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Analysis: Euro twilight zone beckons for Greece

By Mike Dolan

LONDON (Reuters) – Speculation about an endgame in Greece’s protracted crisis has flooded markets with euro exit scenarios this week, but investors reckon there’s still every chance that uncertainty will simply drag on for months.

Seeking clear-cut outcomes to the euro saga to date has proven fruitless for investors, who have instead been forced to live with the “muddle through” of European politics.

And more used to precedent, probabilities and precise numbers, asset managers are far from their comfort zone when interpreting the hyper-politicized standoff over Greece’s future membership of the single currency.

So instead of mapping binary outcomes, investment strategists are once again looking hard at the grey areas.

The political vacuum in Greece after May 6′s inconclusive elections seems to have hastened a showdown where no government in Athens can deliver more budget cuts, so no more bailout funds are forthcoming and public money drains away, leading to mass defaults and a euro exit with all its wider ramifications.

And if that’s the will of the Greek people, then it may be tempting for all sides to try and manage the outcome as best they could. But nothing’s that simple. Even though Greek voters rejected austerity in favor of anti-bailout parties, opinion polls show more than 75 percent want to stay in the euro.

What happens when the cash runs out is the crux question. Greece will most likely need more outside funds from its bailout program before any new elections in June establishes a fresh mandate to secure further tranches of foreign money.

So what analysts are homing in on is whether Greece can bridge any gap while still staying in the euro.

IOU OR PROXY DRACHMA?

Many are looking at the possibility that Athens issues IOUs to meet salaries and key service bills for a fixed period, much in the way California did during its budget crunch in 2009 when it issued ‘registered warrants’ with a coupon in place of dollar salaries and which banks then accepted for cash.

Much hinges on whether the European Central Bank would allow the Greek central bank to accept such IOUs and there’s little clarity on those hypotheticals.

However, strategists reckon any Greek government IOUs would quickly act as a proxy for a new drachma and exchange values against the euro would mostly likely plummet in practice as people rushed to cash out – offering Greeks a glimpse of the shock of devaluation in a euro-ized economy with euro-denominated debts.

“I’m really not sure Greece could survive for very long if external money was cut off,” said Darren Williams, economist at fund manager AllianceBernstein. “But what an experience of IOUs may do rather quickly is bring home to the average Greek citizen just how much more difficult a place it is outside the bailout program and outside the euro.”

Others said that such an unstable twilight zone within the euro but with a parallel proxy drachma could possibly last for several months as the euro policy machine churned.

“Whether it is something that lasts six to 12 months or something that lasts longer term depends on how many IOUs they have to put out,” said Erik Neilsen, global chief economist at Unicredit. “And that will be a function of how deeply the economy collapses.”

The limits of any half-way system hinge on domestic depositors’ anxiety and the risk of accelerated capital flight from Greek banks. It would be hard to calm fears of capital controls and, as per Argentina’s break with its dollar peg in 2002, forced conversion of euros in Greek banks into new drachmas.

But this is where the story changes. Depositor concerns in Greece could well infect other periphery euro economies and cause consternation – upping the ante for euro policymakers to respond, either through fresh action from the European Central Bank to reliquify banks or open-ended government bond buying.

RBS analysts warned on Monday that in the event of another hung parliament “Greek government IOUs could trade as proxy currency as early as July. This may then galvanize a large pro-euro vote intention into accepting Troika demands. If not, exit looms.”

But they added that only returns investors to guessing about wider policy responses.

“Opening up the Pandora’s box of exit means deposit risk across the periphery. The future of the euro would then be dictated by the subsequent policy response.”

Seeing binary outcomes by fixed deadlines still seems a dangerous way to invest on this and daily scenario sketching is probably a safer option through a likely fraught summer period.

David Shairp, global strategist at JPMorgan Asset Management, said the situation was “incredibly fluid” but one possibility was certainly prolonged stalemate, one that may be better for world markets than a dramatic end-game but carrying all the gnawing uncertainty along too.

“Increasingly we’re dealing in the realms of political economy rather than pure economy and that makes things so much more difficult for multi-asset investors.”

(Additional reporting by Swaha Pattanaik; graphic by Scott Barber; Editing by Ruth Pitchford)

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