After a dramatic weekend, capital controls have been

imposed in Greece and its banks will be closed from Monday 29 June

We answer key questions, including the likely market reaction and how events could play out in the coming days

The risks of Grexit have increased sharply, but we do not think it is inevitable

We updated you on Sunday morning (Greek referendum: playing with fire, 28 June 2015) on the dramatic developments in the negotiations between Greece and its creditors:

The Greek prime minister Alexis Tsipras said on Friday night that he intended to put the latest reform proposal from Greeces creditors to a referendum on 5 July, which was later approved by the Greek parliament. The Greek government has said it will advise a no vote but has committed to implement the agreement in the event of a yes vote

The Eurogroup on Saturday rejected the Greek governments request for an extension of the current programme of financial assistance, due to expire on 30 June, to allow time for the referendum. Funds will therefore no longer be available after 30 June.

On Sunday, the ECB decided not to raise further the limit for the provision of ELA to Greece, leaving it capped at the current level (EUR89bn). The press release says that the Governing Council stands ready to reconsider its decision but, in our view, the ECB will not do so unless negotiations between Greece and its creditors re-start before Tuesday.

After the ECB decision, with reports of some EUR700m of deposit withdrawals from ATMs on Saturday alone and with possibly higher electronic requests for deposit transfers, Greek banks had little option but to remain closed on Monday. Indeed, after a meeting of the Greek Financial Stability Council, it was announced that Greek banks would remain closed on Monday for six working days. But the period could be longer, in our view, even if there is a positive outcome to the referendum, particularly as it is uncertain what a yes or no vote would mean. Capital controls were also announced, with the cashing of cheques halted, fixed-term deposits locked down, and withdrawals from ATMs limited to EUR60 a day.

We address key questions over the likely market response and broader questions such as what happens next and whether a Greek exit from the eurozone can still be avoided.

29 June 2015

Fabio Balboni European Economist HSBC Bank plc +44 20 7992 0374 fabio.balboni@hsbc.com

Janet Henry Chief European Economist HSBC Bank plc +44 20 7991 6711 janet.henry@hsbcib.com

Daragh Maher FX Strategist HSBC Bank plc +44 20 7991 5968 daragh.mager@hsbcib.com

Christopher Attfield Fixed Income Strategist HSBC Bank plc +44 20 7991 2133 christopher.attfield@hsbcib.com

Fredrik Nerbrand Global Head of Asset allocation HSBC Bank plc +44 20 7991 6771 fredrik.nerbrand@hsbcib.com View HSBC Global Research at: http://www.research.hsbc.com

Issuer of report: HSBC Bank plc

Disclaimer & Disclosures This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

Greece crisis

The key questions now

Multi-Asset Europe

Flashnote

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1. Could things change between now and 30 June? The Eurogroup appears to have left the door open for Greece to change its mind before the programme expires on Tuesday. Therefore, if the government made a U-turn before 30 June, in principle it could still be possible to finalise the agreement on the reforms and extend the Greek programme, a key condition for avoiding a default and allowing the ECB to extend the provision of ELA.

Perhaps as a desperate attempt to make the Greek government change its mind on the referendum, the European Commission published on Sunday the text, which includes lower VAT on hotels but this element has been disputed by the Greek government as well, which also appears to contradict many statements of EU policy makers, including the head of the Eurogroup, Jeroen Dijsselbloem, that further debt relief was not on the table (at least not until a third programme had been agreed, which is the reason why the IMF would not have disbursed any funds until October even if agreement had been reached with the Eurogroup last week).

The leader of the main opposition party, New Democracy and former prime minister, Antonis Samaras, issued a call on Sunday to Syriza to cancel the referendum plan and try to form a national unity government. However, up to now, the Greek government has remained firm in its intention to hold a referendum, and a sharp U-turn on this is likely to create a split among Syrizas MPs, and as we wrote over a month ago (Greece: still gaps to bridge, 11 May), at this stage, a referendum might be the only face-saving strategy for Syriza.

