Global financial markets have entered a new period of volatility, with events in Europe continuing to dominate the outlook. For investors, the ongoing debt situation in Greece means yet more uncertainty, with the potential for both global shares and commodity prices to suffer.

As the European debt crisis continues to shake financial markets around the world, Greece remains the key source of risk for investors.

The main issue is whether there is still the political will for the beleaguered Greek authorities to continue the fiscal austerity measures required by the EU authorities, the European Central Bank (ECB) and the International Monetary Fund (IMF), collectively known as the troika. Especially if anti-austerity parties gain the upper-hand in the new Greek elections called for 17 June.

If Greece fails to meet its fiscal austerity obligations, there is a real risk that the tap will be turned off, with no more cash flowing from the troika to Greece. Without those funds, Greece may have little choice but to leave the EU, abandon the euro and return to the drachma.

What would a Greek exit mean?

Leaving the EU and abandoning the euro could have medium-term benefits for the Greek economy. But the short-term impact on Greece, the EU and global financial markets could be severe.

Just as with the collapse of Lehman Bros. in September 2008, the unintended consequences may be significant, with the risk of financial contagion very real.

Estimates on the cost of a Greek exit vary widely. Counting both the exposure of the official sector to Greece and the Greek central bank’s liabilities to the ECB, the first-round costs to the EU of a Greek exit could be between €240 billion and €290 billion1.

It seems clear that it would be less expensive for the EU to keep Greece within the union, even with a re-negotiated deal involving a further restructuring of Greece’s debts and a delay in fiscal austerity plans.

One positive is that, unlike the situation when Greece received its first round of financial support, there are now policy tools in place for a new EU protection strategy.

The policy response will need to be big, bold and decisive to ensure the ongoing stability of the EU and the global banking system. That may require other global central banks to join in, possibly including the US Federal Reserve and the Bank of England.

What are the implications for investors?

A Greek exit from the EU would be likely to see markets around the world moving to reduce risk. Possible implications include:

  • A  flight to quality, including the US dollar, US Treasury bonds and German government bonds. That would likely see the Australian dollar and the euro fall against the US dollar.
  • Global share markets could be weak and volatile as investors assess the impact of slower global growth, plus the impact on EU banks and global bank funding.
  • Commodity markets would be likely to fall, with investors concerned that a weaker outlook for the European economy would slow the pace of growth in China and other emerging regions.
  • Banks within the EU could suffer increased volatility and uncertainty.
  • The cost of funds for banks around the world could rise as EU bank capital markets either close or become much more expensive.

The uncertainty is set to continue

At this stage the outlook for Greece, the EU and global financial markets remains clouded in uncertainty. It is this uncertainty that will continue to weigh on investors in the near future.

Meanwhile the EU economy as a whole is heading rapidly towards recession, with some nations already in that position.

With the EU accounting for around 25% of the global economy, a recession in the EU has negative implications for most other economies around the world. Markets are clearly pricing this weakness into their expectations. As a result, investors can expect more volatility ahead until the situation is resolved.

This information is correct at the publishing date, 22 May 2012

 1 Estimates include those from UBS and Barclays on 18 May 2012.

This article first appeared on The Wealth Generation Investor Knowledge Centre