Robert Farago at Schroders Private Banking outlines steps in case of Grexit
Some answers about what to do should Greece leave the eurozone have been provided by Robert Farago, head of Asset Allocation at Schroders Private Banking.
At the time of writing (18 May), Spanish bond yields are trading at 6.25% after starting the year at just over 5%. The lack of a conclusive election in Greece has left the consensus, including ourselves, expecting Greece to exit the euro. This has led to sharp sell-offs across a broad range of risk assets. Below we try and address some of the key questions facing investors.
What will happen to Greece after it leaves the euro?
We would expect the new drachma to depreciate by anywhere from 30-70%. It is also possible that the authorities would peg the exchange rate at a set rate to the euro.
It is likely that capital controls will be imposed to put an end to the flow of money out of the country. This is against the rules of the European Union and therefore the country may have to leave the Union, either temporarily or permanently.
The day that Argentina allowed its currency to devalue at the end of 2001 marked the start of that country’s recovery. This is likely to prove true in Greece too. Exports of goods and services account for a quarter of annual output and would be significantly boosted by the currency depreciation. However, the initial outlook is uncertain as the political situation is extremely unpredictable, with none of the parties that have ruled in the past maintaining any credibility and none of the alternatives offering a convincing alternative.
If Greece goes, what can be done to avoid contagion?
A credible commitment to a common bond market would be the ultimate solution. However, this requires referendums across the euro area so will not provide an immediate support.
Additional financial support to the periphery countries that have followed through on reform is possible. However, this involves handing over more money at a time when the papers will be full of stories of how much money was given to Greece and will never be recovered.
A commitment from the European Central Bank to buy sovereign bonds, perhaps capping interest rates at a rate that markets would consider sustainable (somewhere below 6%) would be effective if the bank followed through and sustained this cap. This would be similar to the move by Switzerland to peg their currency to the euro by standing willing to print as much money as is necessary to cap the exchange rate. However, there are no signs that the ECB is willing to do this.
A further injection of money into the banking sector through a third tranche of the long-term refinancing operation is also possible. This would provide banks in Spain and Italy with funds to buy their domestic government bonds.
In conclusion, there are a number of measures that could be taken to provide liquidity to the stressed sovereigns and banks in peripheral Europe. However, most measures would only address the immediate liquidity crisis rather than addressing the underlying solvency problems.