A couple of ‘fundamentals’

A default/restructure/debt reduction of any form removes euro financial assets and is a contractionary/deflationary bias that makes euro ‘harder to get’ and thereby firms the currency.

Also, Greece has been running a budget deficit, which adds net euro the global economy, making euro easier to get, etc. so if Greece leaves the euro that source of net euro financial assets goes away as well, also fundamentally firming the euro.

And any Greek contribution to the euro trade surplus would be lost, which would work to weaken the euro.

Not that markets would initially react this way!!!
;)

As we had been expecting, the third and final round of the Greek parliamentary vote to elect a new President failed this morning and the country is now headed for a general election. The most likely date for this is January 25th (+/- a week, elections are always held on a Synday), with the constitution stipulating that parliament has to now be dissolved within ten days (most likely tomorrow) and elections held as soon as possible after. With Greek banks still reliant on the ECB for funding and bond maturities ongoing throughout 2015, a significant period of political and financial uncertainty now opens up for Greece and the Eurozone as a whole. Here are the three major questions that need to be answered as we enter the New Year:

1. What will the European response to early elections be?
Greece now has to deal with exceptionally pressing deadlines from its creditors. The current financing programme has been extended to the end of February to allow Troika negotiations to conclude and disburse the remaining 1.8bn EFSF funding before transitioning into a new financing arrangement (most likely an ECCL). If this deadline lapses without agreement, Greece will legally no longer be “under a program” and the undisbursed amounts will cease to exist. The European position across three fronts will therefore need to be clarified.

First, how “hard” is the February headline? Assuming the election takes place on January 25th, it will take around another 10 days to elect a new president (three 5-day distance parliamentary rounds are required, but the second round only requires 150 MP majority), and probably at least a week to form a new governing coalition.* With at best a few weeks left for a new government to negotiate the disbursement of the final tranche and a new credit line, completing talks will be a tall order. European partners will need to discuss if they would be open to another program extension, or if talks would have to start on a blank slate. Both avenues would require fresh approval of the extension or new funding from national parliaments.

The second question relates to ECB funding of Greek banks. We estimate that at least a third of the current 42bn EUR of Eurosystem financing is reliant on collateral that currently benefits from a credit rating threshold suspension from the ECB. It would become ineligible in the event the Greek program expires in February without a financing umbrella. Where the program to lapse after February, part of Greek bank funding would have to shift to Emergency Lending Assistance (ELA) at the Bank of Greece. With the size and scope of ELA financing being under bi-weekly review and press reports suggesting that the Governing Council is considering a broader re-think of its terms and conditions, ECB policy on Greek bank funding remains a key source of uncertainty as well as the most direct means of putting pressure on a new Greek government.

The third and final question relates to the Troika’s broader willingness to negotiate and compromise with a new government. As with the negotiations this year, the primary source of disagreement is likely to remain the fiscal gap for 2015, with the Troika’s current demands standing at a 3 percent primary balance target equivalent to a 2bn fiscal gap versus the current government’s budgeted measures. Our prior is that with a new government in place and a fresh 4-year mandate, the Troika would be more willing to give leeway to authorities to assess budget execution over the course of 2015 rather than voting a large number of proposed fiscal measures upfront, if not revising the primary balance target lower. Still, the timing and extent of such concessions remains highly uncertain, if at all possible.

Despite the pressing nature of the above questions, we would not expect full clarity from European authorities on any of the three fronts above while the election period in Greece is in full swing. The Eurogroup next meets on January 18th where local press reports that the European Commission will present a preliminary report on the terms and conditions which Greece would need to satisfy to remain eligible for an ECCL as well as complete the final review of the current program. A further extension of the latter in any case requires a formal request from the Greek government, and we would expect international creditors to remain quiet on most fronts until a new Greek government has emerged.

2. Who will win the Greek election?

The ability to meet the deadlines above in large part depends on the outcome of the general election and the position of the new government. Opinion polls have been showing a consistent lead for the Radical Left SYRIZA party over ruling New Democracy in the last few months, and our baseline remains that SYRIZA wins the elections. Still, the parliamentary and governmental outcome is not a foregone conclusion. First, SYRIZA’s opinion poll lead over New Democracy has narrowed from 4-6 percentage points over the last few months to 3-4 percent currently. With the political environment remaining particularly fluid (and polls unreliable), the outcome on voting day is not a done deal. Second, a SYRIZA first does not guarantee a parliamentary majority. Greek electoral law operates under an enhanced representation system that allocates the first 50 parliamentary seats as a bonus to the first party, with the rest split proportionately. This in practice requires a party to win 34-38 percent of the national vote to gain an absolute majority. As things stand, SYRIZA would win around 140 MPs in parliament and be required to form a coalition* with at least one of the following four smaller parties that are projected to enter parliament:

The River (“To Potami”) – this is a newly founded moderate left-off-centre party that has been founded by journalist Stavros Theodorakis a few months ago. We would consider this the most likely coalition partner, given that the party has openly expressed a desire for coalition-making. The party is currently polling around 7pct.

