Greek Default Seems Increasingly Likely
The past week began with optimism that Greece would reach agreement with its "troika" of creditors, the International Monetary Fund (IMF), the European Central Bank (ECB) and the European Union (EU), and steer the Greek debt crisis into a controlled phase. The week ended with both sides arguably as far apart as ever with a Greek default on the nearly 1.6 billion-euro debt repayment that it owes to the IMF becoming increasingly likely at the end of June.
Before Greece put a new deal on the table Monday that is still being evaluated, Prime Minister Alexis Tsipras and Finance Minister Yanis Varoufakis steadfastly refused to agree to any deal that raises taxes or reduces pension benefits. The troika and many government leaders are equally fed up with delaying the reforms that were the fundamental conditions for bailout. The rhetoric reached the point that Christine Lagarde, Managing Director of the IMF, took a swipe at Greek officials by stating, "...the key emergency is to secure a dialogue with adults in the room."
Events are happening quickly enough that by the time you read this either a last-minute deal may have been reached or talks have completely broken down and both sides are preparing for the aftermath of default. Both equity and bond markets have had a tendency to overreact, positively and negatively, to the news of the day or even the hour. Fed Chief Janet Yellen even cited the Greek crisis as part of a potential drag on the US economy that makes near-term interest rate hikes less likely.
The real question is: why is there such a level of overreaction? Is the degree of daily concern truly warranted on a global scale or is it time to take a steadier, longer view of the situation?
Which Path is Worse?
Greece has a choice between bad and worse; it just doesn't seem to agree with the rest of the world as to which is which.
Many Greek citizens believe default is the worst case. Without a deal or further infusions of cash during the week of June 21st, both of which seem unlikely, capital controls are a possibility. Fearing that scenario, Greek citizens have pulled over 30 billion euros out of the banks, an estimated 4.2 billion euros within a week and 1.2 billion euros just on Friday the 19th. That same day, the ECB gave Greece over $2 billion to support the banking system in the face of this run.
Other Greeks agree with the government stance. They claim that any deal that rolls back the promises to fend off tax hikes and lowering of pension benefits is too harmful to the Greek people, although no practical alternate solutions are offered.
Regardless of which path wins out, the concern isn't so much with Greece; arguably, the Eurozone would be better off without Greece in it. The real question is whether this will affect confidence in other areas that have broader market implications: the banking system and the Eurozone itself.
Bad is Preferable to Uncertain
Banks and private entities have already greatly lowered their holdings to minimize effects of a Greek default, thus the likelihood of a "banking contagion" is quite low. Greek debt is now mostly held by governments and other official non-private groups.
The greater long-term harm may be in a deal that is unnecessarily favorable to Greece and either extends the further debt relief without reforms or writes off large portions of the debt entirely. Other economically troubled EU nations such as Portugal or Italy will also push the limits, seeing that the EU fears an exit by any country more than it fears the economic drag from an uncontrolled, unreformed economy in its ranks.
Further, assuming that a British referendum on EU membership comes to pass, a Greek exit from the euro and/or EU likely increases the chance of Britons questioning the long-term stability of the EU and also pulling out.
Another disturbing possibility is that Greece simply declares the debt illegitimate. The Greek Truth Committee on Public Debt, established by the Greek Parliament in April, issued its preliminary findings that called the bailout debts "illegal, illegitimate, and odious," claiming "the debt emerging from the Troika's arrangements is a direct infringement on the fundamental human rights of the residents of Greece." In essence, the argument is that the Troika overstepped statutory and constitutional boundaries with the bailout program and that the true goal was to shift private debt to the public sector.
Should the Greek government choose this path, another round of uncharted territory would follow. The Troika certainly won't acquiesce and write off the debt, but how would they proceed? Would it reach confiscation of assets? It seems unlikely that Greek negotiators would go that far, but that approach as a plan B would explain the unusual calm of the Greek negotiators.
These or similar actions destabilizing to the EU/Eurozone will cause a new round of long-term uncertainty, which will keep markets on edge. Bad news upsets markets, but uncertainty keeps markets on perpetual hair triggers.
Certainly, a Greek default and a subsequent "Grexit," a Greek exit from the Eurozone, would cause short-term turbulence in world markets, but the size of Greece's economy and debts are not enough to send world markets spiraling. In the short-term, it would probably cause a drop in stocks and a run on Treasuries and other relative safe havens. The effect would likely even out once the mechanics of the Grexit become clear and uncertainty fades.
Banks and private investors have already insulated themselves against Greece, so the biggest concern is whether shattering the invulnerability of the EU and the euro leads to longer-term European financial instability that drags down the world economy (and slows American growth as well). Should the area fracture, it will take time for those cracks to manifest themselves in the market, giving you plenty of advance warning to analyze the trends and react.
There's no need to react to the short-term news unless your holdings are unusually unbalanced toward Euro-backed equities and other investments — in which case you should be rebalancing regardless of the Greek situation. Keep your eye on the longer-term concerns, particularly with the future of the Euro and the Eurozone.