News that the Greek government had submitted a proposal to its creditors – including the European Central Bank (ECB) and International Monetary Fund (IMF) – coincided with a sharp rise in stockmarkets on Friday (July 10 2015), with the MSCI Europe equity index rising by over 2%. This led many to assume that the markets were rising because a deal between Greece and its creditors seemed more likely. Louise Armistead wrote in the Telegraph: “Global stockmarkets rose as traders banked on Greece’s €130bn (£108bn) bail-out package being released ” (http://www.telegraph.co.uk/finance/financialcrisis/9089932/Shares-rally-on-hope-for-Greek-deal.html).
I think this cause and effect narrative is a fiction. The real reason for the rally was that the market wanted to go up, and Greece was the last excuse not to buy. The market will go up when the Greek negotiations are concluded, whatever the outcome.
Greece could disappear and no one in Europe would notice
There are many reasons why markets might fear the possibility of a resolution of the Greek debt crisis in which Greece leaves the Euro (“Grexit”): confidence in the Euro as currency might be undermined; the damage to Greece’s economy might be contagious and spread to other countries; other countries such as Spain might be encouraged by Greece’s example and leave the Euro too, leading to a kind of domino effect; and we have never been here before and it is normal to be wary of the unknown.
In practice, however, Grexit would have limited economic consequences for Europe. Greece accounts for only 2% of Eurozone GDP; of the few European banks that still have any exposure to Greek banks and government bonds, that exposure represents a very small percentage of their equity (most banks’ exposure is less than 1% of core tier one equity, and in the most exposed country – ironically Germany – the aggregate exposure is only 5%); and private investors outside Greece own only €20bn of Greek government debt (to put that into context, Lloyd’s in the UK – just that one bank – had €180bn of bonds on its books at March 2015, so €20bn across all private investors is a drop in the ocean). In other words, Greece could disappear down a hole or fall off the edge of the world, it would make no difference to the European economy or financial system.
What about the impact on Spain and other peripheral countries? There would have been potentially negative consequences whatever stance the ECB took. Had the ECB allowed Greece to walk away from its debts, or to abandon liberalisation and fiscal austerity, it might have encouraged the Spanish and others to ask for similar relief. Suddenly fiscal discipline in Europe might disintegrate, causing bond markets to doubt the creditworthiness of European governments and undermining the banks. If on the contrary the ECB had not softened its stance and Greece were to head for the exit, that might have encouraged others to follow Greece out the door.
The risk of Grexit encouraging others to leave the Euro is very small however, simply because Grexit would be so painful to Greece that it would discourage them, not encourage. Imports were 35% of Greece’s GDP in 2014 according to the World Bank (http://data.worldbank.org/indicator/NE.IMP.GNFS.ZS) compared to 30% for countries like France and the UK. And Greece has very few domestic alternatives to its imports. Exiting the Euro would leave Greece with a new and heavily devalued currency. That would make vital imports – think gasoline or medicines – prohibitively and painfully expensive. And apart from tourism, olive oil and feta cheese, Greece doesn’t export much to compensate. Greece is also heavily indebted. Even if it reneges on those debts it is dependent on the bond market to fund its budget, particularly if it pursues the Syriza party’s anti-austerity agenda of increased government spending – which after all was supposed to be the whole point of exiting the Eurozone and its fiscal constraints. Exiting the Euro will make those borrowing costs painfully expensive. And a Euro exit would, at least in the short term, create chaos in whatever was left of Greece’s banking sector. It is unlikely that Spain and other peripherals would want to endure such duress for the sake of more government spending, however populist it might first appear.
Resistance is futile
Syriza and its supporters, both in Greece and abroad, have called for debt relief and an end to austerity. Greece’s negotiations with its creditors was an important test of whether such ideas might ever be implemented in the real world, or would just remain as pipe dreams. In the end, Greece has offered to do exactly what its people voted against in the referendum. For all the bluster of the Greek leaders and their pointless referendum, Europe effectively called their bluff. They said “take it or leave it.” The Greeks blinked first. This has demonstrated to all countries in the Eurozone that they have to abide by the rules of budgetary discipline demanded by Germany as the price for its financial support of the periphery via the ECB. The anti-austerity movement has lost.
There are only two potential outcomes now. Either Greece’s current proposals form the basis for some sort of agreement, in which case Greece stays in the Euro and accepts the principles of fiscal austerity, privatisation and liberalisation. Or it doesn’t, and Greece leaves in a painful way which encourages other countries to stay in the Euro and accept those same principles. In either case, Europe will follow the German model of budgetary discipline, with or without Greece. The dogs bark, but the caravan passes.
If you listened to the press, you would have thought that the Greek question was of huge importance to markets. This is what behavioral economists Kahneman and Tversky call the “availability fallacy.” Greece was understandably a much discussed news topic. Why markets go up and down is not something most people, and certainly most journalists (many of whom are not financially literate), understand. So they turned to the most “available” story, the Greek debt resolution, and used it as a way to explain what was going on.
In fact, if you look at the market’s behavior before the current series of Greece-related twists and turns, share prices did not exhibit any profound concern. Markets sold off 10% from mid-March to the latest trough, but that’s from a level close to the 2007 pre-financial crisis highs, and no bigger than the sell-off between March and May 2012 after which markets rallied in nearly a straight line by over 30%. Italian bond spreads have hardly moved, and after rallying 8 cents against the dollar from mid-April to mid-May the Euro has been trading in a tight range between $1.08 and $1.15. The press may be breathless, but the market is nonplussed. It knows that Grexit will have no great consequences for the corporate or government cashflows into which it invests. It has treated the Greek crisis as substantially irrelevant.
So why did the market go up on Friday? The market has in fact been a lot more subtle, and at the same time simpler than most of the press. The current Greek drama happened in the context of European stock markets which had rallied in pretty linear fashion since the ECB’s commitment, made at the end of 2011, to support Europe’s financial system “by any means necessary,” with an accelerated c. 20% jump at the beginning of 2015. Anyone who wanted to add to their position or to take an initial position after missing the rally would be looking to time their entry at the optimal point. Intelligent market participants will view the current negotiations as a catalyst or even pretext for flakier investors to panic or reduce positions. If you wanted to be “cute” you would hope to pick shares up from those flaky investors. Others will hold back from investing until they are sure the flaky investors have finished selling.
After the resolution of the Greek case, either by Grexit or an acceptance of fiscal discipline by Greece, there will be no discernible reasons left for the markets to sell off. Interest rates are low, companies are profitable, growth is recovering, and the financial and fiscal systems are stable. Greece was the last obvious reason for the market to sell-off. Markets were so strong on Friday, I believe, because of a pent up demand for securities which the Greek negotiations are temporarily holding back. Any sign that the negotiations are close to an end – whatever their outcome – is positive in that context. The resolution of the Greek debt crisis won’t be the tragedy many have been fearing, but it will certainly provide a catharsis in which the market can cleanse itself of its remaining doubts, at least in the short term.