What will Greece's Default Mean for the Rest of the World?
06/29/2015 | David Joy

Developments in Greece evolved rapidly over the weekend. In the early morning hours on Saturday, Greek Prime Minister Tsipras called for a national referendum, to be held on July 5, to determine if his government should accept the conditions offered by its creditors for an extension of its existing financial bailout agreement.

However, since the existing bailout agreement expires on June 30, Greece needed a five day extension in order to meet its financial obligations due at month end, including 1.5 billion euros due to the International Monetary Fund. European Union finance ministers refused to grant an extension, turning their focus instead on containing the fallout from a possible Greek default, all but ensuring that Greece will miss the scheduled payments.

Throughout these negotiations the Greek banking system has been funded through an emergency liquidity mechanism from the European Central Bank (ECB). As long as the negotiations continued, the ECB had been willing to incrementally increase the amount of funds available as needed.

However, on Sunday morning, because the negotiations have ceased, the ECB's governing council voted to cap the amount of available funds at its present limit. In anticipation of just such a possibility, long lines were seen at ATM machines on Saturday, and reportedly Greek banks remain closed on Monday, and possibly all week, as the funding cap would likely be overwhelmed by depositors demanding their money.

Greek Stock Market Shuts Down

On Monday, the Greek stock market also did not open. Because of this, markets elsewhere are expected to react swiftly to these developments, as volatility rises and a flight to safety ensues. Core Eurozone bond yields are likely to drop and credit spreads widen as risk aversion rises. Stocks are likely to come under pressure, especially in peripheral Eurozone markets.

U.S. Treasuries and the dollar should also see an increase in demand. How the euro will react is unclear. To the extent that riskier assets are dumped for cash, the euro could firm as a result.
However, although missed payments by Greece on Tuesday do not mean that its exit from the Eurozone is inevitable, it could eventually come to that. If confidence in the solidarity of the Eurozone is compromised as a result, the euro may come under more widespread selling pressure. How that unfolds depends first on the results of next Sunday's referendum.

If the Greek people vote not to accept the agreement on offer, then its exit from the Eurozone becomes far more likely. Conversely, if they vote to accept it, and opinion polls have reported a strong desire to remain in the Eurozone, then the process of stabilizing the financial system and funding the banks can begin. In that event, the ruling political structure in Greece may change as EU negotiators have expressed skepticism regarding the existing government's willingness to implement fiscal conditions it repeatedly rejected throughout the negotiating process.

All of this comes in stark contrast to the relative optimism that prevailed last week when expectations of a deal being reached resulted in a 16 percent rise in Greek stocks, and more broadly, a 4.8 percent rise in the EuroStoxx 50 index.

What will the Implications be for the Eurozone?

Setting aside the important question of the long-term future of the Eurozone should Greece exit, and the geopolitical implications, the financial impact should be relatively modest. With a gross domestic product of approximately $242 billion, Greece represents just 1.8 percent of total Eurozone GDP, and European bank exposure is estimated to be approximately $50 billion, down from $250 billion in 2008.

Its largest sovereign creditor is Germany, which has estimated that a Greek exit would cost it roughly $1.1 billion annually for as much as forty years, a manageable amount for a country whose annual GDP totals almost $4 trillion. The German IFO Institute has estimated a Greek exit would cost Germany $76 billion, while a default within the Eurozone would also cost it $76 billion, although their calculations excluded private claims, which would push the total cost higher. The cost for Greece is another matter. Already experiencing depression-like conditions, matters will only get worse in the near-term.

The situation in Greece will obviously overshadow what would otherwise be a busy week of economic data in the U.S., headlined by the June employment report on Thursday, but also including vehicle sales, pending home sales, ISM manufacturing and factory orders.

Last week's reports were generally strong, including new and existing home sales, durable goods orders, and even an upward revision of first quarter GDP to a contraction of -0.2 percent from the previous estimate of -0.7 percent. Perhaps the most encouraging report, however, was the stronger than expected pace of consumer spending in May, reinforcing the view that the consumer may be finally emerging from a long period of caution, although volatile markets in response to the Greek crisis won't exactly help confidence.

Markets will be closed on Friday in celebration of Independence Day. With the Greek referendum on Sunday, trading could be quite volatile in the shortened week, especially as investors prepare to head out of town early on Thursday.

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