Greek Moves Test ECB Resolve On Europe

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Includes: EU, GREK
by: AllianceBernstein (AB)

By Darren Williams

Greece's five-year debt crisis is escalating fast. A default on the IMF now looks almost certain and the country is taking a big step toward a possible exit from the euro area. What really matters now, though, is the impact on other countries-and how the ECB will respond.

Greece has shut its banks until at least July 6 and put capital controls in place after the government ratcheted up the crisis with its official creditors. The government announced plans for a July 5 referendum on the latest bailout plan and said it would recommend rejecting the deal. In response, euro-area finance ministers decided they'd had enough and chose not to extend a credit lifeline to Greece once its bailout and all funds attached to it expire on June 30.

Alexis Tsipras, the Greek prime minister, wanted the current bailout to be extended to provide time to hold the referendum. Unsurprisingly, this request was declined. As a result, Greece is expected to default on debt obligations due to the International Monetary Fund (IMF) on June 30. And it is difficult to know where it will find the funds to meet payments due to the European Central Bank (ECB) on July 20.

Will Greece Leave the Euro?

This does not necessarily mean that Greece will leave the euro. If the referendum goes ahead and the Greek people accept the terms of the bailout (the most likely outcome according to recent opinion polls, but by no means certain), the Greek government has said it will abide by the wishes of voters. However, it's difficult to see how the government would be able to carry on in these circumstances. Indeed, Greece's creditors have already stated that they would have no confidence in the government's ability to implement the required reforms. If the Greek people vote "no", this will be widely interpreted as a vote to leave the euro.

Meanwhile, the priorities of other euro-area countries are changing. The creditors have stated they'll do everything possible to help Greece and the Greek people during a very challenging period. But they've also made clear that their priority now is to protect the monetary union from any adverse spillover effects.

Recent developments have surprised financial markets - particularly given the complacency over the prospects for a deal that has built up in recent weeks. The rest of the periphery is likely to come under pressure, but the region has the tools - in the form of the European Stability Mechanism (ESM), ECB quantitative easing (QE) and Outright Monetary Transactions (OMTs) - to prevent volatility from spiraling out of control.

In our view, the ECB is willing and able to do just that. With the QE program in place, the central bank can calibrate its moves to address turbulent conditions, for example by adjusting the speed and composition of bond purchases as trouble spots arise. Indeed, the ECB said on June 28 that it was closely monitoring developments and was prepared to respond if necessary.

ECB Backstop May Mitigate Damage

Greece's potential exit from the euro area would represent a stiffer challenge than debt default. We believe the region is better placed to handle such an event than it was a few years ago - not only because of the financial firewalls outlined above, but also because the economy is stronger. Greece has been ring-fenced and investors increasingly distinguish between it and the rest of the periphery.

All this suggests that the authorities should be able to contain the spillover to other economies and markets more generally. Still, we are conscious that a Greek exit would represent a step into uncharted territory, with unpredictable consequences. The outlook is therefore highly uncertain, but would be much more so if the ECB weren't acting as a backstop.

Darren Williams, Senior Economist—Europe