If there is a U-turn and the referendum is called off, however, it is exceptionally unlikely that capital controls will be eliminated immediately. Experience shows that once capital controls are in place, it takes some time to return to normality. Iceland still has capital controls in place after seven years, whilst Cyprus had them for a little longer than two years. In any case, with Greece under a programme, the situation could slowly return to normality. Similarly, the EUR 1.55bn IMF payment on 30 June is likely to be missed. Even the disbursement of the EUR1.9bn ECB profits from its holdings of Greek government bonds would be pending the Greek parliament approving the new deal and passing at least a first set of laws on reforms. In addition, the money would only be released after eurozone national parliaments endorse the principle of disbursing such profits. However, as reiterated by an EU official on Friday, being in arrears with IMF for a few days is not the end of the world as long as there is a clear deal.

2. Will Greece miss the IMF payment on 30 June? And what happens next? Unless the Greek government makes a U-turn in the coming days, it is almost inevitable that Greece will miss the IMF payment on 30 June. S&P on 15 June issued a statement that non-payment of the EUR7.7bn of Greek bonds held by the ECB which mature on 20 July and 20 August would not, per se, constitute a default under its criteria, because the ECB is not considered a commercial creditor. We would expect it to take a similar approach with regards to a missed payment to the IMF. However, given the circumstances, the IMF is likely to promptly notify the board of this, as the director of communications, Jerry Rice, said last week, rather than waiting for a full month. The ESM could at that stage request an early repayment of the loans provided to Greece, which would trigger a cross-default to the other asset classes. Possibly even more importantly from the prospects of Greece leaving the eurozone, it would raise even

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further concerns among ECB board members about the appropriateness of continuing to provide liquidity to Greek banks, not just not increasing the limit.

The government has to pay wages and pensions at the end of the month, and it will need around EUR1.5bn. We dont have the latest figures on government deposits by the central bank, but there is a possibility they might have to issue IOUs in lieu of payment. This may not necessarily be an acute problem in the very short term given that banks are closed and limits on the amounts that people can withdraw by the ATMs, but not receiving the money might exacerbate some of the social anger.

Another important element to keep into consideration is the T-bills. With banks no longer having access to ELA, it is far from certain they will be able to roll-over the T-bills coming to maturity (the next one is a EUR2bn 26-week T-bill on 10 July), as they have been doing so far, putting the countrys finances into an even more difficult situation.

3. What if the outcome of the referendum is a "Yes" to the creditors' proposal? First, it is not clear what the Greek population will be voting on. IMF Director Christine Lagardes stated that legally speaking, the referendum will relate to proposals and arrangements that are no longer valid". At this point, however, we assume that the referendum will go ahead and that the population will be asked in broad terms whether it agrees with the creditors' proposal. We have so far only found the results of one opinion poll, conducted by Kappa research on Saturday for "To Vima" newspaper. In response 47.2% said they agreed with the deal proposed by the creditors, 33.0% said No, 18.4% undecided, and 0.8% didn't know or wouldn't answer. Presumably, their votes could shift in the coming days depending on how the financial, economic, and political situation unfolds.

If the referendum results in a yes, the Greek government has said it stands ready to implement the agreement. Mr Varoufakis even stated on Saturday that it would do so "even if it means a reconfigured government". Even if the referendum gives the Syriza government an excuse to make a U-turn, it would appear that there has been such a big breakdown of trust between the current government and its creditors that the Eurogroup's offer really is no longer available to the current Greek administration. Indeed, Mr Dijsselbloem on Saturday expressed major concerns about the credibility of the promise by the Greek government that it would implement the proposal if the referendum result is a vote in favour. He noted that programme ownership by governments has been crucial for ensuring their success in other eurozone countries. Therefore, realistically, there would need to be more than a government reshuffle before a new deal could be struck.

A government of national unity or a swift move to hold new elections in Greece might be needed but the latter would mean a prolonged period of uncertainty with no guarantee that a different government will be elected. Hence, the formation of a government of national unity, which is formed following a strong majority for the "Yes" vote in the referendum and which is willing to negotiate a credible programme with the creditors (and the continued provision of ELA) would appear to currently offer the best prospect of Greece being able to avoid Grexit. But it would have to start from scratch in terms of negotiating a whole new programme given that the current one will have expired on 30 June.

