13 May 2012

FT Analysis: Eurozone - If Greece goes ...

European governments are furiously thinking through various scenarios, while still urging Athens to stick to its agreements on austerity and reform. If those hopes are dashed and Greece goes, what happens next?

Is Europe ready to jettison one of its own?

Now, with a new, permanent €500 billion rescue fund backed by the strength of an international treaty with multiple tools to buy sovereign bonds on the open market and inject capital into eurozone banks, some officials believe the contagion could be contained – much as it was after Athens finally defaulted on private bondholders last month.

Still, uncertainty over how Europe’s banks would be affected has continued to be the primary concern. Witnessing Greek bank customers suddenly having their euros turned into drachmas overnight, depositors in other peripheral banks might suddenly withdraw their cash and place it in seemingly safer euro accounts in Germany or elsewhere. Such a massive run could destroy much of the eurozone periphery’s banking sector. 

What would exit from the eurozone entail?

In a game of brinkmanship, neither Athens nor the rest of the eurozone would want to take responsibility for a Greek exit from the single currency. Recriminations would fly.

Against accusations that it is imposing, in the words of Mr Tsipras, “barbarous” demands, the core of the eurozone is already positioning itself to ensure any exit is seen as a sovereign decision. “The future of Greece in the eurozone lies in the hands of Greece”, Guido Westerwelle, German foreign minister, said on Friday. “If Greece strays from the agreed reform path, then the payment of further aid tranches won’t be possible. Solidarity is not a one-way street.”

After exit, Greece would have to negotiate continued EU participation. The EU treaties have a provision for leaving the union, but not just the eurozone. That negotiation would be all the more difficult if new Greek authorities defaulted on debt to the European Financial Stability Facility, the ECB and the IMF. If the country defaulted on its IMF debts, it would join a small ignominious club of nations – including only Zimbabwe, Somalia and Sudan – that have overdue financial obligations to the fund.

What economic effects will Greece suffer?

In any exit scenario, the new drachma would depreciate rapidly. How far cannot be predicted but the IMF estimates Greece needs at least a 15-20 per cent devaluation against the eurozone average – and considerably more against Germany – just to achieve a current account balance. Currency moves tend to overshoot, and US investment bank Goldman Sachs has estimated that to stabilise Greece’s international debts at a reasonably low level – needed to ensure the country can insulate itself against the risk of capital flight – a devaluation of 30 per cent is needed compared with the rest of the eurozone, and more than 50 per cent with Germany.

The IMF estimates that even if there is no exit there will be a primary deficit of 1 per cent of national income in 2012, a figure that would almost certainly rise in a recession deepened by uncertainties surrounding exit and a bust banking system.

Can the eurozone contain the contagion?

This is the biggest unknown. If the eurozone authorities could persuade investors and the public that Greece was a special case, the effects of an exit could be contained. If not, a Greek exit would soon become a disorderly break-up of the euro project.

The inevitable question after a departure is: “Who’s next?” Eyes would turn rapidly to Portugal, which followed Greece into the bailout club. Investors would sell Portuguese bonds, seek to extract money from the country’s banks and take euros across the border for fear of an exit and devaluation. Currency risk has been evident in the European banking system since late last year, but the incentives to move deposits into German banks from those in Portugal, Ireland, Spain and Italy would be clear.

If the political will to hold the single currency together exists, the eurozone has a big weapon in its arsenal to contain the contagion: unlimited action by the ECB. It could restart bond-buying at very high levels to limit rises in sovereign bond yields and offer unlimited liquidity to peripheral-nation banks to offset a run on deposits. This would worry Berlin, which feels the ECB has already gone too far in underwriting bank and sovereign debt in peripheral countries. But the alternative is worse, as the EU has no other sufficiently powerful defence against a systematic bank run in such nations.

The answer, therefore, is that the eurozone could limit contagion, but it is highly uncertain whether it would. If it did not, the end of the euro would be nigh. In either case, the outlook for the European economy is highly risky. After the Lehman collapse in 2008, it was not a dearth of bank lending that plunged the region into its worst recession since the second world war, but a collapse in confidence and spending as households and companies decided simultaneously to tighten their belts in fear of what might happen next. Unless the European authorities are extremely skilful in ringfencing Greece, a similar scenario would be a severe danger.

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