Greece’s High Political Price for Europe

9/7/2015

By Richard Barley

As day of destiny looms, political spillovers are a bigger risk than financial contagion

European markets are still playing it cool. There is no panic, even as a day of destiny looms for Greece and Europe; stocks and southern eurozone government bonds rose sharply Thursday. But whatever the outcome, European political risk is rising.

Investors and analysts believe, correctly, that direct financial contagion from Greece isn’t a concern. Banks and private investors have little exposure. Greece accounts for just 1.8% of eurozone output and around 0.3% of the global economy. But while Greece may have been financially isolated from Europe, its political punch remains powerful. That is likely to be the case whether Greece remains in the eurozone or not.

Consider first a new bailout deal for Greece. Investors may yet be pinning their hopes on this, despite the repeated disappointments of the past five months. But it isn’t without risks. A “soft” deal will encourage radical parties elsewhere while drawing flak from those skeptical of the merits of a further rescue. A harsh deal may simply postpone a Greek exit, unless there is a vast shift toward structural reform rather than near-term fiscal tightening.

A Greek exit would of course pose a far bigger political challenge to markets. True, the European Central Bank has pledged to step in to combat instability, and in the near term there is no danger of another exit. But part of the ECB’s power lies in the idea the euro is irreversible: it was this that President Mario Draghi focused on with his “whatever it takes” intervention in 2012. Yet in implementing quantitative easing, the ECB was forced, via its complicated risk-sharing model, to acknowledge that the euro isn’t like other currencies. If the ECB and eurozone governments were to end up taking losses on their exposures to Greece, that will likely fuel a backlash.

Meanwhile, Europe continues to struggle to win the hearts and minds of voters. Over half of Europeans think their voice doesn’t count in the European Union, the Eurobarometer survey shows; 50% don’t trust the EU and 65% don’t trust their national governments. And the eurozone recovery may impress voters less than investors. Unemployment—a lagging indicator for markets, but a hot-button issue for voters—remains extremely high. Youth unemployment stands at 49.3% in Spain and 41.5% in Italy.

Investors may think these big-picture questions are for another day. But they have consistently taken too rosy a view of even near-term risks: 66% of 1,244 investors polled by Barclays three days ahead of the Greek referendum predicted the wrong result. Many remain sanguine about political risk elsewhere in Europe, even in Spain where elections are due later this year and new parties like Podemos have risen from nowhere to challenge the incumbents.

Markets find it difficult to price political risk. But that doesn’t mean investors can ignore it completely. Political risk may be another good reason for holding a little more cash and being more cautious as the second half of 2015 unfolds.

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