Contagion Effects of Greek Default Should be Limited
Despite the high probability of a Greek “No“ vote in the July 5th referendum, most likely followed by a default, the effects so far on Eurozone financial markets have been quite modest. Italian and Spanish 10 year government bond yields have increased by about 0.25 percentage points during the week of June 25th-July 2nd, and by about 0.2 percentage points for the whole month of June. Eurozone stock market prices declines have been moderate, with a one week decline in the Euro STOXX index of 3.6% as of July 2nd. Sovereign default probabilities for Italy and Spain have also barely increased, rising by less than 0.3 percentage points during the month of June according to Deutsche Bank estimates. These indicators suggest that financial markets do not see a large risk of contagion from a Greek default to financial distress in other Eurozone economies. Several fundamental factors support financial markets‘ assessment.
Figure 1: Major Stock Market Indices since June 25 (June 25 = 100)
Note: Euro STOXX Index represents 290 large, mid and small capitalisation companies listed on 12 Eurozone countries. FTSE 100 is a benchmark index for the UK, and SP500 is a benchmark index for the USA.
Direct exposure of Eurozone financial institutions outside of Greece to a Greek default is small. Following the previous bailout agreements and debt write-downs from 2010 and 2012 the overwhelming share of Greek government debt is owed to official institutions rather than to the private sector. Private investors (including Eurozone banks) own €38.7 billion in Greek bonds, amounting to less than 14% of the total value of the debt. Exposure to the Greek private sector is harder to quantify, but it should be below that to government debt. The overall exposure of non-Greek Eurozone banks at the end of 2014 amounted to less than €15 billion. It should be even lower now, due to the extra uncertainty and deteriorating economic outlook in 2015 discouraging lending.
Of the remaining €242.8 billion debt, €194.7 billion are owed to other Eurozone government with the biggest stakes held by Germany and France. The rest is owed to the ECB and the IMF. The ECB in particular is also exposed to losses on its €118 billion in liquidity funds provided to Greek banks through the Emergency Liquidity Assistance and other programs. However, these potential losses are still not that large in comparison to the overall debt levels and the size of the main Eurozone economies.
The main remaining risk is of indirect contagion, due to investors reassessing the risks of other Southern European debt markets, in particular Italy and Spain. In the worst case scenario, this could cause a return to the high interest rate on those governments‘ bonds from 2011-2013 and a renewed Eurozone recession. However, there are several factors significantly reducing these risks in 2015 relative to 2011. First the ECB has been much more aggressive in terms of using unconventional monetary policy tools such as quantitative easing and longer term cheap lending to banks (via its Long Term Refinancing Operations). Any signs of significant turmoil on financial markets following a Greek default or a Grexit are likely to see a big expansion in the ECB‘s sovereign and private sector debt purchases. Other programs such as the European Stability Mechanism should also help contain contagion risks.
Second, the governments of Italy and Spain have made significant progress relative to 2011 in implementing structural reforms that should boost their long-term solvency and reduce creditor concerns. The Eurozone economic outlook has also improved significantly since then. While Italy is still barely growing, Spain has clearly turned a corner and is now on track to be the fastest growing major economy in the Eurozone in 2015 and 2016. Third, the Eurozone‘s financial sector is less vulnerable. The typical Eurozone bank has increased its capital buffer by more than 2 percentage points since 2011 (measured by the common equity Tier 1 capital ratio).
For all these reasons, a Greek default is unlikely to lead the Eurozone into a recession, though we still assign a probability of 9-15% to negative GDP growth in the Eurozone in 2015.