Our Partners in Enterprise at Bank of Scotland have shared the views of Lloyds Banking Group Economic Researchers on the recent activities in Greece.

Overview
The decision of the Greek public in yesterday’s referendum to reject comprehensively further austerity has taken Greece another huge step towards the euro exit door. Pulling it back may be too much to ask of its exasperated creditors. Although the Greek government will view the result as strengthening its mandate to secure a better deal, it is not clear its official creditors will see it this way. Developments remain fast-moving and within the next 48 hours we should have a much clearer idea about whether a deal can be struck or not. We now see Grexit as the more likely outcome.

Market reaction
The result has been met with general ‘risk-off’ sentiment in global financial markets overnight. Given the potential magnitude of the news, however, arguably market reaction has been relatively muted. Overnight, equity markets across Asia dropped around 2-3 percent, with European bourses posting slightly smaller losses this morning. The FTSE was down around 65 points at just above the 6,500 level. In the bond markets, there have been signs of flight into the relative safe havens: 10-yr government bond yields in Germany and the UK opened around 5-7bp lower, while spreads of European peripheral debt – the most vulnerable to contagion – have gapped around 10-15bp higher. Notably, the euro is holding up very well. Having dropped from 1.11 against the US dollar at Friday’s close to an overnight low of 1.0970, it is currently trading back towards 1.11. Similarly, against the pound, the euro is so far trading only a little lower, at 0.71 (GBP/EUR: 1.4050). The limited market reaction may reflect the markets’ belief that direct financial exposure to Greece is relatively small and the potential firepower of the ECB has reduced contagion risk. It could just as easily, however, reflect a ‘rabbit in the headlines’ reaction: with the outcome still extremely uncertain, and the potential for volatility extremely high, market participants may be reluctant to add to short positions until the outlook is clearer. It could also be that investors still believe a last-minute solution to
keep Greece in the euro will be found.

A game of brinkmanship
The final vote showed the ‘No’ to fiscal austerity winning by a comfortable majority of 61% to 39%, on a turnout of over 60% (compared with 63% in January’s General Election). The Greek government views the result as a strong mandate to insist on further concessions from its official creditors – and not as a vote on whether to leave the euro. With the Greek banking system on the brink of collapse, the stakes are incredibly high. If Greece has miscalculated, and the Eurogroup does not blink, Greece could be forced to exit the single currency. In an effort to smooth the path to a deal, Greek Finance Minister, Yanis Varoufakis – a thorn in the side of official creditors – announced his surprise resignation this morning. This, however, is unlikely to be enough. Judging by the early response to the referendum result from Greece’s main creditor – Germany – they appear to be in no mood to compromise. The German Deputy Chancellor, Sigmar Gabriel, warned last night that Greeks ‘have torn down the bridges’ and a resumption of negotiations is ‘barely conceivable’. Other German cabinet ministers have made comments along a similar vein. With the majority of Germans now supporting Greece leaving the single currency, Chancellor Merkel’s scope for manoeuvre appears extremely limited.

Next steps
German Chancellor Merkel and French President Hollande will meet later today (at 17.30BST) to discuss the implications of the referendum result ahead of an emergency euro area summit tomorrow. While Germany’s position appears implacable, France has recently sounded a more conciliatory tone. Any comments following the meeting will provide a key steer on the prospects for real progress tomorrow. Comments from the IMF will also be watched closely given that Greece missed its last debt payment to the Fund. At this stage, the onus is on Greece to table a new proposal. If, as we suspect, the government will include a requirement for a debt haircut, the chances of reaching a deal are likely further reduced. Having negotiated for the past five months, the Greek government will be well aware of the entrenched stance of its EU creditors. However, comments from the IMF last week suggested that it has some sympathy with Greece’s demands for debt restructuring, alongside further rescue funds. In the meantime, the European Central Bank will meet today to decide on what changes, if any, to make to its provision of emergency liquidity assistance (ELA) to the banking sector. This has been unchanged at €89bn since late June. While the ECB is unlikely to change its stance, in the absence of a deal, it is difficult to see how long this lifeline to the Greek banks can continue.

How events may unfold
Today’s Merkel-Hollande talks, the ECB meeting and tomorrow’s euro area summit all pose substantial event risk for markets as early indicators of what may be coming. Starved of funds, Greece needs to reach a deal quickly or events are likely to overtake it. If the ECB’s ELA is not extended, the Greek banking system is expected to run out of money over the next 24-48 hours. Capital controls would then need to be tightened even further. But this is unlikely to be sufficient – raising the possibility of bank recapitalisation through the ‘bailing in’ of bank deposits (as was the case in Cyprus). There are reports that the Greek government is considering bailing-in private deposits over €8,000. Given the political, economic and social costs of doing this, however, it may be preferable to use an alternative means of payment – for example, introducing government-backed IOUs, in the first instance. As funding conditions tighten, the potential economic and social costs are likely to soar. The key question then is whether the resulting pain encourages the Greek government back to the negotiating table with a compromise. If so, there is a possibility that a ‘last chance’ deal could be struck. To be credible to the market, however, this would likely need to include some form of debt forgiveness/restructuring from the Eurogroup in exchange, perhaps, for more stringent implementation of structural reform. To do so would potentially undermine the credibility of the Eurogroup’s insistence on fiscal austerity to resolve the crisis, and set a precedent for other highly indebted countries. This could compromise the whole euro project – and is potentially more damaging than effectively forcing Greece to leave. In the absence of an agreement, Grexit would be inevitable. Indeed, this now looks the more likely outcome. The challenge then for both Greece and its creditors would be to avoid, as best they can, a disorderly and traumatic exit and to hopefully keep Greece within the EU.

Implications for the UK
The uncertainty generated by the escalation in Greek tensions has short- and potentially significant longer-term implications for the UK. The impact could be expected to felt through three main channels: confidence, financial linkages, and external trade. Over the short term, the first two are likely to dominate. The potential deterioration in financial market confidence would likely result in negative UK wealth effects, and while direct exposures of the UK to Greece are very small (0.5% of GDP), the indirect contagion from other European cross-border linkages could exacerbate the deterioration. Over the longer term, if Greece continues to deteriorate, the UK’s direct exports to Greece (and the rest of the euro area indirectly) are likely to weaken. The likely appreciation of the pound against the euro in this environment could be expected to add further downward pressure to UK exports and a disinflationary impetus to the UK. Overall, the combined threat posed by these transmission channels to the UK is likely to strengthen the case for the Bank of England keeping interest rates on hold.