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4. Does a no vote means Greece will exit the eurozone? Also if there is a no vote, it is not clear what that would mean. The current Greek government might have given the Greek population the hope of a better deal if it voted against the proposal, but so far the position of the eurozone has been very firm. This point was also made in the debate in the Greek parliament on Saturday night, with Greece's former prime minister, Antonis Samaras, telling parliament that a no vote would mean bankruptcy and a euro exit.

When Mr Varoufakis stressed that Sunday's vote was not a referendum on Greek membership of the eurozone, he reiterated that there are no provisions in the EU treaties for a country to leave the eurozone; only to leave the EU. This suggests that the Greek government might believe that it could refuse to leave the euro even if it does not accept the creditors' proposal. Our understanding is also that there are no legal provisions for a country to leave the eurozone, and that the exit from the EU has to happen through a negotiated process. However, the rest of the eurozone would have the means, in our view, to make such an outcome inevitable, starting with the ECB ceasing to provide liquidity to the Greek banks, stopping EU funds, and imposing financial penalties. This could quickly leave the Greek government in the position of being unable to pay public sector wages and salaries and having to write IOUs and accumulate further arrears.

But at least so far, there does not appear to be unanimity within the rest of the eurozone on the next steps to take towards Greece, with resistance towards a possible Greek exit from the eurozone particularly among the southern European countries: the French Finance Minister Michael Sapin offered on Saturday to be a mediator between the requests of Greek government and the creditors, the Italian Prime Minster Matteo Renzi tweeted on Friday that Greeks need to know theres very strong pressure to use this window to close pending issues and eject Greece from the euro and the Cypriot Finance Minister Harris Georgiades said today that the Eurogroup should have extended the Greek programme until after the referendum.

5. How long can Greece keep capital controls, and will the ECB cut ELA? Capital controls are against the EU treaty, and can be imposed only in "exceptional" and "temporary" circumstances. The rest of the EU, however, will probably tolerate them at least until the referendum has taken place, and the current situation of impasse - both political and on the future of the Greece within the eurozone - is resolved. Indeed, the Eurogroup itself said that "The institutions stand ready to provide technical assistance to safeguard the stability of the Greek financial system". But in a situation in which Greece is not willing to cooperate, the illegality of capital controls could be used to undertake initiatives against Greece, such as financial penalties and withdrawal of funds allocated to Greece from the EU budget. These could put Greece in a position to decide whether to come to an agreement, or leave the EU.

Stopping the ELA from rising further was really the only option the ECB had for the moment. The ELA provided so far has already gone to the Greek people in forms of bank notes, and had the ECB decided to reduce, or withdraw the ELA completely, it would not have been possible to do so. This would have therefore caused an immediate default for the banks, which would have had to give to the ECB the collateral used for the ELA (Greek bonds, T-bills, and a large variety of Greek assets). Therefore, for the moment, the most likely scenario is that the ECB will keep the ELA limit as it is, and only withdraw it if

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it becomes certain that Greece is headed for an exit (in which case, it would also mean that the collateral will not be worth much).

6. What about the medium-term implications? As we have explained in previous notes (see for instance Greece crisis: the top ten questions, 16 June), if this is indeed the end of the road for Greece within the eurozone, we believe that Grexit would inflict major damage on the monetary union and the rest of Europe, even though some are of the view that the monetary union would be stronger for having rid itself of the bad apple and that Greeces economy would revive on the back of currency devaluation. While we accept that, in a world of QE and OMT the initial market reaction may not be huge, there can be no doubt that a country leaving the euro would change the fundamental nature of the eurozone. The medium and long-term implications could be very large indeed: economically, politically, and geopolitically. It would be a currency union where the risk of exit was greater than was previously the case: a union where any country still battling with large budget deficits and high government debt would probably face a permanently higher risk premium now that we would know that it is indeed possible for a member state to leave the euro. At the first sign of bad news, be it signs of a budget deficit overshooting or a recovery faltering, or anti-euro parties doing well in the polls, market pressure could quickly return.

