The costs of a Greek exit
Cutting up rough
How much do Greece and the rest of Europe stand to lose?
May 26th 2012
IT COULD come sooner; it might well drag out longer; it can still be averted: but the week following the next Greek election on June 17th still looks set to be the time when the euro zone’s debilitating fever peaks, and the patient’s prognosis becomes clear. That election could well produce a government determined to renege on or radically renegotiate the reforms and austerity measures its predecessor committed the country to at the time of the second bail-out, earlier this year. If that happens, the rest of Europe will have to decide whether to be party to those negotiations or to walk away.
If European leaders follow through on their threats to enforce those terms, the flow of bail-out money to the Greek government will stop. Since March Greece has received half of the €145 billion ($185 billion) it is due to get from the European Financial Stability Facility (EFSF), the euro area’s temporary rescue fund, by the end of 2014. And it has received a first payment of €1.6 billion out of a total €28 billion due from the IMF by
Although the Greek government is close to running a primary budget surplus (ie, before interest payments) it still needs further official loans to honour obligations due this year, notably redemptions of bonds held by the European Central Bank (ECB), which were excluded from the restructuring in March that slashed the face value of €200 billion of debt held by private bondholders by over half. If the lifeline from the EFSF were cut off by its creditor nations, Greece would be unable to pay those debts. And if the ECB makes it a matter of principle not to lend (or permit the Bank of Greece to lend) to banks against collateral consisting of bonds and guarantees from a government in default, then it in turn would cut Greece off. Greek banks currently rely upon some €130 billion of central-bank funding. Without the ECB money the entire banking system would collapse. If the flow of money was reduced, and the conditions it is lent on tightened, the Greek government might start to issue IOUs to its workers to make up the shortfall. If the flow stopped, leaving the banks no euros to pay out, a new currency would be the only alternative.
The government would redenominate domestic bank assets and liabilities into drachma and insist that domestic contracts, such as pay and prices, be also set in drachma. Capital controls would be necessary because the drachma would immediately fall against the euro, possibly losing 50% or more of its value in a trice.
In the short term Greece’s economic agony—its economy shrank by 13% from 2007 to 2011 and is expected to contract by almost 5% this year—would intensify. A precipitous exit without preparation would leave the country without notes and coin. The surrounding chaos would paralyse economic activity, causing consumers and businesses to stop spending. Economists at UBS, a Swiss bank, have estimated that the cost of a catastrophic exit might amount to 40-50% of GDP in the first year.
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That figure assumes that Greece would have to leave the EU as well as the euro, and thus lose access to the single market. On strict legal grounds that may be the case, in part because exit requires capital controls, and those controls are illegal under EU treaties. In practice European policymakers are making it clear they would do their utmost to keep Greece in the EU. Assuming such helpfulness, Mark Cliffe, an economist at ING, a Dutch bank, reckons that the effect would be less. He puts the first-year extra loss of output at 7.5% (see chart).
Run like the wind
If Greece’s new currency avoided lurching into hyperinflation—which in a chaotic country with a weak government and a new currency would be a serious risk—the country might regain some of its losses the following year. Rather than having to spend years grinding down domestic costs, the exchange-rate fall would provide them overnight, boosting competitiveness. If the country looked safe, stable and welcoming, other Europeans would flock to take their holidays in the Aegean.
That is another rather large if; and other Europeans may have a lot more to worry about than holiday planning. European governments would bear losses on the loans they have made to Greece in the various bail-outs. The ECB for its part is exposed in two main ways. Firstly, to calm market tensions after the May 2010 rescue it bought Greek bonds worth about €40 billion. Second, the Bank of Greece owes the ECB around €130 billion in “Target 2” debt, internal obligations within the European central banking system, which would turn into real debt in the event of an exit. All in all, the Greek government owes the governments and institutions of the euro area over €290 billion, about 3% of euro-wide GDP, say economists at Barclays Capital. After an exit most of this would probably never be repaid.
