Greek turbulence

• I do not expect even an outline of a deal between Greece and its partners at the EU summit this week.
• I expect negotiations to continue until May-June, ending in a deal that restructures Greek debt and provides a line of credit with limited conditionality. The nominal value of the debt will not be cut.
• The Bank of Greece will be allowed to provide emergency liquidity to its banks as needed to keep the banks afloat.The government will be allowed to issue T-bills as negotiations on restructuring progress.
• An accidental exit may happen. A trigger could be that the ECB demands that Greece imposes capital controls.

Greek interest rose significantly on Monday. The five-year interest rate is up 231 bp, to 15.9%.

In line with what Syriza promised voters before the election, the Greek Prime Minister Alexis Tsipras said to parliament on Sunday that the new government would not accept more bailout loans with conditions attached. This means that Greece is not going to accept the EUR 7.2 billion in new bailout loans that are pending a review of Athens' finances and its structural reforms, and Tsipras' government will not accept a renewed bailout program. The current bailout program ends on February 28.

Tsipras will instead ask for acceptance from Eurozone partners to issue EUR 10 billion more than the current limit in T-bills until the end of June while he tries to negotiate a restructuring of the Greek sovereign debt. The Greek Prime Minister is also demanding that the European Central Bank (ECB) pays Athens the profits the central bank has had on its holding of Greek debt. Markets had expected a softer tone after the negative feedback from the overtures of these plans in European capitals last week.

What's going to happen next?

The finance ministers in the Eurozone, the so-called Eurogroup, are holding an emergency meeting on Wednesday. The Greek finance minister Yanis Varoufakis is then going to present the details of his government's bridge financing and restructuring plan. The following day all the heads of state in the EU meet for a two-day summit. But we should not expect any agreement between Greece and the rest of the Eurozone this week, as what Athens is demanding is too far from what its partners are willing to accept. Hence the negotiations will drag on, with both sides needing to make concessions. The alternative to an agreement is a Greek exit from the Eurozone, which would be disastrous for Greece and have negative consequences for the Eurozone.

A Greek exit, whereby euro deposits and withdrawn euro notes are converted to much less valuable drachma-denominated assets will imply a default on Greek sovereign debt and result in a wave of bankruptcies, with repercussions from a dysfunctional financial system. Investment will collapse due to lack of confidence as Greece enters unchartered territory, and both inflation and unemployment will take off. After a while Greece might enjoy the benefits of having a sovereign monetary policy, and the economy will eventually rebound, as it finally began to do last year after the economy had shrunk 25%. Nevertheless, the government's radical interventionist economic program is likely to cause meagre trend growth.

Tsipras' government might have a different view. If they think the short-term turmoil will be limited and that their radical economic program is just what Greece needs to grow rapidly over time, then this increases the chances of an exit.

For the Eurozone, a Greek exit will fundamentally alter the perception of the common currency. It will no longer be viewed as a common currency but as a multilateral system of potentially breakable currency pegs. An exit risk premium might be added if an economy deteriorates, the public debt rises and/or left or right wing populists stand a chance of winning an election. The latter can happen in the core of the Eurozone, where the anti-euro xenophobic National Front is on the rise. What might moderate exit premiums, however, is the probability that a Greek exit, at least in the short-term, will end in Greek tears. Syriza might teach populists the cost of a euro exit.

A deal will likely be reached - eventually

For the reasons outlined above, I expect Greece and its Eurozone partners to eventually reach a deal. But it will likely take months, not weeks, to agree on a restructuring of Greek sovereign debt, though. This will probably amount to an extension of the loans' maturity and lower interest rates but not a write-down of the debt that Athens owes its creditors. In return for accepting that the amount of debt will remain intact, Greece will probably get away with most of conditionality attached to the current bailout program and be offered a line of credit that is only conditioned on a target for the primary budget surplus.

The problem for the Eurozone is that it needs to offer Athens enough to stay in the Eurozone but not so much that the popularity of populist parties in other member states, like Spain's left-wing Syriza clone Pademos, is galvanised.

While the negotiations drag on, the deposit flight from Greek banks, which began when it became likely that Greece would have an anti-bailout government, is likely to accelerate. In order to avoid an exit due to illiquid Greek banks, the Greek central bank (The Bank of Greece) will likely be given leeway to provide Emergency Liquidity Assistance (ELA) to the extent necessary as long as the negotiations are ongoing. The ELA limit was raised last week as the ECB curtailed Greek banks' ability to borrow from the ECB.

I also expect, as negotiations progress, that Athens will be allowed, in sequentially and limited amounts, to raise money through the issuance of T-bills, as they did last week. The T-bills are mainly bought by Greek banks which finance the purchases by borrowing from the Bank of Greece. The argument that this amounts to monetary financing is, I think, misguided. Since its inception the ECB has lent to banks which then purchase government bonds, and over the next month the ECB will begin to purchase government bonds on a large scale. T-bills issuance financed by ELA will not count as monetary financing since it is too similar to what the ECB itself does. An overdraft of the government's account with the Bank of Greece, or direct purchases of T-bills by the Bank of Greece from the treasury is another matter though. But these options are not on the table.

While I think a scenario as outlined above this is the most likely outcome of the Greek drama, there is certainly the possibility that the whole process will unravel. A trigger for a Greek exit could be that the ECB decides that the Greek government must impose capital controls in order to limit deposit flight and the use of ELA. While the ECB got away with such a solution, which was a violation of the EU Treaty that guarantees the free flow of capital, for Cyprus, I do not think it will go down well in Greece. Capital controls will hamper growth, cause problems for Greece's non-Eurozone foreign investors, be understood as a curtailment of national sovereignty, and further alienate Greeks – not just from the Eurozone, but also from the European Union. I take it that this is understood in the ECB's Frankfurt Tower. But policy mistakes with unpredictable consequences have happened before.

Investment implications

While I think that there will eventually be a deal that keeps Greece in the Eurozone and prevents a default, the outcome of the negotiations that have just started is uncertain. And even if there is a deal, it's uncertain what will happen to privately-held Greek sovereign bonds. Extension of their maturity and lower coupons might be part of an agreement. Hence I prefer to stay out of Greek bonds until developments indicate a more favourable risk-reward conclusion.