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What would happen if Greece defaulted and left the euro?
02/17/2012 8:30 am EST
Paddy Power, Ireland’s biggest bookmaker, quotes odds of 5/4 that Greece will be using the drachma again by the end December 2012. The country also is the betting line’s hand’s-down favorite for the first country to leave the euro at 1 to 4. Portugal is a distant second place at 8/1.
But what would a Greek default and departure from the euro actually mean?
I’ve seen a description from hedge fund manager John Paulson calling the resulting chaos “a greater shock to the system than Lehman’s failure, immediately causing global economies to contract and markets to decline.” A Greek default and exit from the euro would likely spell the end of the euro, he has said.
German Finance Minister Wolfgang Schaeuble, on the other hand, has gone out of his way recently to suggest that it would be no big deal. Certainly Germany would like to keep Greece in the euro and EuroZone, but if attempts fail “we’re better prepared than two years ago,” Schaeuble has said.
The global financial markets seem to be extraordinarily blasé. When European Finance Ministers cancelled their Monday, February 13, meeting that was to approve (or not) the Greek rescue package, stocks didn’t plunge and the euro didn’t plummet. Same when a conference call on Wednesday, February 15, passed without discernable progress but with talk of pushing the decision off until March 1 or even later.
So should you be quaking in your boots or switching from CNBC to watch Linsanity on ESPN?
As with so many investment questions, the answer to this one depends on what time frame you’re talking about.
In the short-run I think a Greek default and possible departure from the euro would be devastating to Greece but not an especially big deal to European or global financial markets.
In the long run I think a Greek default would indeed hit the euro hard, send interest rates rocketing toward the sky again in Italy and Spain, and end the EuroZone as it’s currently constructed.
Let’s start with the short-term, okay?
In the short-term a Greek default and/or a departure from the euro would come down really, really hard on the Greeks. Judging from the experience of Argentina, which defaulted in 2001, Greeks would see their bank accounts frozen and ATMs closed. Transactions in anything other than cash would dry up. And even companies with cash would have trouble finding suppliers who would accept it. Barter would be the preferred medium of exchange. Contracts would need to be renegotiated and in the meantime they’d be null and void. The country’s banks would be closed pending reorganization—and who knows where the capital for that would come from. (The first to recover the ability to do business would be Greek banks with foreign parents. Other banks would wind up putting themselves on the block to foreign banks with cash.) The country’s ability to import would be close to nil—not exactly a minor issue for a country that imports its oil. In 2011 Greece ran a current account deficit of 4.6% of GDP—creditors willing to fund that deficit will be few and far between. When the banking system did re-open and the government did issue a new currency, Greeks would find themselves coping with run-away depreciation as the New Drachma (or whatever) sank and sank as it tried to find its real rate of exchange.
From the Argentine experience we know where the Greek government will look for the cash that it needs to pay its bills if it’s cut off from the financial markets. Argentina raided the retirement accounts—the country’s equivalent of 401(k) plans--and central bank reserves. Greek citizens can expect the same—which is why so many are desperate to move their money out of Greece. Argentine had a relatively easy time pulling itself out of the hole created by the default thanks to a boom in global commodity prices. Greece isn’t the commodity exporter that Argentina is.
In the short-run the Greeks won’t be the only one taking punishment. Banks and other investors who own Greek bonds will see the value of those bonds drop, temporarily at least, to zero. In the Argentine default the country and 95% of its bondholders reached a settlement in 2005 that paid bondholders 35 cents on the dollar. About 5% of the holders of the then $81 billion in Argentine debt have refused to accept the deal and are still trying—anyway they can—to collect their money. (That’s one reason that Argentina still can’t access global financial markets.)
The Argentine default at $81 billion was much smaller than a Greek default would be at $144 billion in government debt. French banks own $15 billion in Greek sovereign debt and German banks own $23 billion. (Add in private sector debt and the totals go for these two countries, the two most exposed to a Greek default, go up to $34 billion for Germany and $57 billion for France, according to the latest data from the Bank for International Settlements.)