On top of that, there is the exposure of the private sector. At the end of 2011 Greek companies and households owed international banks $69 billion. And, harder to quantify but just as real, there are losses from uncertainty and increased bond yields in other vulnerable countries that will follow from the demonstration that the euro really can be left.
What might this mean in numbers? Recent forecasts by the European Commission project the euro zone’s GDP declining by 0.3% this year, and then growing by 1% in 2013. Mr Cliffe estimates that following an orderly and well-managed Greek exit—one with very limited contagion and some continuing support to Greece from the euro zone and IMF—the euro area would suffer an extra first-year GDP loss of 1.6%, making a mild recession harsher. The other troubled peripheral economies would be hit hardest, though in this model they would increase their commitment to structural reform having seen the alternative. Germany would be least affected. Its economy is in any case forecast to do better than the euro area, expanding by 0.7% in 2012 and 1.7% in 2013; relative to this baseline it would incur a first-year output loss of 1%. America, he thinks, might be hit half that badly.
But could a Greek exit really be contained at its borders? European banks remain worryingly weak, not just in small economies like Cyprus—already in trouble, and very exposed to Greece—but also in large ones like Spain, the fourth biggest in the euro area. Bad loans in Spain have risen by a third over the past year, to €148 billion or 8.4% of outstanding loans, the highest since August 1994. Spanish banks are widely believed to require an injection of public capital of at least €30 billion (3% of GDP) and perhaps a lot more. Borrowing that much would be a hard task for the deficit-stricken Spanish government (which has yet again raised its estimate for last year’s deficit, to 8.9% of GDP).
With Spanish banking woes so prominent (see article), there is a danger of bank runs as citizens of vulnerable economies fear ending up with devalued deposits. Such runs would become much more likely after a Greek exit, but it is possible that they could start before one, and indeed precipitate it—possibly the worst of all bad options. If confined to relatively small economies like already bailed-out Ireland and Portugal this might be manageable. In an economy the size of Spain’s or Italy’s they would be a terrible danger.
The “firewall” which is supposed to protect against contagion is neither designed for bank runs nor adequate to the needs of large economies. At present the EFSF, the temporary bail-out fund, has €250 billion of uncommitted funds which it could use to provide financing for governments that find themselves cut off from the markets or facing punitive rates as they try to save their banking systems. The permanent rescue facility, the European Stability Mechanism (ESM) is due to start in July, but has not yet been ratified by several countries, notably Germany. Even when it does get going, the new lending capacity available from the two funds will be capped at €500 billion, supplemented by possible support from the IMF of up to $430 billion.
Beyond the adequacy or otherwise of the funds’ size, there is the problem of what they can be spent on. If they were used to bail out commercial banks directly, they could break the pernicious circle in which unstable banks use the debt of barely solvent governments to shore themselves up. But as things stand neither the ESM nor the EFSF is allowed to do that. To free them in this way would require both agreements to be ratified again, a politically risky and time-consuming process.
That leaves the ECB as the last bulwark. It could buy bonds again, but this tactic would be less effective than before unless it dropped its insistence on being protected against any future haircut. If it does not, bond investors will regard every purchase it makes as pushing them down the pecking order, thus reducing any residual appetite they might have. It could also provide near unlimited liquidity through yet another huge long term refinancing operation. But this would involve loosening its collateral conditions and exposing the central banks to greater and greater risk.
If neither the rescue funds nor the ECB can do enough, a wider break-up might ensue, with huge costs all around. Mr Cliffe says that a disintegration of the euro would be catastrophic even for core Europe, with first-year output losses of 8.9% for the euro area (as was). This time Germany would not be spared, incurring a GDP loss of 8.2% as its exporters contended with the strength of a reborn D-mark. Across the former euro area, there would be a wave of bankruptcies as firms suddenly found themselves either owed money in a depreciating currency or owing money in an appreciating one.
Currency unions have cracked before, but none with the scale, ambition or interconnectedness of the euro area. Contemplating the dread consequences of such a disintegration may yet prompt concessions from both Greece and its creditors that prevent the worst happening. But can the level of fear be adequate to engender such a change of heart while not so powerful as to trigger panic? Again, the prognosis is uncertain.