Funny what a difference two months make. Back on October 4, we wrote “Here We Go Again: Greece Will Be In Default Within 15 Months, S&P Warns” and… nobody cared as the Greek stock market meltup continued. Now, after the biggest three-day rout in Greek stock market history (or about 30% lower), and with the overhyped, oversold, oversusbcribed recent Greek 5 Year bond issue available in the open market some 16 points lower, and suddenly everyone cares. Including Goldman Sachs.

Overnight the bank with the $58 trillion in derivative exposure issued a note “From GRecovery to GRelapse” which is quite absent on the usual optimism, cheerfulness and happy-ending we have grown to expect from the bank whose former employee is in charge of the European printing press. Here is the punchline: “In the event of a severe Greek government clash with international lenders, interruption of liquidity provision to Greek banks by the ECB could potentially even lead to a Cyprus-style prolonged “bank holiday”. And market fears for potential Euro-exit risks could rise at that point.

Dear Greeks, “don’t vote wrong” as EU’s Juncker urges you – you have been warned.

Here is the full note.

Why Have Greek Assets Tumbled?

Over the last three months, Greek assets have come under intense selling pressure. The 10y Greek government bond trades at a yield of 9.1% compared to 5.5% in September and the Athens stock exchange is trading 32% lower over the same time-frame (and 40% below the post-crisis peak). As we have written extensively, this deterioration in market conditions has taken place despite an ongoing improvement in macroeconomic indicators. Markets have sold off on the back of election uncertainty ahead of a key year for Greece’s recovery process.

Greece needs official sector funding to pass the 2015 funding hump and ensure financial stability.

Indeed 2015 is a pivotal year for Greece. The most recent growth data prints suggest that the recovery may be gaining momentum. But financial risks still lurk, which could destabilize the Greek economy back into recession. More specifically, 2015 is the last year the government faces large financing needs, nearing €24bn (net of the established primary surplus). Part of those needs may be covered with domestic resources (see Box 1). However, additional funds will likely be required to ensure the government is able to meet its liabilities. As discussed in Box 1, the additional funds required may range between €6bn and €15bn depending on different economic assumptions.

It is important to note that from 2016 onwards, overall financing needs become a lot more manageable (compared to €24bn in 2015) – at or below €10bn until 2022 (lower primary surpluses or higher bond yields than the ones provisioned in the program could push these calculations up somewhat).

With government bond yields at prohibitively high levels, the Greek government will require official sector financing to provide the additional funds for 2015. €7.1bn of IMF funds are currently available as part of the Greek assistance program under relevant conditionality. In addition, the Eurogroup decided on Monday to grant Greece a precautionary credit line (ECCL) provided Greece completes the ongoing review by end of February. There are three main items to be agreed on for the current review to reach a conclusion: a) further reform in labor markets and in union legislation, b) further pension system reform, and c) further budget cuts. Greece is also likely stay under close economic supervision thereafter.

Political complications arise with the presidential vote.

According to the Greek constitution, the parliament needs to elect a President of the Hellenic Republic every five years. The presidential vote requires an extended majority. The term of the incumbent, President Karolos Papoulias, ends in early March 2015. The parliament would need to start the process of electing a new president at least one month in advance – by early February the latest. Should the parliament fail to elect a president, general elections would need to be held.

Due to a tight timeframe between the new deadline for completion of the program review and the deadline for the presidential election, the government decided to speed up the voting process. Three votes will take place – first two on the 17th and the 23rd of December respectively. The first two votes require a majority of 200 votes, which is unlikely to be achieved given the current parliamentary balances. The one that essentially matters is the third and final one on the 29th of December, where the Greek government would need to find 180 votes in the current parliament (of 300 members) to back their presidential candidate. As things stand, the government majority does not suffice to elect a president and avoid elections. 25 independent MPs and MPs from small parties would need to consent to meet the tally.

In the event that the parliament elects a president, the government and the troika will likely resume negotiations and an agreement is likely to be found. Financial risks would decline and Greek assets would likely rally.

In the event that the parliament fails to elect a president, general elections would be held and market uncertainty/pressures would extend. At this stage it is important to understand that market pressures are not linked to the democratic process of elections nor to a potential government change, whatever the ensuing government formation may be. They are linked to the risk of policy discontinuity and a severe clash between Greece and international lenders. More specifically, we think the room for Greece to meaningfully backtrack from the reforms that have already been implemented is very limited. Any such attempt would lead to an interruption of official financing to Greece.

Examining the downside scenario.

To be sure, even in the event of a government change, there is room for a cooperative solution between Greece and Europe. Greece has made significant reform progress between 2012 and the gap between what has already been implemented and what remains to be done is not insurmountable.

Also, the incentives for a clash are not there. For instance any Greek government would likely want to capitalize on the momentum that the economy is building on the activity front, rather than trigger a disruptive capital flight that would lead Greece to a double–dip recession. In addition, given that more than 80% of Greek debt is held by the official sector and given that any OSI would be feasible only as part of an agreement with the Euro-area, there is an incentive for a Greek government to pursue cooperative solutions.

However, the history of the Euro-area crisis has shown that the probability of an “accident” can never be dismissed, when it comes to intra-EMU politics. And it is important for markets to be able to understand and quantify the aspects of a potential downside scenario, where official financing to Greece is interrupted.
The Biggest Risk is an Interruption of the Funding of Greek Banks by The ECB.

Pressing as the government refinancing schedule may look on the surface, it is unlikely to become a real issue as long as the ECB stands behind the Greek banking system. In fact, refinancing became a lot more pressing between 2011 and 2012. But financing needs were met despite the impasse in negotiations between Greece and international lenders – partly via the issuance of T-bills repoable at the ECB by Greek banks. Such methods can always be revisited at times of extreme need.

But herein lies the main risk for Greece. The economy needs the only lender of last resort to the banking system to maintain ample provision of liquidity. And this is not just because banks may require resources to help reduce future refinancing risks for the sovereign. But also because banks are already reliant on government issued or government guaranteed securities to maintain the current levels of liquidity constant.

And this risk can become more pressing from a timing perspective. At the heat of the Greek crisis, there was evident deposit and broader capital flight, which Greek banks helped accommodate with ECB’s help via the ELA facility. In the event of a severe Greek government clash with international lenders, interruption of liquidity provision to Greek banks by the ECB could potentially even lead to a Cyprus-style prolonged “bank holiday”. And market fears for potential Euro-exit risks could rise at that point.

Will European assets be affected?

Outside the spectrum of Greek assets, the main question becomes whether Euro-area assets (such as peripheral bonds, the EUR etc) as well as global assets (equities) are likely to be affected by the Greek crisis. We think this is unlikely. Should financial pressures from a Greece related shock hit the peripheral countries formerly in a program (Ireland & Portugal), there may be special arrangements to avert the transmission of the shock locally. Moreover, in our view, the ECB is likely to engage in outright market purchases of sovereign debt securities as part of their monetary policy operations in H12015. We do not think that the volatility from Greece is likely to derail the QE decision.

There is of course the risk of broader contagion, should the participation of Greece in EMU once again be put in doubt. But we think this is a low probability event as the majority of the Greek population is still in favor of EMU parti