Moody’s: Impact of Greek exit from euro area should not underestimated

Alastair Wilson, Moody’s Managing Director - Jueves, 30 de Abril

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Following our downgrade of Greece’s ratings to Caa2; negative outlook last night,  Moody’s has today published a report on the impact of Greece leaving the euro area, though an exit is not our base case scenario. The report shows that while Moody’s expects the direct economic and financial impact of a Greek exit from the euro area would be small, it would undermine the euro area’s longer-term resilience to an extent and could yet trigger a more immediate confidence shock, disrupting government debt markets. Moody’s also expects that Greece will aim to reach an agreement with its creditors and avoid default. However, lack of progress so far means the probability of a default, and of exit, is rising.

“The impact of a Greek exit should not be underestimated,” says Alastair Wilson, Moody’s Managing Director – Global Sovereign Risk. “The direct impact might be limited because of Greece’s limited trade links and lower financial market exposure to Greece in other euro area countries. But its exit could nevertheless cause a confidence shock and disrupt government debt markets.”

 

On the impact of a Greek exit for other euro area countries:

 

“Greece leaving the euro area would offer an example that might be followed in future,” Mr. Wilson adds. “That would inevitably influence the course of future reform and fiscal consolidation programmes. It would raise, even if only a little, the likelihood that they too could end in default and exit.”

Greek Euro Area Exit Might Be

Manageable, But Risks Should Not Be

Underestimated

» Negotiations between Greece and its official creditors have achieved little to date. We

do not expect Greece to fail to reach agreement with its creditors and default, but the

probability is rising. If it did, the consequence might well be Greece’s exit from the euro.

» The impact of an exit should not be underestimated. The euro area was built to be

irreversible, and belief in its irreversibility is its main strength. Evidence that it is not

would damage confidence in its resilience.

» The direct economic and financial impact of Greece leaving would be small, given limited

trade linkages and reduced bank exposure to Greece. The greatest threat would come

from a confidence shock disrupting government debt markets.

» The risk of a shock is lower than in 2012. The euro area financial system and economy are

in better shape and Greece’s problems are clearly distinct. But there are parallels, and the

calm since 2012 partly reflects the protections available to euro area members.

» The scope for contagion would depend on the immediate response by policymakers.

The crisis demonstrated the limits on the capacity of fiscal policymakers to engender

confidence. Much would rest on the shoulders of the ECB.

» We would expect a robust policy response from the ECB, which has more policy leeway

and internal consensus than it had at the height of the crisis. But the actions needed to

reassure investors might test that consensus.

» Euro area sovereign ratings currently balance fundamental improvements seen in

recent years against the fiscal consolidation and reform still needed to reduce high debt

burdens, as well as the potential for disorderly debt market dynamics to re-emerge.

» Greece's exit could be particularly credit negative for those periphery countries with high,

and in some cases still rising, debt ratios, and ongoing fiscal consolidation challenges,

which would likely be at the heart of any investor concerns.

» Over the longer term, the increase in the risk of shocks arising from the demonstration

that countries can leave the currency union would constrain credit improvement and

rating uplift across the zone somewhat.

MOODY'S INVESTORS SERVICE SOVEREIGN AND SUPRANATIONAL

This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on

www.moodys.com for the most updated credit rating action information and rating history.

2 30 APRIL 2015 GREECE, GOVERNMENT OF: GREEK EURO AREA EXIT MIGHT BE MANAGEABLE, BUT RISKS SHOULD NOT BE UNDERESTIMATED

Negotiations have achieved little to date. The likelihood of Greek default and exit is rising

Negotiations between the Greek government and the euro area authorities have made little progress, and we have learnt little about

the likelihood of an agreement being reached which avoids a further default by Greece. The euro area authorities have demonstrated

uniformity of purpose, offering little if any accommodation to the Greek government’s desire to water down its economic reform and

fiscal consolidation programme. The Greek government has signalled its willingness to backtrack in a few key areas including in relation

to its desire to end the programme and on its demands for a haircut to official sector debt. But its willingness or capacity to fulfil the

substantial majority of its reform programme, and the Greek parliament’s willingness to endorse the need to do so, remain unclear.

Should negotiations fail to achieve some sort of accommodation in the near future, the outcome is likely to be a disorganised default

by Greece on its official sector loans and privately held bonds.

Default need not necessarily entail Greece's exit from the euro: even if Greece were to miss a payment on official sector debt, we

would expect negotiations to continue for a period, with the curing of missed payments part of any eventual settlement. However,

while failure to service its official sector debt would not necessarily lead to Greece's exit, it would still be a significant event and a clear

indication of the distance between Greece and its creditors, and of the rising probability of exit.

