If
Greece Exits, Here Is What Happens
13
May, 2012
Now
that the Greek exit is back to being topic #1 of
discussion, just as it was back in the fall of 2011, and the media
has been flooded by groundless speculation posited by journalists who
have never used excel in their lives and are merely paid mouthpieces
of bigger bank interests (long live access journalism and the book
sales it facilitates), it is time to rewind to a step by step
analysis of precisely what will happen in the moment before Greece
announces the EMU exit, how the transition from pre to post occurs,
and the aftermath of what said transition would entail, courtesy of
one of the smarter minds out there, Citi's Willem Buiter, who
pontificated precisely on this topic last year, and whose thoughts he
has graciously provided for all to read on his
own website.
Of course, take all of this with a huge grain of salt - these are
observations by the chief economist of a bank which will likely be
swept aside the second the EMU starts the post-Grexit rumble.
From
Willem Buiter
What
happens when Greece exits from the euro area?
Were
Greece to be forced out of the euro area (say by the ECB refusing to
continue lending to Greek banks through the regular channels at the
Eurosystem and stopping Greece’s access to enhanced credit support
(ELA) at the Greek central bank), there
would be no reason for Greece not to repudiate completely all
sovereign debt held by the private sector and by the ECB.Domestic
political pressures might even drive the government of the day to
repudiate the loans it had received from the Greek Loan Facility and
from the EFSF, despite it having been issued under English law. Only
the IMF would be likely to continue to be exempt from a default on
its exposure, because a newly ex-euro area Greece would need all the
friends it could get – outside the EU. In the case of a
confrontation-driven Greek
exit from the euro area, we would therefore expect to see around a 90
percent NPV cut in its sovereign debt, with 100 percent NPV losses on
all debt issued under Greek law, including the debt held, directly or
directly, by the ECB/Eurosystem. We would also expect 100 percent NPV
losses on the loans by the Greek Loan Facility and the EFSF to the
Greek sovereign.
Consequences
for Greece
Costs
of EA exit for Greece are very high, most notably the damage done to
balance sheets of Greek banks and nonfinancial corporates in
anticipation of EA exit.
We
have recently discussed at length what we think would happen should
Greece leave the euro area (Buiter and Rahbari (2011)), so we shall
be brief here. Note that we assume that Greece exits the euro area
and does not engage in the technical fudge discussed in Buiter and
Rahbari (2011), under which it technically stays in the euro area but
introduces a second, parallel or complementary currency.
The
instant before Greece exits it (somehow) introduces a new currency
(the New
Drachma or ND, say).
Assume for simplicity that at the moment of its introduction the
exchange rate between the ND and the euro is 1 for 1. This currency
then immediately depreciates sharply vis-Ã -vis the euro (by 40
percent seems a reasonable point estimate). All pre-existing
financial instruments and contracts under Greek law are redenominated
into ND at the 1 for 1 exchange rate.
What
this means is that, as
soon as the possibility of a Greek exit becomes known, there will be
a bank run in Greece and
denial of further funding to any and all entities, private or public,
through instruments and contracts under Greek law. Holders of
existing euro-denominated contracts under Greek law want to avoid
their conversion into ND and the subsequent sharp depreciation of the
ND. The
Greek banking system would be destroyed even before Greece had left
the euro area.
There
would remain many contracts and financial instruments involving Greek
private and public entities denominated in euro (or other currencies,
like the US dollar) that are not under Greek law. These would not get
redenominated into ND.
With part of their balance sheet redenominated into ND which would
depreciate sharply and the rest remaining denominated in euro and
other currencies, any portfolio mismatch would cause disruptive
capital gains and losses for what’s left of the Greek banking
system, Greek non-bank financial institutions and any private or
public entity with a (now) mismatched balance sheet. Widespread
defaults seem certain.
As
discussed in Buiter and Rahbari (2011), we believe that the
improvement in Greek competitiveness that would result from the
introduction of the ND and its sharp depreciation vis-Ã -vis the euro
would be short-lived in the absence of meaningful further structural
reform of labour markets, product markets and the public sector.
Higher domestic Greek ND-denominated wage inflation and other
domestic cost inflation would swiftly restore the old uncompetitive
real equilibrium or a worse one, given the diminution of pressures
for structural reform resulting from euro area exit.
In
our view, the bottom line for Greece from an exit is therefore a
financial collapse and an even deeper recession than the country is
already experiencing - probably a depression.
Monetising
the deficit
A
key difference between the ‘Greece stays in’ and the ‘Greece
exits’ scenarios is that we believe/assume that if Greece remains a
member of the euro area, there would be official funding for the
Greek sovereign (from the Greek Loan Facility, the EFSF and the IMF),
even after the inevitable deep coercive Greek sovereign debt
restructuring, and even if NPV losses were imposed on the official
creditors – the Greek Loan Facility, the EFSF and the ECB. The ECB
probably would no longer engage in outright purchases of Greek
sovereign debt through the SMP, but the EFSF would be able to take
over that role following the enhancement and enlargement of the EFSF
later in 2011.4 If Greece remains a member of the euro area, the ECB
would likewise, in our view, continue to fund Greek banks (which
would have to be recapitalised following the Greek sovereign debt
restructuring), both through the regular liquidity facilities of the
Eurosystem and through the ELA.