Independent Greeks – this is a radical populist party sitting on the right of the current government, whose main policy plank has been opposing current “memorandum policies”. While the party stands at the opposite end of the spectrum from SYRIZA on a number of non-economic issues (eg. immigration, separation of church and state), both sides have indicated they would be open to discussions on a governmental program. The party is currently polling at the fringe of the 3 percent threshold required to enter parliament.

PASOK – the current junior coalition party member, the stigma attached to this party would make it a more difficult coalition candidate for SYRIZA. Still, it is possible that the party is faced with internal pressure in coming weeks that forces a leadership change making coalition-making easier. Indeed, local press is reporting that former prime minister Papandreou (whose father founded the party) is considering running under his own separate platform.

Communists – with the agenda of this party being firmly against EU membership, it is the least likely coalition partner of the above.

As things stand, our baseline remains that either a SYRIZA-Potami or SYRIZA- Independent Greek coalition remain the most likely outcomes after a Greek election.

3. What will the new government’s position be?

A New Democracy win is likely to lead to a relatively swift agreement with the Troika by the end of February, likely meeting the relevant deadlines. In contrast, a SYRIZA government has the potential to create a much wider set of possible outcomes. Even more so that international creditors, the negotiating position of a new SYRIZA government is highly uncertain, and not yet fully clarified within the party itself.

Speaking in a Reuters interview a few days ago, SYRIZA leader Alexis Tsipras stated that the party is fully committed to Eurozone membership, and has no intention of making unilateral moves on the existing agreements “unless forced”. Ultimately however, the party’s position is likely to be dependent on a number of factors: (i) the internal political dynamics within the party, which is composed of a number of competing groups. Most vocal of these is the “left platform” led by current parliamentary spokesperson Panagiotis Lafazanis, who sits to the left of the leadership and favours a more confrontational stance versus international lenders; (ii) the outcome of the general election and the potential partner that emerges, with a “River” or PASOK coalition having a much greater moderating influence on the party than Independent Greeks or an outright SYRIZA majority; (iii) market pressure in the run-up to the election.

Ultimately, the party’s position on Europe is unlikely to be fully fleshed out until February, most likely formulated by the leadership team that emerges around party leader Tsipras, inclusive of the person that is appointed to lead the finance ministry. Nikos Pappas (party leader’s chief of staff), Yannis Milios (responsible for economic policy), George Stathakis (responsible for development policy), Yannis Dragasakis (current deputy Speaker of parliament) and Dimitris Papadimoulis (current member of the European parliament) all stand out as potential influential members of a new SYRIZA-led government.

Conclusion
To sum up, markets are likely to be left with more questions than answers until the domestic political progress in Greece plays out more fully over the next two months. In the meantime Greek financing needs over the course of 2015 are ongoing, with large uncertainty on when the government will lose its ability to repay maturing obligations. We estimate this would take place at some point in the second quarter of next year, with a 1.4bn IMF maturity being due in March, another 2.5bn due to the IMF over Q2 and a large 4.2bn GGB payment due to the ECB in July. Ahead of that the role of the ECB – in particular the willingness to tolerate ELA financing of Greek banks in the face of potential renewed deposit pressure on the financial system – will be a key pressure point between Europe and a new Greek government.

Ultimately, we see a consensual outcome between a SYRIZA-led government and its creditors as achievable, but it would require a moderation from both sides. On the European front, it would consist of a lowered primary balance target for this and coming years and an offer of additional official sector debt-relief via maturity extensions – we would consider neither impossible given the adjustments in fiscal targets already granted to other peripheral economies and the low political cost of maturity extensions. On the SYRIZA side, agreement would require the party to give up on its pledges to reverse structural reforms as well as a commitment to maintaining a path of fiscal prudence.

This notwithstanding, convergence is not currently apparent and is unlikely to become so until well after January. It requires both sides to shift to a consensual rather than confrontational approach, in turn perhaps dependent on greater market pressure. Either way, large uncertainty and path-dependent outcomes suggest damaging confrontation cannot be ruled out, which in turn has the potential to generate much greater destabilizing outcomes for Greece and the Eurozone as a whole in 2015. The New Year welcomes Europe with renewed challenges.

George

*If a government does not win an outright 151 majority of MPs, the leader whose party leader comes first is given a 3-day mandate to explore the possibility of a coalition government with other parties. If this fails, the mandate is passed to the second largest party and so on. If all three largest parties fail to secure a coalition, the country goes to a new general election

**The rating threshold exemption is apparent in the ECB document detailing GGB haircuts here: https://www.ecb.europa.eu/ecb/legal/pdf/en_ecb_2014_46_f_sign.pdf