Greek Contagion Is Not a Something, Not a Nothing
Austrian-British philosopher Ludwig Wittgenstein argued that trying to discuss private sensations such as pain is impossible because "it is not a something, but not a nothing either." That enigmatic statement is a useful way to reflect on whether a bad outcome for Greece will have a contagious effect on other members of the euro zone.
Contagion refers to the risk that Greece would infect its neighbors if it either defaulted on its debts or exited the euro. Investors, for example, might decide that Portugal is next in the firing line if Greece left the euro. They would demand a higher financial reward for taking on the greater risk of default, and thus drive up Portugal's borrowing costs. So far, apart from an almost imperceptible blip higher in borrowing costs in the past week for Portugal, Spain and Italy versus Germany (the euro zone's AAA rated benchmark borrower), Greece's inability to reach a deal on getting fresh money from its creditors hasn't rattled markets:
And as Luca Cazzulani at Unicredit in Milan points out, the correlation between the borrowing costs of Portugal, Spain and Italy with those of Greece has steadily diminished since the middle of last year. Spanish 10-year bonds, for example, had a 0.6 correlation with Greek debt in June 2014 (where a value of 1 means two numbers are moving in lockstep and a value of zero means they have no influence on each other); now the match-up is down to less than 0.2:
The Greek economy contributes a negligible 1.8 percent of the gross domestic product of the euro zone. The region's banks have slashed their exposure to the country. The nation's creditors are mostly official agencies. The European Central Bank, for example, says it is at risk to the tune of 110 billion euros ($119 billion), while the International Monetary Fund is the lender Greece must repay about 775 million euros on May 12. So Greece running out of money won't trigger a financial disaster for its neighbors.
All of which makes the question posed in a research report this week by Jens Nordvig, the managing director of currency research at Nomura in New York, all the more fascinating:
Why is Greece still very much in the limelight if it is viewed as insignificant from both real economy and financial market perspectives? At the IMF/World bank spring meetings in Washington DC in the past week, the number one topic of debate was, you guessed it, Greece.
The answer is partly car-crash rubbernecking: the morbid fascination of seeing whether the euro bloc will splinter. The lack of contagion could also reflect money-manager expectations that somehow, someway, a deal will be reached that averts Greece defaulting and keeps it in the euro. Pacific Investment Management, for example, sees a 30 percent chance of an accident that leads to Grexit -- which means a 70 percent chance that the euro group remains intact.
But the more important reason, I think, is the element of uncertainty -- the something/nothing dilemma. Contagion might turn out to be a real possibility, or it might not. Nordvig agrees:
Investors are just not quite sure. Their central case is that Greece will not be a big deal from the perspective of managing global portfolios, even if the local story turns into a true tragedy. But how can we know for sure? It is not every day that a country is on the verge of leaving the Eurozone.
European Union leaders have been unequivocal in their insistence that Greece has been ring-fenced, and that the common-currency project can survive the departure of its weakest member. They may be right; but we won't know for sure whether contagion is alive or dead unless and until Greece bows out.
(Corrects description of the correlation scale between Greek debt and Spanish debt in third paragraph.)
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