The outlook for the global economy and markets is multi-polar, depending on how the eurocrisis develops.
Without the crisis, economic momentum and risk assets would probably now be recovering in response to faster G7 real money expansion since the spring. Recent heightened fears of an imminent hard Greek default and associated funding difficulties faced by some European banks threaten to delay the expected revival until late 2011.
An immediate involuntary write-down of Greek sovereign debt, even if accompanied by measures to shore up bank capital and ensure continued access to funding (including for Greek banks), would represent a further negative “shock”, probably extending economic weakness into early 2012.
As a recent Citi report argues, however, by far the worst-case scenario would be a Greek default accompanied by exit from EMU, involving the redenomination of Greek bank liabilities from euros to new drachmas. This precedent would trigger huge capital flight from other peripheral banking systems, requiring a massive expansion of ECB support to avert collapse. Associated damage to global business and consumer confidence would probably be sufficient to trigger another recession.
The base-case view here, admittedly held with limited conviction, is that, while a large write-down of Greek sovereign debt will ultimately be required, the Greek government will delay initiating such action until the country’s primary deficit has been closed – unlikely before 2013 at the earliest. Official lenders to Greece, meanwhile, will prefer to tolerate non-compliance with fiscal targets and continue to advance funding providing that the government maintains the illusion of co-operation – most of the cash, after all, is being used to service debt held mainly by European financial institutions rather than to cover the Greek primary deficit.
The risk, of course, is that populist pressure either in Greece or “core” Eurozone countries overwhelms such rational considerations, resulting in an immediate withdrawal of funding and involuntary default.
The challenging task for the Eurozone authorities in the latter scenario would be how to prevent a Greek default from spiralling into forced exit from EMU. A key requirement would be a plan to allow the ECB to continue to act as lender of last resort to the Greek banking system – the banks, for example, could be recapitalised by the EFSF / IMF with the ECB granted preferred creditor status in some form.
“Kicking the can down the road” is still the least worst option.
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