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From Special Report: Global Opportunities - May 2012

IA S8-9 280512 Global opps_Eurozone crisis

What happens if Greece exits the eurozone?

By Ted Scott | Published May 28, 2012 | comments

If the rest of the currency union did not finance Greece, the effects of the resulting contagion would be profound.

Although the news has been full of warnings of Greece leaving the eurozone, this saga has been going on for more than two years, leaving many questioning what is different this time.

The significant change is that Greece has had an election without a clear winner. No party has been able to form a government but the voters sent a clear message to its parliament and the politicians in Brussels that the current policy of stringent austerity is unacceptable.

The party with the second largest number of seats is opposed to the terms of Greece’s bailout and particular its austerity measures, and if there is another election next month it is expected to be able to form a government.

If Greece did not then comply with the terms of the bailout it would not receive the funds which are necessary to repay its debts and keep the government functioning.

To coin a phrase, ‘It is different this time’. Greece has failed to implement many of the conditions necessary to qualify for the quarterly disbursements of funds from the bailout when the IMF and EU inspectors travel to Greece to check on their progress.

However, the difference is that there has been a government in power that has previously accepted those conditions and after fraught 11th hour negotiations has agreed to implement enough of them to satisfy the IMF/EU policy makers.

If a new radical government is elected it will have a mandate to oppose the terms of the bailout. In this scenario either the eurozone authorities will have to carry out their threat to force Greece out of the currency union or accede to the demands of the new government.

If it is the latter, the governing authorities will lose all credibility with regard to their ability to enforce discipline in the periphery countries.

Polls suggest that up to 70 per cent of Greeks would like to remain in the euro while a similar number voted for parties that were opposed to the terms of the bailout. In other words the Greeks want the best of both worlds.

The leader of the Syriza party has said that if Greece did not comply with the bailout conditions there is no way that the eurozone would force the country out of the currency union as it has too much to lose.

The only way that the Greeks can get what they want is if the eurozone authorities surrender to the demands of the Greek government. Given recent public pronouncements this is very unlikely although some small concessions, such as an extension of the period to implement the austerity measures, may be made. Therefore, it all comes down to a game of brinkmanship and who blinks first.

Forced to leave

The legal aspect of a departure from the eurozone is a grey area. There is no legal provision in the European treaties for a country to leave the eurozone. However, if Greece defaulted on its debts it would be tantamount to exiting the currency zone.

An added complication is whether Greece would leave the EU as well as the eurozone as there is also no legal provision for leaving the currency union without also exiting the EU. If Greece still wanted to be a member of the EU – but not the eurozone – it would then have to reapply for membership.

Of course, there would be many difficulties in Greece introducing a new currency. Firstly, it would have to decide the exchange value of the new currency. What it may do is to convert euros into new drachmas at a 1:1 rate and then let a floating exchange rate determine the true market value. Based on recent devaluations such as Argentina and Russia the new currency could depreciate by up to 70-80 per cent.

Analysis suggests that it would need to devalue by roughly 40 per cent for Greece to regain competitiveness within the eurozone, but in any event the fall will be large it will probably lose at least half its value against the euro.

Secondly, there is the logistical challenge of introducing a new currency. It cannot be expected that overnight all the ATMs and vending machines can be converted and that day-to-day cash transactions can be done in new drachmas. Ideally, the plan to launch a new currency would be conducted in secret as happened recently with the creation of South Sudan.

However, the exit of Greece has been predicted for a long time so there would be little element of surprise. From a logistical point of view it is possible that cash transactions could still be settled in euros for a limited period before becoming illegal.

As less than 5 per cent of all monetary transactions are settled in cash this may not present too much of a problem and in the meantime the necessary changes, such as converting the ATMs, could be made.

As with any investment decision, such as changing to a cheaper energy supplier, there is a lot of inertia and the average Greek person is concerned about whether he or she has a job and sufficient money to live. Once the devaluation becomes a reality there is likely to be a stampede to get euros out of Greece before they are converted into lower value drachmas. To limit the flight of capital the government may impose exchange controls and secure borders and prevent money leaving the country.

If Greece defaulted and left the eurozone the banks would go bust. The Greek banks hold large amounts of their government’s bonds which would become worthless and, furthermore, the ECB would stop funding the banks.

The Greek banks rely on the ECB for their day-to-day liquidity, especially as they have been losing deposits, and so they would not be able to function. Furthermore, the Greek banking system is due to receive €40bn as part of the second bailout so this would no longer be available. To recapitalise the banking system the new government would have to print new drachmas once the currency conversion had taken place.

If the government had to print money to salvage the banks the spectre of inflation would raise its head. The devaluation of the new currency would already be causing a significant increase in prices due to the rising cost of imports and an ultra-loose monetary policy could make it much worse. Not only would the banks need new capital but the government would have to fund its deficit through the creation of new money. This means that as Greek public sector is still spending more than it receives in taxes and other receipts (called a primary deficit) it would have to cover the shortfall by printing new drachmas.

The other implication of its deficit is that Greece would have to continue to impose austerity measures until it creates a primary surplus. Therefore, far from being better the initial effects for Greece and its population would be devastating.

Uncompetitive nations

The main reason the periphery countries have struggled so much within the eurozone is that they are so uncompetitive. This reflects both the domestic economy where wages, pensions and other costs are too high and also the external account where the euro is at a level that is far too high. While it can and has been working hard to reduce internal costs to improve competitiveness through the austerity measures, Greece can do nothing about the euro exchange rate, which is the same for all 17 members of the currency union. While it is caught in the straitjacket of the currency union it can only become more competitive through ‘internal devaluation’, which has been self-defeating because the economy has shrunk so much. A floating exchange rate provides another means of adjustment to improve competitiveness.

The history of other countries that have devalued recently, such as Argentina, Indonesia, Russia and even Iceland, suggests that after the initial very difficult period of transition that may last a year or two the benefits start to show. Even Iceland is doing quite well now and is able to raise money in the debt markets at reasonable yields.

Greece is tiny in the context of the eurozone (it represents roughly 2 per cent of its GDP) and you are probably wondering why the rest of the currency union keeps on financing it. The reason is that it is not Greece itself that is the problem – it is the contagion it would cause to the rest of the eurozone and even beyond.

A default by Greece could potentially be compared to the bankruptcy of Lehman Brothers that triggered a chain of events that led to the financial recession from which we are still suffering.

Ted Scott is director of global strategy at F&C Investments

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