Big Fat Greek Crisis: Brace for Return to Drachma

By Rupinder Singh 

The Greeks have voted, their message is clear, and the risk of Greece leaving the euro-bloc has significantly risen.

The rejection of new-but-manageable austerity measures demanded by the European Union has thrown a spanner into the bailout talks, potentially forcing the EU to make very difficult compromises to keep crisis-stricken Greece in the euro. Be that as it may, the ‘no’ vote also is seen as the beginning of Greece’s exit out of the euro.

Up until the referendum on whether to accede to its creditors’ bailout terms, markets were quite optimistic that Greece would reach a deal with Europe and continue to be part of the eurozone. But the comprehensive victory for the ‘no’ camp in Sunday’s referendum has now made its exit more likely than ever.

In light of the latest turn of events, Prime Minister Alexis Tsipras is likely to demand financial support, including debt relief, and reductions to pension cuts and other austerity measures. He also has accepted the resignation of Greece’s out-of-favor Finance Minister Yanis Varoufakis, who had led the negotiations.

The European Union leaders and finance ministers will both hold crucial meetings in Brussels on Tuesday to work out an agreement on a new bailout package with the aim of keeping Greece in the euro. But further compromises on the austerity measures that were voted down in Greek’s referendum are expected to meet with opposition from other eurozone members.

The whole situation brings to fore the possibility of Greece needing to print its own currency to meet its domestic payments and recapitalize its banks that are running out of liquidity. The ECB decided not to increase the emergency liquidity assistance it has been providing. Greek banks remain closed after being shuttered for over a week now and reports indicate that Athens has extended its the bank holiday rather than reopen banks Tuesday, as was the plan earlier. With the ECB showing no inclination to offer more aid, the Greek financial system is seen on the brink of collapse after the introduction of capital controls.

As to what it means for the investors and how should you brace for a possible return to Drachma, here’s a 7-point Greek Crisis investment guide:

• Following the outcome of the Greek referendum, if neither the EU nor Greece gives way, talks could break down and a “Grexit” rapidly become a reality. Sure enough, it is now by far the most likely outcome. The process may begin in days or weeks to come, but it won’t be smooth ride into a new currency, even though the IMF has significant experience in managing the launch of new currencies (they helped former Soviet-bloc countries launch new currencies very successfully). The moment of truth will be July 20, when a €3.5 billion ($3.86 billion) bond repayment to the ECB comes due. If Greece defaults again, the central bank could possibly cut off liquidity assistance altogether, i.e. if it doesn’t after Tuesday’s summit.

• The ‘No’ vote will lead to another round of market weakness. Several large banks and institutional investors already are aligning their investments anticipating a ‘Grexit’. As a result, there is a tactical reduction in exposure to eurozone equities, particularly the banking sector. Greek stocks funds, such as the Global X FTSE Greece 20 ETF (GREK), can be short-sold in the short to medium term.

• Bearish options activity is likely to increase this week as investors buy put options to hedge a future decline in their portfolios. Since the possibility of a short-term stock pullback cannot be ruled out, investors sitting on sizeable gains on their portfolios may want to consider this alternative and purchase comparable number of put options of stock index ETFs, such as SPDR S&P 500 (SPY), SPDR DJIA (DIA), etc. Further, investors having sizeable exposure to sensitive sectors/industries, such as banks, could purchase put options of sector-specific ETFs, for instance, the iShare US Financials (IYF) ETF. Alternatively, industry-specific inverse ETFs could also be bought for the same purpose.

• If there is one lesson that Greek crisis has taught us, it is sharing a currency – without sharing an economy or same economic policy – is not viable in the long term. The reason being, a currency’s value is (or should be) an indication of an economy’s strength, growth, and inflation. But euro’s value is aggregated, with some of its member countries facing headwinds while others experiencing tailwinds. Sooner or later the mismatch will crop up, and at times will be more than some constituent economies can burden. Therefore, the financial system’s inability to control its own currency’s destiny could lead to more exits. Greece is just the first to fall. It should be noted that its gross national debt stands at approx. €226 billion (or $250 billion), which represents about 1 percent of the EU’s annual output. But the main threat comes from contagion. That is if the exit strategy works well for Greece, other members may follow suit. For investors with a little more risk tolerance, there are ETFs that track the equity markets of countries where fear of contagion is comparatively greater, like Spain, Italy, etc. An investor could purchase put options on Spanish and Italian stock ETFs, such as the iShares MSCI Spain Capped ETF and the iShares MSCI Italy Capped ETF.

• One of the best ways to benefit from market uncertainty is by trading the CBOE Volatility Index (VIX)—otherwise known as the market’s fear gauge. The VIX can protect your portfolio from sharp, sudden declines.

• If you are not comfortable with buying options, there is one ETF which tends to have a strong correlation with the VIX index. It is the iShares 20+ year Treasury Bond (TLT) ETF. During periods of high market volatility, investors usually park their fund in safe-haven assets, such as the Treasury Bonds, the U.S. Dollar, Gold, etc. As a result, TLT presents a safe choice for investors in such times. Furthermore, gold has historically done well during crisis periods, but the upside would be more pronounced in euro-denominated – and not in dollar-denominated – gold instruments.

• The majority of Greece’s debt is owed to the IMF and the ECB, which can technically print more money to make up for any shortfall. However, this would lead to depreciation in euro value, especially as the region goes through a period of quantitative easing that is expected to last for another 15 months at least. So selling euro against the U.S. dollar (EUR/USD) makes a sensible trading bet for the next couple of months.

To conclude, despite the resignation of Greek Finance Minister Varoufakis – in an apparent move to facilitate a new deal with creditors – Grexit now seems more likely than ever. The rejection of austerity by more than 60 percent of voters will make it even more difficult for negotiators to put together a bailout package now, not to mention, sans reforms. As a result of Sunday’s ‘no’ vote, an easier route towards a resolution has been ruled out and therefore the risk of a ‘Grexit’ has increased. If Tsipras fails to strike a deal with Europe, it will force Greece to issue its own currency, with a tumultuous interlude with IOUs first. So in view of this big fat Greek crisis, it may be prudent to brace for return to drachma. However your choice of investment instrument and strategy should primarily depend on the fears you would like to address, understanding of instruments and degree of complexity you can handle.

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