Prepare for the worst

Greece: Investors are beginning to price in the unimaginable in Europe. For the past few months, markets have assumed the euro zone’s problems could be contained to its troubled periphery. But turmoil in Greece has raised fears that the country will spiral into a disorderly default. The consequences of that would be disastrous.

Greece’s political crisis, combined with violent protests in Athens, has prompted questions about its willingness to accept the reforms required to secure a new bailout from the European Union and International Monetary Fund. If a compromise cannot be reached, the country could find itself unwilling and unable to meet its obligations.

The repercussions of a hard Greek default — as opposed to a debt extension or voluntary rollover by creditors — would be severe. Banks would be forced to write down the value of their Greek government bonds, most of which are not currently marked to market. This would trigger big losses for Greek banks, which would also be likely to default. Depositors would flee.

Moreover, contagion risk would lead investors to dump the debt of other European countries. This would particularly hurt Spain, which has managed to detach itself from the periphery but is still grappling with slow growth and weak banks. Other euro zone lenders with large peripheral exposures would come under pressure. Some might fail or need to be bailed out.

Finally, the European Central Bank would suffer. Default would dent the value of its holdings of Greek debt. Bank failures would also leave the ECB holding the sovereign debt it has accepted as collateral in its lending operations. It might then need to seek a bailout of its own from the euro zone’s governments. The doomsday scenario is still distant. It is in the interests of the EU, IMF and ECB — as well as the Greeks — to reach a compromise. The IMF is already signalling that it will release the next tranche of Greek aid before a new bailout is finalised. That would buy the euro zone a little bit of time to reach an agreement.

However, investors are recognising that a catastrophic event must be priced into markets. A Greek bankruptcy - and the crisis it would trigger — is still unlikely. But it is less remote than it was.