Grexit: Outlining How Greece Might Leave the Euro

PERSPECTIVES: An analysis of how a Greek euro exit would have far-reaching consequences for global markets and economies

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From time to time, Morningstar publishes articles from third party contributors under our "Perspectives" banner. Here, the BofA Merrill Lynch Global Research team outlines what would happen if Greece exited the euro. 

The Risk of a Greek Euro Exit is Rising 
The recent political paralysis has now brought Greece to what could prove to be the worst stage of its crisis. Following the failure of the elections of May 6, another election has now been called for June 17. The latest polls suggest the risks of a coalition government against the austerity programme, or no agreement on a government at all - are increasing. Although polls in Greece show very strong support for the euro, we believe that the current situation could trigger a chain of events that could lead Greece to exit on its own. 

But So Too Are The Incentives To Keep Greece In 
If Greece were to exit, the implications would be profound both for Greece and the eurozone economy. This suggests eurozone policymakers would go a long way to keep Greece in the euro. According to International Monetary Fund (IMF) figures, in the event of an exit, Greek GDP could contract by as much as 10% in year one. For the eurozone, we assume that a forceful set of policy measures would be implemented but they would nevertheless result in elevated costs. Greek assets of ca. €450bn could also be at risk of significant losses in the immediate aftermath of a euro exit. In addition, a Greek exit could spill over to other countries resulting in deposit flights threatening the stability of banking sectors and destabilising sovereign bond markets. As policymakers assess the effect of Greece leaving the euro, the high costs and risk of contagion will, in our view, raise the impetus to keep Greece in. 

In the Event of an Exit, the Policy Response is Critical 
In our view, the situation in Greece is distinct from elsewhere in the periphery. So while expectations of spillovers may be understandable, they might not be rational. The euro governments may look to use pan-euro deposit guarantees and capital injections to contain the potential contagion through the banking sector. The European Central Bank (ECB) may commit to provide liquidity to banks and act as a backstop on the sovereign bond markets, provided the Bank was backed by the 16 euro governments. 

Immediate Reaction Likely be Risk-Off, But Squeezes Are Then Possible 
Initial market response to a Greek exit is likely to be risk-off. EU banks could test November 11 lows and EURUSD could dip to 1.20 even though positioning in both is underweight. Despite rising concerns in Europe, investors are also underweight Bunds and, in our view, 10-year Bund yields could dip to 1% in the aftermath of a Greek exit. Investors remain overweight EU cyclicals and emerging market indices as a wider global recovery play, potentially leaving these assets vulnerable if EU issues lead to cuts in global growth forecasts. However, in the short run if the ECB responds decisively we believe risky assets, especially bank stocks and periphery bonds, may be prone to a short squeeze. While in the longer run, as the EU stabilises, exporters would have scope to outperform domestically geared stocks for a lengthy period. 

This article was provided by the BofA Merrill Lynch Global Research team. The views contained herein are those of the author(s) and not necessarily those of Morningstar.

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