The chain of events that could lead to exit is difficult to predict, but could involve the continuing failure to complete or replace

the current programme; the imposition of capital controls to halt deposit outflows; repeated defaults on official sector loans;

the ‘monetary’ financing of the government’s payments, most likely through rapidly rising T-bill issuance to the Greek banks; the

emergence of a parallel currency of 'IOU's; and, ultimately, the Bank of Greece’s expulsion from the TARGET2 payment system, which

would cut it off from the ECB.

That is not what Moody’s expects to happen, even now. Neither the Greek government nor the electorate appear to see exit as

desirable. Moreover, the euro area authorities themselves have an incentive to avoid Greek exit, given the example exit would set and

the losses it would crystallise on loans and debt holdings, provided the Greek government can be dissuaded from acting in a way which

sets a negative example in other highly indebted euro area member states.

But exit risk is rising. The uncertainty around the outcome of Greece’s negotiations with its official creditors is higher than at any

time since 2012. The euro authorities' firm stance ostensibly signals a willingness to countenance exit, if needed to avoid a difficult

precedent and emphasise the importance of sticking to economic and fiscal commitments. That stance no doubt reflects the view that

the costs of allowing the Greek government to renege on its prior commitments to fiscal consolidation and reform would outweigh the

costs of exit. Particularly given the continuing need for similar reforms elsewhere in the euro area, at a time of growing austerity fatigue

and political uncertainty (with elections due in key member states and alternative electoral forces on the rise), the example set would

be a poor one.

The euro area is more prepared for exit than in 2012

The euro authorities may also be calculating that the euro area economy and financial system are in a better state to weather any

subsequent storm than in 2012. That may be true. Much has been done since then to enhance the resilience of the euro area banking

sector, particularly in countries such as Spain and Ireland where large, weak systems had threatened the solvency of the sovereign.

Growth has returned and is strengthening, albeit slowly. Fiscal and economic reforms have been implemented across most of the

periphery, with government debt ratios falling Ireland, beginning to do so in Portugal and forecast to do so soon in Spain and Italy. The

ECB has indicated its willingness to address market dysfunction through the large-scale provision of liquidity. The European Stability

Mechanism has been introduced, with €450 billion remaining at its disposal. And the introduction of the Banking Union alongside

agreement on bank resolution represents a success of coordination, even if they are of limited use as crisis management tools.

MOODY'S INVESTORS SERVICE SOVEREIGN AND SUPRANATIONAL

3 30 APRIL 2015 GREECE, GOVERNMENT OF: GREEK EURO AREA EXIT MIGHT BE MANAGEABLE, BUT RISKS SHOULD NOT BE UNDERESTIMATED

The near-term economic and financial impact of a Greek exit would be limited

Certainly, the direct economic and financial impact of Greece no longer being in the monetary union should be limited. Banks’

exposure to Greek issuers is manageable – far lower than in 2012. Data on ownership of marketable Greek government securities are

scarce, but a a material share is owned by domestic institutions, with much of the rest being held by foreign asset managers including

hedge funds. Euro area authorities including the ECB would take losses from Greece’s default, both as a result of direct exposures and

through the need to inject additional capital into the ESM, but those losses would be manageable. Greece’s share of euro area output is

very small, as are exports from other euro area member states to Greece.

Exit might nevertheless disrupt near-term euro area growth, which is already expected to be low. Given the spectre of deflation,

investment and consumption across the euro area are vulnerable to shifts in confidence. It seems inevitable that an event as significant

as the exit of a member state would have some negative impact on confidence, further undermining near-term growth. The levers

available to the authorities to respond to such a shock to confidence are very limited, given the lack of fiscal space in most member

states and the limits on the ECB’s ability to stimulate credit through money creation.

That said, while we might well see growth stalling or even recessions emerging in the weaker economies such as Italy and France,

the impact on growth would likely be transitory. In the absence of a more acute shock, we would expect policymakers’ response to

restore confidence in the euro area’s growth engine quite quickly. Should that happen, the credit implications of lower growth would

be limited and quickly reversed.

Overall, looking only at fundamental factors, Greek exit should have little if any immediate credit impact on remaining euro area

sovereigns.

However, Greece's exit would leave the euro area more exposed to shocks over the medium term

However, sovereign credit risk analysis also takes into account exposure to shocks. Looked at through this lens, the potential

consequences of Greek exit for other euro area sovereigns, and for the euro itself, should not be underestimated. The likelihood

of shocks occurring in future would rise, and the authorities’ ability to absorb those shocks would be impaired. That would have

implications for sovereign credit risk across the euro area, limiting upward momentum in ratings over the medium term.

