A "No" Victory Appears Probable: What Happens Next According To Deutsche Bank

With early forecasts all telegraphing a modest victory for the "Oxis", barring some last minute miracle, the Varoufakis gambit - with some last minute assistance by the IMF - may succeed. What happens next? Here is Deutsche Bank's "map for the post referendum" which presents the four possible outcomes 

In this document DB, which is one of the banks that may stand to lose the most from any major stresses to Europe's precarious status quo as a result of its tens of trillions of notional derivatives, lays out the possible post-referendum scenarios. 

Here is how the German megabank sees the possible outcomes of what is shaping up to be a "No" vote: 

• N1 – Soft deal: The most unlikely scenario is that the euro-area partners offer a much softer programme to Greece.
• N2 – Default-and-stay: Moderately less unlikely is a scenario where Greece defaults but stays in the euro thanks to a direct recapitalisation of Greek banks by the euro-area partners, with the Greek government using only domestic resources for the country’s fiscal needs.
• N3 – New deal: The third scenario is one in which the rising economic and political cost of a closed banking system results in the Syriza government being replaced by a new government of national unity and a new deal with creditors being reached.
• N4 – Grexit: In our view, Grexit and Scenario N3 are the most likely – with about equal probabilities. That said, we see the probability of Grexit increasing the larger is the margin of victory of the NO vote. Even with a NO vote, the cumulative probability of the first three scenarios still exceeds that of Grexit.

And the details:

NO, Scenario #N1. Soft deal

This, in our view, is by far the least likely outcome, as it would generate significant moral hazard issues, which in the longer term could be as damaging as an exit. If Europe were to offer significant concessions to Greece following a no vote, it would de facto incentivize other borrowing countries to call domestic referenda to improve the terms of their rescue packages. This would be unsustainable in the long-run as (a) it would create obvious political issues in creditor countries, (b) it would not deal with the structural adjustments and political integration which are necessary for the longer term viability of the euro area.

NO, Scenario #N2. Default-and-stay

A direct recapitalization of the Greek banks is more likely, we think, than a very soft programme, but would be a challenge for Greece and, above all, euro-area partners to accept.

From the European perspective, it could be the start of a new round of financial commitments, all the more so unless there is a strong, credible agreement on structural reform to boost growth and protect Europe’s capital investment. After a default, getting the necessary consensus for such a bank-based deal will be difficult. Indeed, a public default would likely lead to a cascade of private defaults — starting with corporates.

The most serious flaw with this scenario is the moral hazard it creates. If Europe facilitates this default-and-stay option in Greece, it opens the door across the periphery to similar demands. If it is easy to renege on debts but have Europe preserve your banking system and access to the single currency, others will want the same. It will promote instability.

It is not only a question of ex-post moral hazard either. There are general elections in Spain at the end of the year and in Ireland by April 2016. How could the governments of these countries explain to their electorates that they should help to shoulder the direct recap of Greek banks after their own public debt ballooned because of the recap of domestic banks?

From Greece’s perspective, the cost of direct recapitalization in terms of deposit bail-in and general economic conditionality (see Box 1) means this scenario is not a shoe-in either.

It is also a scenario that needs time, measured in months, to come to technical fruition. In the meantime, the economic and political cost of a closed banking system will be mounting. There is a considerable probability if Greece and Europe go down this route that it merges into Scenario N3.

An additional consideration is that the HFSF is a guarantor to the EFSF. In the event of a Greek default, the EFSF may have a direct claim on the HFSF shares in the Greek banks. If Europe becomes the beneficial owner of the Greek banking system, the argument for direct recapitalization could grow. This does not diminish the technical and political complexity of direct recapitalization.

NO Scenario, #N3. New deal

Whether the ECB withdraws ELA — and when — is almost beside the point. The liquidity in the Greece economy is seriously impaired and as each week passes the economic, social and ultimately political cost of the crisis will rise exponentially. The tourist season may be compromised. We cannot judge Greece’s capacity for this. There may be new negotiations after a NO vote, but the chances of a soft programme (Scenario 1) or direct bank recapitalization (Scenario 2) are, in our view, very low. In the meantime the domestic political cost of a closed banking system will rise.

At some point, the rising economic and political cost of a closed banking system could cause the Syriza government to fall. A national unity government could emerge and new negotiations could take place around a deal with the international creditors.

How quickly such a scenario plays out depends on the economic and political cost. By that time, after the economic shock of failing talks and default, the scale of debt relief required to return Greece to sustainability will be even larger. If the EU wants to retain Greece in the single currency, more debt relief might be the price to pay.

Such an agreement would have to be based on a more balanced programme, probably along the lines outlined by the IMF in their latest debt sustainability report. There would need to be much more emphasis on structural reforms in exchange for a less growth-unfriendly fiscal consolidation and a commitment on a gradual debt relief based on implementation milestones . There needs to be a sequence that creates the incentives to improve the ability of the Greek economy to pass and implement the structural reforms that would allow the country to stands on its own leg within the monetary union.

