Eurozone tragedy: Greece to exit stage right? – asks Newton’s Brain
Paul Brain head of fixed income at Newton Investment Management, comments on the increasing chance that Greece will leave the eurozone.
Financial markets responded positively to last week’s announcement that the world’s major central banks, including the US Federal Reserve, Bank of Japan, European Central Bank (ECB), Bank of England and Switzerland’s central bank, would take bold action to pre-empt a looming US dollar funding crisis in Europe, but they are now less convinced.
Discussions between Eurozone leaders at the weekend, which included the US Treasury Secretary, Tim Geithner, failed to produce any concerted action to solve the ongoing problems dogging the single currency area. Meanwhile, on Tuesday, Standard and Poor’s downgraded Italy’s sovereign credit rating to A/A-1 from A+/A-1+, citing economic, fiscal and political weaknesses as the rationale behind its decision.
Despite much rhetoric from Eurozone leaders, ultimately, nothing has changed. Questions remain over when Greece will receive the next tranche of its bailout payment, while we continue to believe that it is time for Greece to default and possibly exit the euro.
However, it’s not that simple given the political ramifications of such a move. If there was a default, we would expect a change of stance by the ECB. The ECB may be reluctant to buy Greek bonds and avert a default, but if a default comes about, it would throw its support behind the banking system and help those banks worst affected by such an eventuality. While on the face of it, the scale of such support looks enormous, in reality, the European banking system has had around two years to digest the Greek problem and factor in the likelihood of a default, so the burden shouldn’t actually be that great.
That said, there is little doubt that a Greek default would create a mess and a further crisis in the Eurozone, but with little sign of action aimed at preventing this from happening, it seems the focus has shifted to dealing with the after effects.
With the idea of the ECB issuing eurobonds effectively ruled out due to the lack of fiscal union, along with legislative issues in Germany, it seems the ECB would look after the banking system and the IMF could be used to look after the aftermath of any defaults.
Would a Greek default also see the country exit the single currency? We believe that this would be the best course of action for Greece, given the inevitable devaluation of its new currency the positive growth possibilities that would entail. Remaining in the Eurozone would do little to help re-ignite economic growth.
However, there is the problem of further contagion should Greece exit and we would expect this to continue regardless, given the state of uncertainty across global financial markets and the continued lack of cohesive policy in the Eurozone and the resultant impact on investor sentiment. Spain and Italy are issuing bonds over the next couple of month, so we will wait to see what issues emerge on that front. Contagion will happen, and peripheral Eurozone bonds will sell off, but we believe the future of Italy, Spain and Ireland in the euro bloc to be fairly secure. Portugal is a different matter, and there is the possibility that it would be a casualty.
Meanwhile, we continue to feel that the euro is still slightly overvalued relative to the US dollar. The US economy remains shrouded in uncertainty, and while a near-term US dollar rally versus the euro is unlikely on economic grounds, it is likely on risks to the financial system.
Paul Brain is head of fixed income at Newton Investment Management.