ECONOMETER

Excuse the lack of posts over recent days. I’m just finishing up a trip to London and am back in HK at the end of the week. I thought in the meantime it would be worth discussing the impact on the euro of a potential Greek exit.

The fact that European officials are openly talking about the prospects of a Greek exit from the Eurozone highlights just how drastic the situation has become. Much will depend on the outcome of new government in Greece in mid June following inconclusive elections recently. Even fresh elections in mid June does not mean that it will be any easier to form a government, leaving the option of a euro exit firmly on the table.

If Greece was to leave the Eurozone there would be a significant amount of confusion in FX markets. It is not obvious that the EUR would strengthen. It could be argued that the departure of Greece would eliminate the weakest link in the chain thus allowing the EUR some relief. Should Greece default on its debt and leave the Eurozone it would not have a marked direct impact on the Eurozone economy but the biggest risk is the financial contagion to other Eurozone countries.

A Greek exit would imply a new currency (Drachma) for the country, a separate monetary policy etc. However, any competitive gain from a weaker currency would be lost in a huge increase in inflation while the local corporate sector would be forced to default en mass on any EUR debt that they hold. Confidence in the new currency would be weaker leading to an exodus of capital further strengthening the EUR.

Admittedly the Eurozone would be stronger without Greece but it would not be long before market attention turned to Portugal and Ireland and even Spain as the next candidates for exit. Indeed, a Greek exit would set a precedent that did not exist previously. It would imply a significant increase in volatility for the EUR given the uncertainty it would create for other Eurozone members. Any rally in the EUR that would be experienced following a Greek exit would therefore be very short lived.

Ultimately for the EUR to experience a sustained strengthening it would require some sign that policy makers are addressing growth concerns as well as progress on austerity and deficit reduction. The formation of a common Eurobond, increased spending on investment projects to enhance productivity, reform of labour markets and a bolstering of the firewall around other peripheral countries would help confidence.

However, this is a long way off and the EUR is likely to suffer for some months to come as growth worries and peripheral country tensions persist. The downside risks to the EUR are clearly opening. The fact that the market is very short EUR already may limit the pace of decline but not stem it. There may be some stabilisaiton of the EUR towards year end assuming Eurozone officials get their act together.

However, in the interim the situation could become far more dire. If Greece were to exit, the prospects of further financial contagion would result in more and not less pressure on the EUR, leading to a potential drop to around the mid 2010 lows just below 1.20. Even if Eurozone political and debt tensions subside I still believe the EUR will decline based on an unfavourable growth and yield differential trajectory but it is clear that the downside risks are much greater even with short market positioning, should the situation deteriorate. In this event, even the strong bids from official investors (namely Asian central banks and sovereign wealth funds) will pull back and the EUR could plunge sharply.