Where Will Greece Go From Here?

Jason Stipp: I'm Jason Stipp for Morningstar. As the Greek drama is playing out and moving markets as it goes, we're checking in today with senior economist Francisco Torralba from Morningstar Investment Management for his take on the possible scenarios and what they may entail.

Francisco, thanks for joining me.

Francisco Torralba: Thank you for having me here.

Stipp: First of all, we've known for a long time that Greece has had financial troubles. But to take a step back, why are the issues flaring up again recently? Why are they in the headlines?

Torralba: The existing bailout program that Greece had with its creditors was expiring on June 30. And as we got closer to that deadline and it was apparent that there wouldn't be a deal, markets got nervous, understandably, and this is where we are today, one day after that deadline.

Stipp: And we know that that deadline was technically missed, but negotiations are still going on. One thing is that the markets, although they have been disrupted somewhat as these negotiations have been happening, it does feel like it's different from the last time Greece was in the headlines. How would you characterize the context this time around versus the last time?

Torralba: Well, it's worse. I think it's worse. The second bailout officially expired in February, but they were able to get an extension for four months that ended in June. I think Europe now feels that they have allowed enough time for the two parties to reach a new agreement for a third bailout, and they feel like Greece hasn't really made enough progress with the reforms that they need to make. So, I think that this time Europe has less patience or is less willing to yield to Greece's demands. So, I think that's the main difference. We are getting to a point where Greece has less room to get what they want.

Stipp: I know there were concerns last time around about financial shocks to the rest of the eurozone and to the rest of the globe. Do you think those shocks are as pertinent today as this crisis is happening as they were last time?

Torralba: No, they are less likely to happen. Since the last time we had a Greek crisis, European institutions--in particular, the European Central Bank--have put in place mechanisms that make contagion less likely. They have the asset-purchase program. They also have put in place the EFSF and the ESM to lending institutions that would be there for other countries should they need to borrow from them.

Stipp: There was news on Wednesday that the Greek prime minister is prepared to agree to some recent bailout terms, and so that was causing the market to go up on Wednesday. However, there is also a referendum that's scheduled for the Greek people this weekend. So, if we have news that the PM is ready to agree to the terms, where does the referendum come into this story now?

Torralba: As of 12:45 PM Central time [Wednesday, July 1], this is precisely what we know: There was a request for a third bailout and agreement to most of the conditions that Europe was demanding. Nothing really transpired officially from Europe, but a few hours after that, the Greek prime minister said they were going to still hold the referendum. So, I don't know if there was some communication that we are not aware of. Europe said they weren't going to agree to those terms. So, what we know as of now is that they are holding the referendum on Sunday. My personal take on this referendum: The main difficulty here is that, whether you vote yes or no, it's a complicated question with scenarios that are difficult to understand. So, that makes it very difficult for Greek voters to make a decision.

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Stipp: Given, though, that we have the Greek prime minister agreeing to most of the terms, will the result of this referendum--yes or no--change his opinion one way or the other now that he has already said he is agreeing to most of the terms?

Torralba: Well, one key point is that it's not all of the terms. He is agreeing to most of the terms but not all of them, whereas Europe wants every single point of the proposal fulfilled for them to agree to a new bailout. But number two, it could be simply an indirect communication of strategy by the prime minister saying, "I'm OK with most of these terms, but it's an important decision and I want to hear from the Greek people. So, just let me know if you're OK as well."

Stipp: So, we'll have to wait and see what the result of that vote, which is scheduled for July 5, will be. So, given that there are some unknowns here, what do you think are some of the possible scenarios that we'll be seeing coming out of this?

Torralba: Well, I think the most likely scenario is that the Greeks vote yes to the terms of the bailout. The prime minister has already said that if the Greek people vote yes, he will step down as prime minister because he has already said that he thinks the terms are too harsh and that Greece shouldn't accept them. That would mean there will be new elections in Greece or perhaps a technocratic government for a brief period. That's, I think, the most likely scenario. They submit to the terms, the ECB immediately raises the liquidity program they have for the Bank of Greece, and we buy ourselves a few more months.

Scenario B is essentially that they vote no, but Europe and Athens agree to sit down again and renegotiate the terms. So, the Greeks say, "We don't agree to these terms, but we are not saying we want to be out of the euro. We still want to be in but not on those terms." So, we have new negotiations, in which case the ECB would probably agree to continue providing liquidity during those negotiations. Those will be very short, and I think the deadline in that scenario is July 20 when there is a payment due to the ECB by Greece.

Then, the least-likely scenario is the Greeks vote no, and there is no more waiting. The ECB immediately pulls the plug on the liquidity to the Bank of Greece and the Grexit becomes a de facto scenario.

Stipp: But you are saying, at this point, that seems like it's the least-likely scenario?

Torralba: I think so.

Stipp: In the best-case scenario after this, there is some agreement on the terms. Does that solve Greece's problems? You said "for a few more months," which make me think no, but it allows them to continue for a little while.

Torralba: We are talking about a very difficult economic problem of integration of very different economic areas within one currency--not just Greece, but Portugal, Spain, Italy. Greece is perhaps the most extreme example of a diverging economy; it's very different from the core of Europe. This doesn't solve the problems that really make staying within the eurozone a long-term feasible choice. I think more structural reforms and more convergence toward economic conditions in the rest of Europe are needed, and that won't happen in just a few months.

Stipp: We already talked about that there is less risk of contagion, potentially, this time around than last time. How should investors in the U.S. think about this? What would be the transmissions from any kind of market shocks should we see a worst-case scenario here?

Torralba: Probably, to the U.S., it would come in the form of a higher dollar-euro exchange rate, because of an appreciating dollar. The second effect would be higher volatility, both in bond markets and stock markets. I don't think that the Fed is going to necessarily make any announcements or any decisions before their next meeting at the end of July. If there was a spike in global volatility, which I think is very unlikely, they might announce some extraordinary liquidity measure, but I think this is an extremely unlikely scenario. So, I think investors really shouldn't be concerned about the direct repercussions of Greece. I think it's a transitory event. There are other things to worry about--profit growth, how close we are to the end of the business cycle--which don't depend directly on Greece at all.

Stipp: Last question for you, then: Given this test of the eurozone and this Greek crisis, what does that say to you about the sustainability of a successful eurozone for the longer term--the fact that we've had such trouble getting through particular test?

Torralba: It's going to undermine the confidence in the euro project. Let's say Greece leaves the eurozone, what does that say about Portugal or Spain or Cyprus? I think it would probably mean higher sovereign premiums for those peripheral countries. And I think that despite the ECB programs, which have restored the confidence of the markets in the eurozone quite a bit, I think there will be a permanent, if small, increase in the sovereign premiums. And then the next level is, if Greece leaves, will there be some institutional response to make it less likely that another country leaves in the future? I don't know what the answer is, but I think that will be the next question: Besides what the ECB is doing, is there going to be some sort of fiscal pact or some other form of institutional reform that makes the eurozone more durable?

Stipp: Well, it sounds like there are a lot of things still to come, a lot of things still to watch, a lot of unanswered questions. But thanks for giving us a handle on what's happening today with the situation.

Torralba: Thanks, Jason, for having me.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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