7. What instruments can the ECB and other EMU institutions deploy to contain any contagion if Grexit happens? In the press conference on Saturday, Mr Dijselbloem highlighted the various measures, frameworks, and institutions which had been put in place since the crisis, claiming that the monetary union was "in a much stronger position" and that eurozone member states intend to "make full use of instruments available to preserve the integrity and stability of the euro area.

Concretely, the ECB could increase the rate of purchases of sovereign bonds under the QE programme, having already effectively started to do so after ECB board member Benoit Cour announced it on 19 May . While QE could help to calm the markets, it does not necessarily reduce the systemic risk, taking into account the limited risk-sharing: only about 9% of the sovereign bonds purchased sit on the ECB balance sheet, while the rest remain on the balance sheet of the national central banks. From this point of view, the Outright Monetary Transaction (OMT) programme announced in October 2012 is a more adequate instrument to limit the risk of contagion, but its usage requires a country to request a programme of financial assistance to be activated, which could be difficult in some countries also in light of the recent rise of euro-sceptic parties.

Progress has also been made in terms of banking union, with the recapitalisation of European banks, which are now in a much better shape according to the AQR results in October last year, but with still limited progress on issues such as a proper backstop to the single resolution fund and an adequate system of deposit insurance. But progress on fiscal union has been limited, with the focus so far only on fiscal governance and stricter rules, but no concrete action towards a eurozone budget and joint issuance.

In light of this, we are of the view that further actions might have to undertake in the future to limit the risk of contagion to other countries. And indeed, the ECB today in its statement: https://www.ecb.europa.eu/press/pr/date/2015/html/pr150628.en.html welcomed in particular the

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commitment by ministers from euro area Member States to take all necessary measures to further improve the resilience of euro area economies and to stand ready to take decisive steps to strengthen Economic and Monetary Union

8. What are the other eurozone countries' exposures to Greece? Eurozone banks have significantly reduced their exposures to Greece since 2010, and German banks remain the only countries with exposures in excess of EUR10bn (source: BIS, as at December 2014). Public sector exposures are large, EUR195bn in loans to Greece, and another EUR116bn through the ECB. Hence, in total exposures would be around 3% of the eurozone GDP, most of which would have already been accounted for in the eurozone countries debt. The overall impact appears, therefore, manageable, from a financial perspective.

Selected EU countries financial exposures to Greece

EURbn Banking sector Loans ECB (ELA + SMP)* Total

Germany 11.0 52.6 32.7 96.3 France 1.4 41.5 25.7 68.6 Italy 1.1 36.0 22.4 59.5 Spain 0.3 25.9 16.1 42.2 Netherlands n/a 11.7 7.3 19.0 Belgium n/a 7.2 4.5 11.7 Austria 0.1 5.7 3.6 9.4 Finland n/a 3.7 2.3 6.0 Slovenia n/a 1.0 0.6 1.6 Luxembourg n/a 0.6 0.4 1.0 Estonia n/a 0.6 0.4 0.9 Cyprus n/a 0.4 0.3 0.7 Malta n/a 0.2 0.1 0.3 UK 10.0 n/a n/a 10.0 * Liquidity provided by the ECB with EFSF bonds as collateral (EUR38bn) was not included in the calculations, as the ECB would retain the collateral. ELA is backed by Greek assets as collateral. Source: ECB, Bank of International Settlements, HSBC

Market reaction

9. What will happen to the EUR/USD exchange rate? The reaction to the weekend events is likely to be a lower EUR and a broader risk off mood in the FX market. The running assumption until this weekend was that some deal would be struck between creditors and Greece at the last minute. While this is still possible, the confidence the FX market will have in this outcome will have declined materially in recent days. We believe this will be echoed in a lurch lower in the EUR. Other currencies will mirror the risk off mind-set, with USD, JPY, and CHF to capitalise. GBP might also join the list of near-term winners. EM FX will struggle, particularly the fragile five and MYR, RUB, and MXN.

