Aftershocks of Greece's euro exit may reach China

Greece, responsible for 0.4 per cent of the world economy, now poses a threat to international prosperity as investors raise bets its days using the euro are numbered.

A Greek departure from the currency would inflict “collateral damage,” says Pacific Investment Management Co’s Richard Clarida, a view echoed by economists from Bank of America Merrill Lynch and JPMorgan Chase & Co. At worst, it could spur sovereign defaults in Europe as well as bank runs, credit crunches and recessions that may spark more euro exits.

Global trade and financial ties mean the pain wouldn’t be confined to the Euro area. JPMorgan Chase estimates a 1 percentage point slump in the euro countries’ economy drags down growth elsewhere by 0.7 percentage point. Exporting nations from the UK to China would suffer and commodity producer Russia would face falling oil prices. While the US may fare better, even it would feel echoes similar to the financial infection following the bankruptcy of Lehman Brothers Holdings Inc.

 

“An awful lot depends on what is done to limit the contagion within Europe,” said Barry Eichengreen, a professor at the University of California, Berkeley, and author of a 2006 history of the European economy, in a telephone interview. “If too little is done then, to use a financial term, all hell breaks loose. I can imagine things playing out that way.”

Citigroup economists, who earlier forecast departure chances at as much as 75 per cent, now are assuming as a “base case” that Greece will leave on January 1, 2013. BofA Merrill Lynch strategists estimate the Euro-region’s gross domestic product would contract at least 4 per cent in the recession that follows, similar to the decline after Lehman’s 2008 collapse. The euro would slide through $1.20 and Europe’s Stoxx 600 Banks Index would tumble below 110 points, from 123 yesterday, according to BofA Merrill Lynch’s May 17 report.

Other crisis-torn countries, such as Portugal and Spain, would incur higher borrowing costs. In Germany, perceived by investors as a safe haven because of its stronger economy and lower debt, 10-year bund yields could fall to 1 per cent, the report said.

“If you let Greece go you would be sending the message that being a member of the Euro zone is not necessarily permanent, which could be a disaster for some countries,” said Laurence Boone, chief European economist at BofA Merrill Lynch in London. Her primary scenario is that Greece remains within the euro because of the high cost of the alternative.

The creditworthiness of governments and banks in Italy and Spain, the Euro area’s third- and fourth-largest economies, would be thrown into fresh doubt as traders shun their sovereign bonds and pore over their financial institutions’ balance sheets, said Yiannis Koutelidakis, an economist at Fathom Financial Consulting in London.

Investors are signaling increased concern. The euro has dropped about 5 per cent in the past month against the dollar, while the cost of insuring Spanish government and financial debt reached a record this month. Germany, by contrast, last week sold euro 5 billion ($6.3 billion) of two-year notes with a zero-per cent coupon for the first time.

Beyond the Euro area, major trading partners such as the UK, Switzerland and nearby emerging economies including Romania’s could be hurt as demand slows. Their currencies probably would rise against the euro, making exports less competitive. China’s biggest investment bank says that nation could see its weakest growth in more than two decades.

Even if the dollar surges, the US may be more insulated given signs of a rebound in its domestic economy — at 8.1 per cent in April, the jobless rate is down from a peak of 10 per cent in October 2009 — and the fact that just 13 per cent of its exports head to the Euro area. Capital flooding into a perceived safe haven may also hold down interest rates.

Still, BofA Merrill Lynch estimates US bond and stock markets each account for a third of global capitalization, leaving them prone to a European shock. Greek elections helped wipe almost $3 trillion from worldwide equities this month.

A splintering of the 13-year-old currency bloc might not come to pass even if Greece next month elects parties campaigning to reject the terms of the bailouts needed to pay its bills, said Jacob Kirkegaard, a fellow at the Peterson Institute for International Economics in Washington.

Such an event would probably cut the nation off from outside aid, tipping Greece’s economy and financial system into such chaos that the new government would fall within weeks, he predicted. Credit Suisse Group AG analysts say a majority of Greeks back staying in the euro, the costs of leaving for the country and the rest of the Euro region would be considerable and the single currency is a political project.

“I will attach less than a 5 per cent probability for an actual Greek exit,” said Kirkegaard.

Continued membership may still cause headaches for the world economy as Greece suffers political paralysis, a fifth year of recession, the need to repay what it owes and the burden of austerity goals. “Our best guess is they’re not leaving yet and that this will be a story that will be discussed repeatedly for more than another year,” said Jim O’Neill, chairman of Goldman Sachs Asset Management in London.