Risks on the Day After Greece Defaults

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

By Lena Komileva

NEW YORK (BBH FX Strategy) -- Recent market action suggests that investors have largely prepared for the eventual certainty of a Greek credit event, but the markets remain vulnerable to a broader contagion from a eurozone government default across sovereigns, financial sector and risk assets.

Ultimately, the risk is no longer Greek default, but the day after the Greece defaults. This is consistent with our long-held view that the markets are trading the political risk of the EU's management of the crisis rather than the probability of a Greek credit event as such. The distinction is one between a managed and an unmanaged default scenario for Greece. This is what will ultimately mark the difference between a government's solvency crisis and a euro crisis.

The Germany-ECB standoff on the ECB's role in the second aid package for Greece, Greece's inability to fulfill the IMF program conditionality, and the challenge with getting crisis-stricken private bondholders to commit more capital to an insolvent government borrower have started to dissolve the political shield surrounding Greece's default scenarios. But that is the channel of transmission for the political risk. The real economic cost behind it is not so much the direct cost of Greek default but the uncertainty surrounding broader financial stability the day after Greece defaults.

The immediate risk is that a Greek credit event could compromise stabilization processes elsewhere. An unmanaged default (i.e. a "sudden death" scenario) would be almost certain to destabilize stabilization plans elsewhere. Portugal and Ireland could yet succumb to disorderly processes as investors take the view that the probability of default, as a way of resetting debts to sustainable levels, has increased against the options of increased economic integration (internal devaluation that converges core-peripheral productivity and labor costs trends between the core and the periphery) as well as increased fiscal and political integration.

It is a well-known fact that the European Monetary Union is not an optimal currency area but without the prospect (or hope) of long-term convergence in economic, political and monetary trends, financial convergence will come under threat. This means increased volatility in government bond yields and in the euro, which will have a direct knock on effect on the European banking system as a whole and on global capital markets.