This week's article comes from the Financial Times and explains the risks associated with a potential Greek exit from the Euro common currency. The risks of contagion in financial markets is significantly lower than during previous years, as investors have had time to prepare for a potential Greek debt default.
How Greek contagion is being contained
Ralph Atkins in London
Fears are mounting about how a Greek exit from the euro could affect markets
As Greece’s crisis escalates, the big concern for European and global policy makers is the potential for the country’s ejection from the eurozone creating turmoil across financial markets. Greek politicians have played on such concerns to put pressure on international creditors for a better deal.
So far disruptive “contagion” has not happened, however. European bond and share prices have this week moved within normal ranges. Why not? And could that change?
Here’s a brief guide to “manageable contagion” or “Greek contagion contained”.
What is financial contagion?
As in virology, financial crises in one country can quickly infect others — for instance if foreign investors suffer losses, sentiment is hit or through economic channels such as trade links. In the eurozone, the fear is that Grexit — Greek withdrawal from the currency bloc — would set a terrible precedent, and that investors will fret about other countries being ejected in the future. As the likelihood of Grexit rises, contagion effects could build.
What is the best gauge of eurozone contagion fears?
Since the eurozone debt crisis erupted in 2010, markets have watched the interest rates that different governments pay when raising debt in international capital markets. These should reflect the perceived riskiness of different countries. Before the eurozone crisis, differences were minimal. But from 2010 they widened dramatically, reaching peaks in 2012.
So-called “periphery spreads” are the differences in yields on bonds issued by governments on the eurozone’s southern periphery — Spain, Italy and Portugal — compared with German Bunds, which are regarded as the safest European assets.
So what are they showing?
Periphery spreads have widened this week, but not as much as many feared — and by nowhere near as much as in 2011-12. Portuguese 10-year bond spreads, for instance, reached 2.44 percentage points on Monday, some 0.67 percentage points wider than on Friday. In 2012 they had soared as high as 15.6 percentage points.
One reason could be that markets still believe Grexit is unlikely. They expect Greeks on Sunday to snub prime minister Alexis Tsipras and vote Yes, in favour of international creditors’ reform plans.
But many investors believe Grexit contagion effects would anyway be manageable. Linkages with Greece are much less than in 2012: banks have reduced exposures, little of the country’s debt is now held by private investors, and nobody could argue they had no time to prepare for a possible Grexit. What is more, Greece looks increasingly unique; it faces a combination of political and economic problems not found in any other eurozone country. So if Greece did leave the eurozone, others would not necessarily follow.
But perhaps the biggest reason is that markets expect Grexit would be followed by a forceful policy response from the European Central Bank — for instance by stepping up purchases of government bonds. That would stop bond yields rising, preventing contagion. So what we have seen is being dubbed “manageable contagion”?
Yes — at least so far. But there is an important qualification: periphery spreads are distorted because the ECB is already buying government bonds in its quantitative easing programme launched in March. That has pushed prices up and yields down — reducing their value as “contagion fear indicators”. Arguably it is better to look at what has happened to eurozone share prices for a cleaner, less distorted, view on contagion worries.
What has happened to eurozone shares?
Eurozone stocks have fallen since Monday, with banks seeing particularly big declines, but they are still 15 per cent higher than at the start of the year, also suggesting contagion fears are not rampant. Strikingly, US share prices have been largely unaffected. The Vix index of expected US share price volatility — known as the “Wall Street fear gauge” — has spiked in recent days, but that might reflect concerns about yo-yoing Chinese equity markets. However Vstoxx, the European equivalent of Vix, has jumped this week to levels not seen since 2012.
Does the euro’s value tell us anything useful?
Perhaps not. It is unclear what effect Grexit and contagion effects would have on Europe’s single currency — and it has remained remarkably firm even as the Greece crisis has escalated. Threats to the eurozone’s stability might have a weakening impact, as would expectations of a forceful bond buying by the ECB. On the other hand, some think a eurozone without Greece would be stronger.
So can we all relax?
Yes — if you really believe markets are right and can correctly price Europe’s complex politics as well as all the complications that would result from Grexit. Otherwise, No.