In
the case of a (confrontational and bitter) departure of Greece from
the euro area, it is likely that all official funding would vanish,
at least for a while, even from the IMF (which would, under our most
likely scenario, not have suffered any losses on its loans to the
Greek sovereign). The
ECB/Eurosystem would, of course, following a Greek exit, cease
funding the Greek banks.
This
means that the Greek sovereign would either have to close its budget
gap through additional fiscal austerity, following its departure from
the euro area, or find other means to finance it. The gap would be
the primary (non-interest) general government deficit plus the
interest due on the debt the Greek sovereign would continue to serve
(the debt issued under foreign law other than the loans from the
Greek Loan Facility and the EFSF, and the debt to the IMF), plus any
refinancing of this remaining sovereign debt as it matured. We expect
the Greek General Government deficit, including interest, to come out
at around 10 percent of GDP for 2011, while the programme target is
7.6 percent. General government interest as a share of GDP is likely
to be around 7.2 percent of GDP in 2011, which means that we expect
the primary General Government deficit to be around 2.8 percent of
GDP. We don’t know the interest bill in 2011 for the IMF loan and
for the outstanding privately held debt issued under foreign law. If
we assume that these account for 10 percent of the total interest
bill on the general government debt – probably an overestimate as
interest rates on the IMF loan are lower than on the rest of Troika
funding – then we would have to add 0.72 percent to the primary
deficit as a percentage of GDP to obtain an estimate of the budget
deficit that would have to be funded by the Greek government, say 3.5
percent of GDP. We would have to add to that any maturing IMF loans
and any maturing privately held sovereign debt not under Greek law.
This is on the assumption that even those creditors under
international law that continue to get serviced in full, would prefer
not to renew their exposure to the Greek sovereign once they have
been repaid. In addition, future disbursements by the IMF under the
first Greek programme would be at risk following a Greek exit. This
would create a further funding gap.
Assume
the Greek authorities end up (very optimistically) having to find a
further 5 percent of GDP worth of financing. This could be done by
borrowing or by monetary financing. Borrowing
in ND-denominated debt would likely be very costly.
Nominal interest rates would be high because of high anticipated
inflation – inflation that would indeed be likely to materialise.
Real interest rates would also be high.
Although
the Greek sovereign’s ability to service newly issued debt would be
greatly enhanced following its repudiation of most of its outstanding
debt, the default would raise doubts about its future willingness to
service its debt.
Default risk premia and liquidity premia (the market for
ND-denominated Greek debt would be thin) would raise the cost of
borrowing in ND-denominated debt. Even if the Greek authorities were
to borrow under foreign law by issuing debt denominated in US dollars
or euro, default risk premia and liquidity premia would likely be
prohibitive for at least the first few quarters following the kind of
confrontational or non-consensual debt default we would expect if
Greece were pushed out of the euro area.
So
the authorities might have to finance at least 5 percent worth of GDP
through issuance of ND base money, under circumstances where the
markets would inevitably expect a high rate of inflation. The demand
for real ND base money would be very limited. The country would
likely remain de-facto euroised to a significant extent, with euro
notes constituting an attractive store of value and means of payment
even for domestic transactions relative to New Drachma notes. We have
few observations on post-currency union exit base money demand to
tell us whether a 5 percent of GDP expected inflation tax could be
extracted at all by the issuance of ND – that is, at any rate of
inflation. If it is feasible at all, it would probably involve a very
high rate of inflation. It is possible that we would end up with
hyperinflation.
The
obvious alternative to monetisation is a further tightening in the
primary deficit through additional fiscal austerity (of something
under 5 percent of GDP), allowing for some non-inflationary issuance
of base money. Because Greek exit would be in part the result of
austerity fatigue in Greece, this outcome does not seem likely.
A
collapsed banking system, widespread default throughout the economy,
a continuing non-competitive economy and high inflation with a
material risk of hyperinflation would make for a deep and enduring
recession/depression in Greece. Social and political dislocation
would be certain. There would, in our view, be a material risk of a
downward spiral of dysfunctional politics and economics.
Consequences
for the remaining euro area and EU member states of a Greek exit
For
the world outside Greece, and especially for the remaining euro area
member states following a Greek exit, the key insight would be that a
taboo was broken with a euro area exit by Greece. The irrevocably
fixed conversion rates at which the old Drachma was joined to the
euro in 2001 would, de facto, have been revoked. The permanent
currency union would have been revealed to be a snowball on a hot
stove.
