Greek euro exit would hit at home, but fallout could be global
By Howard Schneider,
Spiralling inflation. A collapsed banking system. Hundreds of billions of dollars in unpayable debts and likely isolation from the world financial community.
That much Greece can count on — at least initially — if its political paralysis continues and it leaves the euro.
But the fallout would extend well beyond Greece’s borders, and analysts have been struggling to grasp whether it would upend markets as the collapse of Lehman Brothers did in 2008 or — if Europe’s financial systems prove durable and its politicians adept in response — simply pass with a shrug.
There could be immediate risks to the Spanish and Italian economies: Tens of billions of dollars have left those nations in recent months as investors doubt their ability to both control rising public debt and boost their economies from recession. A Greek departure from the euro would, officials and analysts fear, push the lack of confidence in the euro zone to another level, accelerate that capital flight and leave one or both nations close to economic collapse.
It is a pattern reminiscent of what happened in Latin America and Asia in the 1990s, and it is the most likely way that a Greek exit from the euro could ignite a global round of financial contagion. The risks were highlighted Thursday when the Moody’s rating agency cut its assessment of Spanish banks, saying it had less confidence in the ability of the Spanish government to support the country’s financial system.
If the crisis “turns to bigger players like Spain and Italy, through so many channels — trade, capital flows — it becomes global pretty quickly,” said Rebecca Patterson, chief market strategist with JPMorgan Asset Management. “If you own a Spanish bond what would you do? Even if in the long term it works out, there are other things to do with your portfolio ... What are we advising? We are staying away.”
That strategy of euro avoidance is one reason the interest rates Spain must pay to borrow money have risen to levels that officials in Madrid acknowledge they cannot sustain for long. Interest rates on some shorter term bonds have nearly doubled this year; longer term Spanish bonds are now being resold on secondary markets at rates equivalent to five percentage points a year more than Germany pays — a disturbing “spread” for a nation that just a few years ago was working hard to have its economy converge toward a German ideal.
Most analysts and officials agree it will only get worse if Greece drops the euro — an event for which there is no procedure, guidebook or precedent.
There are potential benefits to an exit, although they would take time to become clear. By controlling its own money supply and exchange rates, the country could make its exports more competitive and help set the stage for recovery. Officials in Athens could also count on help from their central bank in financing government deficits — rather than being dependent on the stricter rules of the European Central Bank in Frankfurt, which prohibit financing of government debts.
But the immediate impact would be severe for Greece, according to recent analyses by the International Monetary Fund and others, which foresaw rapid price rises, a deep economic downturn and a possible loss of social order as money dries up.
Analysts asked about even rough historical analogies mention anything from the printing of Confederate dollars during the Civil War to the difficult division of debts among the former Soviet states and the collapse 20 years ago of an effort to keep European exchange rates in close line with Germany’s Deutschemark.
How much worse would it get for others, and for how long?
Greece itself is now considered less of a global threat. Since its problems became apparent in the fall of 2009, banks, pension funds and other investors have steadily pulled out. According to the Bank for International Settlements, foreign banks had $244 billion in loans, investments and other Greek holdings as of September 2008. At the end of last year that was down to $96 billion, and is likely far lower now following a write-down that cut the value of the country’s privately held government bonds.
Of the country’s $430 billion in outstanding public debt, well over half is owed to the International Monetary Fund, the European Central Bank and other European institutions. The original worry — that French and German banks might fail because of large holdings of Greek bonds that might not be repaid — has been largely erased. Over the past two years those bonds have been sold or the losses on them absorbed when the debt write-down occurred this year.
What happens to the public-sector debts, however, would be a messy issue for Greece to negotiate — and the same applies to the myriad loan, trade and other contracts held between Greek companies and foreign counterparts.
Those debts and contracts are currently valued in euros, and would become much more difficult to repay if Greece suddenly began dealing in a revived drachma. A recent IMF study looked at Greece’s “effective” exchange rate — something that the fund can estimate with economic models — and projected that a reintroduced drachma would fall in value by about 50 percent.
The shift to a local currency “could bring economic activity to halt for some time” in Greece, the fund said. “The financial system . . . would be badly damaged. Liquidity and credit would dry up, reflected in high default.” The fund estimated that economic output would fall 10 percent in the first year after leaving the euro.
The effects beyond Greece will depend on how the rest of Europe reacts and how effective its various new programs and financial “firewalls” prove in practice.
One immediate effect: The European Central Bank would find itself, in effect, broke. The ECB has an estimated $180 billion on the line through Greek bonds it has purchased and loans it has made to Greek banks. If that gets wiped out, the remaining euro-zone members would have to make it up.
Spain and Italy, meanwhile, both could get help from the bailout fund German and other European officials finished erecting earlier this year. The fund can buy the bonds of a country that finds itself under stress and help hold down its interest rates — defeating, in theory, any effort by market speculators to profit by pushing rates higher.
The ECB, as well, has shown an ability to surprise. It also has intervened in bond markets when tensions rise. Last fall — when the crisis seemed most severe — it quickly loaned more than a trillion dollars to euro zone banks.