Beyond the near-term reaction, we expect heightened FX volatility. The market will swing in quick succession between fearing Grexit or anticipating a deal, depending on the latest headline. This will make for choppy sentiment regarding the EUR, with good news likely to bring the 15 May high of 1.1469 for EUR-USD into focus while bad news will drive the rate lower towards parity. We would be cautious about chasing any knee-jerk safe haven GBP rally as Grexit may simply highlight the GBPs sensitivity to future Brexit fears. We may flip back and forth between risk off and risk on. In the end though, Grexit fears have been justifiably heightened by recent events and until there is clarity on the outcome,

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the tendency towards risk off is likely to add fuel to the fire that has seen EM FX struggle on a number of fronts. The KRW, TWD, SGD, and RMB may be relative outperformers.

10. Will there be contagion to the eurozone periphery bond market this week? There will certainly be a reaction. Periphery-core spreads were at the tighter end of their recent range after the optimism of last week, and the market consensus was overwhelmingly in favour of a deal being done. The weekends events will jolt the bond market out of its complacency, and will force it to price in a lot of new possibilities including the tail risk of a de facto euro exit for Greece. Given this, HSBC FI research thinks it likely that spreads of periphery countries to the core will snap back to their recent wides (c160bp for Spain and Italy). The impact of a flight to quality could have most effect on Bunds, and should draw a line under the last two months' core sell-off. We also note that price action will be very headline-dependent, and last-minute diplomatic efforts in the next 48 hours should not be discounted.

However, that leaves the crucial question of where periphery spreads should be trading given the increased possibility of a Greek exit scenario. We think it important to bear in mind that the direct contagion channels that existed in 2011 simply do not exist today: only EUR39bn (12%) of Greek Sovereign debt is in private hands, the asset quality of the euro area banking system has been scrutinised by the ECBs Asset Quality Review (AQR), and the other periphery sovereigns are financed far more robustly (for example, Portugal is already funded for the remainder of 2015). The only vectors of contagion, in our view, are political and sentiment-based. We think the chances of any Portuguese or Spanish government being elected in 2015 that would set them on a similar course to Greece are negligible, leaving sentiment as the key factor. The ECBs determination to use all the instruments available within its mandate should be a calming factor: we see a short-term risk-off move as all but inevitable, but this could ultimately give a buying opportunity in the periphery when the dust settles.

11. What are the implications for the other asset classes? The current situation in Greece is less a function of the economic trade linkages or bank exposures with Greece than it is about the political risks. That is, once a potential Grexit takes place what does that imply for the rest of the political landscape in the eurozone? It is through this channel the contagion is likely to drive risk premia. In our mind, in any future downturn in economic growth in the eurozone, the market will be quick to draw parallels with the current scenario. This should amplify the volatility associated to these events. Therefore, we would argue that the impact on markets is not just a short term issue but one of heightened risk premia over the long term. While the ECB is supporting rates markets through its QE programme, the impact of higher risk premia may be mostly felt in FX and equity markets. It is worth noting that ECB QE is mostly a function of inflationary/deflationary pressures. If QE was extended on the back of greater deflationary pressures, this could actually act as a support for credit markets over the medium term. However, in the near term, some volatility will be felt in credit as well though especially in secondary markets.

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Disclosure appendix Analyst Certification The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report: Fabio Balboni, Janet Henry, Daragh Maher, Chris Attfield and Fredrik Nerbrand

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Front Page (Page View)Greece crisis1. Could things change between now and 30 June?2. Will Greece miss the IMF payment on 30 June? And what happens next?3. What if the outcome of the referendum is a "Yes" to the creditors' proposal?4. Does a no vote means Greece will exit the eurozone?5. How long can Greece keep capital controls, and will the ECB cut ELA?

6. What about the medium-term implications?7. What instruments can the ECB and other EMU institutions deploy to contain any contagion if Grexit happens?8. What are the other eurozone countries' exposures to Greece?Market reaction9. What will happen to the EUR/USD exchange rate?10. Will there be contagion to the eurozone periphery bond market this week?11. What are the implications for the other asset classes?

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