Policy response to Greece poll outcome key to mkts: BoFA-ML

Although crucial Greece elections over the weekend will be a key catalyst to Eurozone's future, Gary Baker of BofA Merrill Lynch Global Research believes Spain and Italy have snowballed into bigger problem areas that will influence global markets.

In the coming week, market will be driven by two factors: policy decision in the event of a `no' vote on Greece, and bank recapitalization plans of Spain. He analyses that when policy makers concentrate on one problem, markets shifts its focus on next weakest link and the contagion spreads. Baker also thinks Europe is headed towards some form of "inevitable" union of fiscal, banking or political. Below is an edited transcript of Gary Baker's interview on CNBC-TV18. Also watch the accompanying video. Q: What do you expect to see from Greece? Will there be a clear decision in terms of whether Greece is in or out from the eurozone and how do you think markets will read that? A: I think that is the central question for everything. In some ways what's happening in Greece is important because of the catalyst it can provide one way or the other for the wider crisis. But I think the situation in Greece is been slightly overtaken by situation in Spain and Italy and in sovereign bond markets. Greece will make a difference whether there is a no vote or yes vote, I think it's going to be very quick. Any market reaction is going to be subsumed by two things. One, the policy response that you would expect if there is a no vote; Two, where Spain is trading next week as you get details on the bank recapitalization plans coming out at the end of next week. Q: We got a USD 100 billion package for Spain but the market seemed to be quite unimpressed with that. Do you think the way yields have gone up in Spain since a lot more needs to be done? A: I think it's a good number, a USD 100 billion had the initial headline effect and impact that they wanted to achieve, but it was quickly found to be lacking in two things of what it actually represented. This wasn’t any sort of mutualization of debts or third party recapitalization of Spanish banks. This was just essentially a soft loan from the EU to Spain. So that had the effect of immediately increasing Spanish debt burden. Secondly you still have these issues of what happens if the EU offers this loan? Are they then senior to other bondholders. So actually the effects to worsen your situation as Spanish investor and I think the depressing thing for markets was it didn’t seem that these things had been thought through necessarily. So you got another situation of a piecemeal response that on surface looked sensible, but was still lacking in detail and a wider perspective to include Italy and other problems out there. Q: You were talking about more action and there has been a lot of talk about the need for more bank integration in Europe or even common euro bonds. What do you think is the next step from the authorities there? A: I think for many, if you look at the situation on a wide enough perspective then ultimately some form of closer union, fiscal, banking ultimately political seems inevitable. It’s going to be part of the solution if they are going to go down that route. But I don’t think anyone is hiding from just how daunting a task that is to actually get to that point. So as ever in the EU crisis, like any crisis, there is a short, medium and long-term. While Germany is trying to concentrate on medium and long-term structural solutions, the market is forcing the pace from what the shorter term trading environment looks like, and that's being played out in peripheral bond markets at the moment. Q: The problem seems to be not of limiting the contagion, but that the contagion has already happened. Markets like Italy for instance are showing quite a bit of worry in terms of the news flow from there. How high is that contagion risk and what happens through the course of the next six months? A: I think inevitably the evidence or the experience on these things is that if you just deal with one country at a time then the market quickly moves on and focuses on what they regard as the next weakest link in the chain and by association you have seen the reaction on Italian financials in particular this week. That’s where the market seems to be focusing next. So until there is a more comprehensive plan or approach of re-establishing confidence across the whole of the EU rather than individual countries, it seems inevitable, but that the process will continue.