Not
only would Greek official credibility be shot, the same thing would
happen for the rest of the EA member states in our view. First,
monetary union is a two-sided binding commitment. Both sides renege
if the accord is broken. Second, Greece would only exit from the euro
area if it was driven out by the rest of the euro area member states,
with the active cooperation of the ECB. Even though it would be
Greece that cuts the umbilical cord, it would be clear for all the
world to see that it was the remaining euro area member states and
the ECB that forced them to wield the scalpel.
It
does not help to say that Greece ought never to have been admitted to
the euro area because the authorities during the years leading up to
Greek membership in 2001, knowingly falsified the fiscal data to meet
the Maastricht criteria for EMU admission, and continued doing so for
long afterwards.6 After all, what Greece did was just an exaggerated
version of the deliberate data manipulation, distortion and
misrepresentation that allowed the vast majority of the euro area
member states to join the EMU, including quite a few from what is now
called the core euro area7. The preventive arm of the euro area, the
Stability and Growth Pact (SGP) which, if it had been enforced would
have prevented the Greek situation from arising, was emasculated by
Germany and France in 2004, when these two countries were about to be
at the receiving end of its enforcement.
Euro
area membership is a two-sided commitment. If Greece fails to keep
that commitment and exits, the remaining members also and equally
fail to keep their commitment. This is not just a morality tale. It
has highly practical implications. When
Greece can exit, any country can exit. If
we look at the austerity fatigue and resistance to structural reform
in the rest of the periphery and in quite a few core euro area
countries, it is not plausible to argue that the Greek case is
completely unique and that its exit creates no precedent. Despite
the fact that both Greece’s fiscal situation and its structural,
supply-side economic problems are by some margin the most severe in
the euro area, Greece’s
exit would create a powerful and highly visible precedent.
As
soon as Greece has exited, we expect the markets will focus on the
country or countries most likely to exit next from the euro area. Any
non-captive/financially sophisticated owner of a deposit account in
that country (or in those countries) will withdraw his deposits from
banks in countries deemed at risk - even a small risk - of exit. Any
non-captive depositor who fears a non-zero risk of the future
introduction of a New Escudo, a New Punt, a New Peseta or a New Lira
(to name but the most obvious candidates) would withdraw his deposits
from the countries involved at the drop of a hat and deposit them in
the handful of countries likely to remain in the euro area no matter
what - Germany, Luxembourg, the Netherlands, Austria and Finland. The
‘broad periphery’ and ‘soft core’ countries deemed at any
risk of exit could of course start issuing deposits under English or
New York law in an attempt to stop a deposit run, but even that might
not be sufficient. Who wants to have their deposit tied up in
litigation for months or years?
Apart
from bank runs in every country deemed, by markets and investors, to
be even remotely at risk of exit from the euro area, there would be
de facto funding strikes by external investors and lenders for
borrowers from these countries. Again, putting under foreign law
(most likely English or New York) all cross-border (or perhaps even
all domestic) financial contracts and instruments could at most
mitigate this but would not cure it.
The
funding strike and deposit run out of the periphery euro area member
states (defined very broadly), would create financial havoc and
mostly like cause a financial crisis followed by a deep recession in
the euro area broad periphery. The
counterparty inflow of deposits and diversion of funding to the ‘hard
core’ euro area and the removal (or at least substantial reduction)
of the risk of ECB monetisation of EA sovereign and bank debt would
drive up the euro exchange rate. So
the remaining euro area members would suffer (at least temporarily)
from an uncompetitive exchange rate as well from the spillovers of
the financial and economic crises in the broad periphery.
As
noted by the new IMF Managing Director, Christine Lagarde (Lagarde
(2011) and confirmed by Josef Ackerman (Ackermann (2011, p.14)), the
European banking sector is seriously undercapitalised. It
would not be well-positioned, in our view, to cope with the
spillovers and contagion caused by a Greek exit and the fear of
further exits. Ms Lagarde was arm-twisted by the EU political
leadership, the ECB and the European regulators into a partial
retraction of her EU banking sector capital inadequacy alarm call.10
However, this only served to draw attention to the obvious truth that
despite the three bank stress tests in the EU since October 2009 and
despite the capital raising that has gone on since then both to
address any weaknesses revealed by these tests and to anticipate the
Basel III capital requirements, the EU banking sector as a whole
remains significantly undercapitalised even if sovereign debt is
carried at face value. In addition, the warning by Ackermann that “…
many European banks would not be able to handle writing down the
sovereign bonds they hold on their banking books to market levels…”
(Ackermann (2011), see also IMF (2011, pp. 12 -20)) serves as a
reminder of the fact that Europe is faced with a combined sovereign
debt crisis in the euro area periphery and a potential banking sector
insolvency crisis throughout the EU.
A
banking crisis in the euro area and in the EU would most likely
result from an exit by Greece from the euro area. The
fundamental financial and real economy linkages from the rest of the
world to the euro area and the rest of the EU are strong enough to
make this a global concern.
***
Ok,
now we get it...
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