A risk under this scenario is political deadlock could result if the Syriza government resigns but parliament is incapable of forming a new, stable government capable of striking a deal with the international creditors. The parliamentary arithmetic says that about 45 Syriza MPs – about one third of the parliamentary party – would have to join forces with the MPs of New Democracy, PASOK and River to gain a majority in parliament. Syriza retains strong support in opinion polls. Combining forces with the opposition could erode support and push voters further into the political extremes.

If a government cannot be found, the next step would be early elections. Note that there would be legal and financial challenges to new elections. According to the Greek constitution, the incumbent government cannot call elections within 12 months of the previous election. The government would first have to resign, followed by renewed attempts by the President of the Republic at forming a government. The constitution calls for three rounds of at most 3-day negotiations with the next three largest parties in parliament before an early election can be called.

NO Scenario, #N4. Grexit

A resounding NO would embolden PM Tsipras to ask for a complete overhaul of the programme. Actually, from his perspective it would make a much softer deal for Greece a necessity. But as we wrote in Scenario N1, an excessive compromise might be as damaging to medium-term euro area stability as Grexit, if not more damaging.

There is no formal mechanism in the EU Treaty that allows a member state to be expelled. That does not mean exit is impossible. First, Greece can take a unilateral decision to change its national currency back to the Drachma. Greece has this right under international public law (“Lex Monetae”). Second, exit could be agreed by mutual agreement. There is a view that Article 352 of the Lisbon Treaty might provide a basis for such an approach. It requires the unanimous agreement of the European Council, i.e. all EU countries in the EU including Greece.

Even though there is no legal mechanism that allows a member state to be expelled, there is a practical mechanism to trigger exit, namely the withdrawal of ELA. Withdrawing ELA would force the Bank of Greece to call in the emergency lending. The banking system does not have the capital for allow this and the government guarantee for ELA triggers a general default. The Greek banks would not regain access to ECB funding until they have been resolved and recapitalized, a lengthy and costly process.

The Syriza government claims it has no intention of leaving the euro area and that it would fight attempts to force it out through the European courts. This leaves economic circumstance to determine the point at which Greece feels it has no choice but to leave the euro area.

What differentiates the Scenario N4 (Grexit) from Scenario N3 (new deal) is that the Syriza government survives and takes the decision to exit. After a NO vote, these are the two most likely scenarios, in our opinion. They have a broadly similar probability, but we see the probability of Scenario 4 (Grexit) rising the larger the margin of victory for the NO campaign.

It is important to note that leaving the euro area and leaving the EU are two separate questions. If Grexit occurs, Greece would leave the euro area but not the EU. There is no argument being made for Greece to leave the EU. Staying within the EU limits the geopolitical ramifications of the Greek crisis.

Sequencing of events after a NO vote

Given the limited contagion in other peripheral markets and the rising domestic pressures in Greece, it is probably in Europe’s interest to wait. The exposure to Greece is no longer growing now that the ELA is capped. Contagion has been contained and the ECB has the ability to intervene more forcefully if necessary. Therefore, there is little cost in waiting for now.

On the other hand, precipitating an exit by e.g. suspending ELA, would lead to a crystallization of the losses on the existing official sector exposure to Greece, the introduction of potentially more challenging contagion risks and initiating a process that will be difficult to reverse. Conversely, given the trust lost over the last six months, Europe is unlikely to find it attractive to loosen its terms without a more credible commitment from the Greek side (or a change in government), as discussed in Scenario N1.

Given the above, it would be rational for Europe to wait for the political process in Greece to play out, even in the case of a NO vote. It would neither trigger a formal exit, nor offer more lenient terms until one of the following three outcomes realizes.
First, in the most optimistic scenario, there is a credible change in position from the Greek government. This would then enable Europe to restart more constructive negotiations along the “new deal” scenario.

Second, Greece itself gets closer to considering an exit. At that point, Europe may consider other alternatives such as a managed default within the eurozone, which will require Europe to recapitalize and control the Greek banking system which could lead to either “exit” or “default-and-stay” scenarios.

Third, there is an event that makes it institutionally very difficult for Europe to avoid exit. For instance, if the ECB decides that it is unable to maintain ELA following a default on the Greek bonds it owns, and Europe is not willing to recapitalize Greek banks, which would lead to the “exit” Scenario.

Note that it is not necessarily the case that ELA is suspended as soon as Greece fails to pay the ECB on 20 July – indeed, the ECB left the ELA volumes unchanged on 1 July despite the ‘default’ on the IMF. The rules of ELA are not published. It might also be the case that there is a 30-day grace period on the ECB held bonds. If so, the ECB could avail of the grace period before taking action on collateral (or suspending ELA). The counterargument will be that by permitting ongoing ELA the ECB will probably be in breach of the monetary financing prohibition in the EU Treaty.

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