s banks, an enormous (€25 billion) task made much more difficult by the impact of capital controls on confidence in the financial system. Most parties involved want to avoid a Grexit, but the sheer number of moving parts means that the country is not out of the woods yet.
Deal or no deal, risk will linger
Regardless of the dynamics of Greece’s short-term deal, the crisis is far from over. Though welcome, the bailout funds will likely be insufficient, and the IMF has stated confidentially that without meaningful debt relief it might be unable to participate in the long-term package because Greece’s debt burden would be unsustainable. Domestically, capital controls have undermined economic activity and reduced government tax revenues, ballooning the country’s fiscal gap. Non-performing loans accounted for 40 percent of total loans at the end of 2014, a ratio which is likely much higher today. Economic indicators from recent months may improve to reflect high consumption, the result of panicked purchases of consumer durable goods as a store of value where bank deposits are no longer viable. However, extensive hits to investor and consumer confidence mean that multinational corporations will not see sustained demand out of Greece for a long time.
Neither is Europe safe
Regardless of what happens in Greece this week, the common currency faces substantial economic and political challenges to its viability in the medium term. The Eurozone has a tendency to “kick the can down the road,” and the group’s leadership must find a way to prove to investors that this time is different or the euro will face renewed financial market pressure on exchange rates and sovereign yield spreads. While incomplete, previous partial reform measures can arguably be excused on the grounds that they served to buy enough time to implement firewalls to protect the union from future crises. Between 2012 and 2014, these positive changes included creating new pillars of a banking union and performing stringent bank stress tests. Nonetheless, it is FSG’s view that the eurogroup has 18 to 24 months at most to make substantial further improvements to its framework in order to avoid an acute crisis of confidence.
Austerity fatigue renders political consensus more difficult
However, the rise of far-left and far-right groups throughout the region make political consensus more difficult, which will only expose the fragmented structure of the currency union and endanger its viability. FSG first alerted clients to this risk in its 2014 Events to Watch report. As a result, the steady-state impact to asset classes is fairly clear regardless of near-term political events:
- Credit will contract. Bank lending accounts for approximately 85 percent of eurozone corporate financing, compared to less than 15 percent in the United States. As a result of the crisis and deteriorating collateral, interbank lending will contract sharply. FSG also anticipates that credit to households and businesses will be scarce. This makes it difficult for Europe’s businesses to hire new workers or invest in expansion.
- Official ECB interest rates will be low, but sovereign borrowing costs will rise. As a result of economic weakness and the recent threat of euro breakup, the ECB will maintain a very dovish monetary stance. In conjunction with ongoing quantitative easing policies, this will keep policy rates low for the foreseeable future. However, the Greek crisis called attention to the questionable viability of the common currency. This means that financial market participants’ concern over sovereign borrowing will grow, resulting in a risk premium for sovereign bonds based increasingly on countries’ relative debt/GDP ratios.
- The euro will depreciate. Even without a Grexit, the ECB’s monetary expansion in Europe will contrast with a rising US interest rate, and result in euro depreciation over time. Currency volatility, associated with the strong dollar, has been massively painful for US- and Europe-based multinationals, who have seen losses more than 50 percent even higher in Q1 2015 than during the “taper tantrum” in 2013, in the past few quarters.
In conclusion, regardless of the results out of Greece this week, the eurozone faces substantial challenges in restoring confidence in the viability of the common currency. Executives should anticipate weak economic performance in eurozone countries for at least the next 2 to 3 years.
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