The euro was designed without an exit door, in order to convince investors, at inception and thereafter, that the new currency was an

irreversible, indivisible union, not simply a set of fixed exchange rates between identically named currencies. Where divergent fiscal or

economic paths within the euro area implied the need for adjustment in one part of the zone, that would be achieved solely through

domestic fiscal and economic policy changes, not through currency devaluation.

A departure from the euro would show that that need not be so. It would show that where internal adjustment needs are so severe,

so rigidly enforced and so painful or unacceptable to the patient, there is an alternative, which the remaining members of the club

are prepared to countenance. An example would be set which would inevitably influence the course of future 'internal devaluations’,

raising, even if only a little, the likelihood that they too could end in default and exit. Future patients would have a roadmap to exit,

and vicarious experience of its consequences. Even if Greece’s experience were painful – and particularly if it were not – knowledge of

an alternative could undermine political will to achieve adjustment at any cost.

Investors would know this, and would react accordingly. Even if immune to the pressures of overt currency speculation, troubled

members of the single currency would still face heightened risk of capital outflows and sales of domestic assets (including government

bonds) which would complicate the domestic adjustment process. Investor risk aversion would be heightened, increasing, at least

on the margins, the risk of highly indebted governments losing access to private funding markets. Markets would test the euro area

authorities’ willingness and capacity to provide support to ailing members, with any sign of weakness further elevating market distress

and in turn increasing the need for support.

Greater vulnerability to shocks over the medium term would be unlikely to have immediate implications for euro area sovereign credit

risk or ratings. However, it would exacerbate known weaknesses in the governance of the single currency – the absence of strong fiscal

or economic integration and the limited ability to constrain national discretion – which already constrain future rating uplift. Hence,

one effect of Greek exit would be to limit future upward momentum in euro area sovereign ratings.

MOODY'S INVESTORS SERVICE SOVEREIGN AND SUPRANATIONAL

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Potential disruption to debt markets would pose a more immediate risk to credit and to ratings

Exit could have more serious consequences in parts of the euro area in the near term. A shock to investor confidence that fed through

the government debt markets, reigniting the crisis, would have more significant credit and rating implications. A number of member

states remain part way through major adjustment and reform programmes, dependent on investor confidence to finance high debt

loads while that adjustment process is under way. Exit could trigger the kind of vicious cycle – of rising yields and falling confidence –

seen at the height of the crisis.

Could that happen? Yes, it could. Sovereigns are the largest debt issuers in the world. They need to refinance very large amounts of

debt each year, and are critically dependent on investor confidence to be able to do so at affordable rates. The debt crisis was in part

a crisis of confidence. With hindsight, investor confidence returned more quickly in 2012 than can be explained by improvements in

credit fundamentals or by institutional changes. The critical factor was the clarity of purpose brought by ECB President Mario Draghi’s

comment that the ECB would do “all it takes”, and that that would “be enough”. Why would such a statement have such a dramatic

impact on sentiment, when the measures required to address the problems which led to the crisis are largely beyond the remit of the

ECB?

The answer is two-fold. First, the ECB’s willingness to act as buyer of last resort, and its decision not to place explicit limits on its

willingness to do so, provided a deep-pocketed source of demand in markets which had up to that point seen little to counter

negative sentiment. Second, the knowledge that such a buyer existed reassured investors that highly indebted sovereigns would be

insulated from debt market dislocation for sufficient time to implement the fiscal and economic reforms needed to reverse rising debt

trajectories and achieve solid economic growth. Together, these reignited confidence.

Even today, that ‘backstop’ role, which has since been bolstered by the launching of quantitative easing (QE) - even if that programme

has very different policy objectives - is a calming influence in what might otherwise remain fragile debt markets. But of course the

ECB’s support can extend only to members of the euro area, and confidence in its availability rests in part on the certainty that

members will remain within the euro area. Evidence of divisibility could well shake that confidence. Would the ECB remain willing to

purchase government debt, whether in Outright Monetary Transactions or as part of a QE programme, issued by a country which was

perceived to be in even a remote danger of leaving the euro? Concern that it might not could well reignite investor concerns in relation

to the most highly indebted sovereigns.

Policymakers’ response – and especially that of the ECB – would determine the extent of contagion

The likelihood of that happening would depend to a large extent on the policy announcements and initiatives that accompanied exit,

and on their credibility with investors. Strong statements would be expected from fiscal authorities such as the Eurogroup regarding

firmness of purpose on reform, and on the availability of backstop funding to support sovereigns facing liquidity problems (principally

the funds remaining available to the ESM). However, on past evidence it seems unlikely that such statements would calm fractious

markets: the crisis laid bare the coordination and credibility problems which beset the fiscal authorities throughout.

