The recent market rally in the euro and equity markets, despite concerns about a Greek default, suggest that the market is becoming more relaxed about the idea of a Greek default. Either that or they believe such an event won’t be the big deal that it was first believed it would be as recently as six months ago.

Recent comments from EU commissioners, as well as senior EU leaders certainly suggest that just such an event is now being prepared for, despite EU President Barroso’s comments to the contrary yesterday.

It has been noticeable that both French President Sarkozy and German Chancellor Merkel have started to adopt a much firmer line, with Sarkozy insisting that Greece has no choice but to sign up to the new bailout agreement.

With EU leaders openly talking about the possibility of a Greek default the key question needs to be is such an event priced in to the market or not.

The recent rise in asset prices seems to suggest one of two things, either that the markets assumes that a deal will be reached at the last moment, or that the alternative may not be that big a deal and as such containable, due to the recent actions of the ECB in bringing down sovereign bond yields across Europe, by way of its successful LTRO’s.
While not wishing to second guess this assumption, this view could well be misplaced and complacent.

The political landscape in Greece suggests that even if a deal is agreed, implementing it could be well-nigh impossible so the question is not whether a default is avoided, but to when it is deferred.

The latest economic data from Greece suggests further deterioration with a drop in tax revenues of 7% in January, against an expectation of an 8.9% rise.
In the event of a default the most exposed banks to Greek debt are French and German banks, according to BIS stats from the end of September.

Thanks to Reuters Scott Barber for this.

These figures suggest that in such an event the French and German governments may well be asked to bailout some of these banks, certainly French banks would be under most scrutiny.

If the French government were to bailout their banks, and the credit ratings of these banks certainly reflect this, then we could see the French government’s contingent liabilities increase as a result, which in turn will place even greater strain on the country’s remaining triple “A” credit ratings, with Fitch and Moody’s, given that it is already under strain from the Standard and Poor’s downgrade.

There is also the residual knock on effect on the EFSF which could easily find itself stripped of its remaining triple “A” ratings as well, thus eroding the amount of money available for further bailouts, given that there is talk of running it alongside the ESM.

If as expected Portugal comes under pressure as well, and there is plenty of evidence to suggest that it will, then you could well see pressure increase for a PSI agreement here as well. Here the strains are somewhat different, with Spanish banks most exposed to Portuguese debt, which in turn would make the Spanish governments room for manoeuvre much more difficult, going forward, in terms of further budget savings.

It remains to be seen how any of this will play out but the current market rally could well come to a shuddering halt if the small pebble in the pond that is Greece causes a ripple effect through to Portugal and Spain.