Much would depend on the ECB, as the sole unitary authority with sufficiently deep pockets and singularity of purpose to reassure

markets. The ECB is in one important respect even better placed to provide the necessary assurance than it was in 2012: the emergence

of very low inflation/deflation and the consequent agreement in the Governing Council on the need for QE leaves it better placed to

expand its balance sheet significantly, with limited fear of internal dissension or of stoking inflation. That is not to say that neither is a

risk: there may turn out to be no more consensus on the extent and focus of any balance sheet expansion now than there would have

been in 2012. But the risks have fallen.

Current ratings architecture balances fundamental improvements against potential for shocks

As set out in our recent Sovereign Outlook report on the euro area, Moody’s euro area sovereign ratings today balance fundamental

improvements seen since the nadir of the crisis against the potential for further shocks to emerge. The shifting balance has allowed

some uplift to periphery ratings. For example, we have raised Ireland’s rating from Ba1 with a negative outlook to Baa1 with a stable

outlook, Portugal’s rating from Ba3 with a negative outlook to Ba1 with a stable outlook and Spain’s by a notch to Baa2 with a positive

outlook.

MOODY'S INVESTORS SERVICE SOVEREIGN AND SUPRANATIONAL

5 30 APRIL 2015 GREECE, GOVERNMENT OF: GREEK EURO AREA EXIT MIGHT BE MANAGEABLE, BUT RISKS SHOULD NOT BE UNDERESTIMATED

But the overall upward shift has been limited. That reflects the significant amount that remains to be done to address high and, in most

cases, still rising debt trajectories in the periphery. Only in Ireland has the debt burden begun to diminish: the trajectory is reversing in

Portugal and while debt burdens continue to rise in Spain and Italy, stabilisation is in sight. That stabilisation will rest on a continuation

of economic growth and of the fiscal and economic reforms implemented in recent years.

It also reflects the potential for market dislocation to reemerge. Nominal yields and credit spreads are very low, their fall over the past

two and a half years more a reflection of anticipated monetary accommodation than of fundamental improvements. The reduction

in debt costs is positive, but the potential for a sharp rise in yields is clear, and the debt market dynamics in such circumstances are

unpredictable. Re-emergence of disorderly debt market conditions would be strongly negative for peripheral countries such as Spain,

Italy and Portugal, and perhaps also for low-growth, high-debt core countries such as France. While it is difficult to foresee the range of

events that could cause such dysfunction to emerge, the exit of a member of the euro could certainly be one.

Policymakers would probably succeed in limiting contagion. But the possibility that they might not

could be credit negative, particularly for periphery sovereigns

The immediate credit implications of Greek exit would depend on policymakers’ success in reassuring markets and heading off

contagion. There is, in our view, a reasonable likelihood that they would be successful. The improvements seen in other member states

since 2012 create a significant wedge between Greece and the other peripheral states, it is clear that the current confrontation reflects

a range of factors unique to Greece, and the ECB has a strong armoury of tools.

However, the risks should not be ignored or understated. Greece's exit could be particularly credit negative for periphery countries

with high, and in some cases still rising, debt ratios which would likely be at the heart of any investor concerns. The credit implications

would depend on the impact on investor sentiment and therefore on sovereign liquidity risk, and on the effectiveness of the policy

response.

MOODY'S INVESTORS SERVICE SOVEREIGN AND SUPRANATIONAL

6 30 APRIL 2015 GREECE, GOVERNMENT OF: GREEK EURO AREA EXIT MIGHT BE MANAGEABLE, BUT RISKS SHOULD NOT BE UNDERESTIMATED

Moody's Related Research

» Sovereign Outlook – Euro Area: Broadly stable credit outlook reflects balance of risks, assumes no Grexit , 17 March 2015.

» Credit Opinion: Greece, Government of , 6 March 2015.

» Credit Focus: Greece, Government of: Key Drivers for Moody's Decision to Place Caa1 Government Bond Rating on Review for

Downgrade , 10 February 2015.

» Rating Action: Moody's places Greece's Caa1 government bond rating on review for downgrade , 6 February 2015.

» Issuer Comment: Greece, Government of: Election Outcome Is Credit Negative Because It Prolongs Financing, Liquidity and

Economic Growth Risks , 26 January 2015.

» Sector Comment: Euro Area Sovereigns: Greek Exit Would Be Credit Negative for other Member States; but Contagion Risks are

Lower Than in 2012 , 14 January 2015.

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this

report and that more recent reports may be available. All research may not be available to all clients.

MOODY'S INVESTORS SERVICE SOVEREIGN AND SUPRANATIONAL

7 30 APRIL 2015 GREECE, GOVERNMENT OF: GREEK EURO AREA EXIT MIGHT BE MANAGEABLE, BUT RISKS SHOULD NOT BE UNDERESTIMATED

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