But thanks to the bounty bestowed on European banks by the European Central Bank, the short-term effects of a Greek default won’t be devastating to even the most exposed French and German banks. The central bank extended $489 billion euros ($632 billion) of three-year loans to European banks in December and it has another offering set for February 29 where banks are expected to borrow up to another 1 trillion euros. Some French and German banks may need to raise more capital and worries about who is holding the credit default swaps and other insurance against these loans haven’t gone away, but the European Central Bank has insulated the European banking system against the worst shocks with a mountain of cash.
So unless you’re a Greek—or a tourist in Greece who gets trapped without cash by a Greek default—no big deal, right?
In the short-term I think that’s true. In the long-term the picture is very different. Ending this crisis with a Greek default would do major and perhaps fatal damage to the euro.
Let me count the ways.
- A Greek default will certainly raise questions about the EuroZone’s austerity approach to this debt crisis and at a very inconvenient time—just when Ireland, Portugal, Italy, and Spain are running into the same austerity/debt trap. The Greek economy, data released on Tuesday February 14 by the Greek government show, is shrinking even faster than predicted. In the fourth quarter Greek GDP fell by 7% and for all of 2011 the decline is 6.8%. That was worse than the already horrendous 6% drop Athens had projected. That’s one reason that the 130 billion euro rescue package proposed in October 2011 is already a good 15 billion euros short of filling the Greek financial hole. It’s simply terribly hard to reduce a budget deficit and a debt load when a country’s economy is shrinking. Portugal, which is doing a much more disciplined job of actually delivering the budget cuts it promised in its bailout package, showed a 1.5% drop in GDP in 2011 and is projected to show a 3% decline in 2012. The Spanish economy is projected to shrink by 4.4% in 2012, according to the Bank of Spain. The Bank of Italy projects that the Italian economy will contract by 1.2% to 1.5% in 2012. This isn’t good news since the rescue plans for Portugal and Ireland are based on those countries being able to return to the financial markets to sell bonds in 2013 or 2014. And numbers don’t promise any relief any time soon to populations undergoing punishing budget cuts and recessions. According to calculations by David Bencek, an economist at Germany’s Kiel Institute of the World Economy, Portugal would need to produce a primary budget surplus (that’s the budget without interest payments) of 10% of GDP to reduce its current debt load to a sustainable level. Portugal has fought hard to reduce its budget deficit to 5.6% in 2011 from 9.1% in 2011 and forecasts a drop to 4.5% in 2012. But it’s a long painful haul from a 4.5% deficit to a 10% surplus. And if the deficits don’t shrink as projected or even rise, you can expect to see interest rates in Portugal, Spain, and Italy resume their upward move.
- If austerity isn’t a viable solution, then what is? Even the proponents of the package of austerity and fundamental economic reform agree that it will take five or ten years for those reforms to produce growth. It’s hard for me to see how imposing that much pain over that much time works politically in Portugal, Spain, and Italy. As a matter of DNA the Northern AAA-rated countries of Germany, the Netherlands, and Finland seem opposed to any kind of stimulus spending by a country that’s running a deficit. The divide between the non-AAA and AAA members of the EuroZone has already produced a level of acrimony that has tested the unity of the EuroZone. (I frankly don’t think the EuroZone is passing the test.) You think it can survive another five years of this? And how long before proposals for a rump EuroZone, excluding Portugal, Spain, and maybe even Italy, get a serious hearing?
- In the long-term the crisis has done deep damage to the reputation and stature of the European Central Bank. From one perspective—that of the AAA-rated countries—the bank has been shown to be an untrustworthy keeper of the no-inflation, no-monetary stimulus Grail. I think Mario Draghi’s extension of three-year loans to European banks staved off a deeper crisis just in time, but I can hear the grumbling saying that this Italian has sold out the German roots of the European Central Bank. From another perspective, that of debtor nations, the European Central Bank has shown itself to be rigidly wedded to its own self-interest by, among other things, its refusal to participate in the devaluation of Greek debt so it can defend its 50 billion euro portfolio of Greek government bonds.
I think it’s much too late to head off an eventual Greek default sometime, in my opinion, in 2012.
But it still does make a huge difference how that default happens. Right now it looks like Greece is headed toward the kind of disorderly default—if not in March then in June or so--that results in the country leaving the euro and produces all the long-term damage I’ve described above.
But it’s not too late to create an orderly default that might even keep Greece in the euro. That would head off some of the worst of the long-term damage from this crisis. I see the chance of that kind of orderly default getting less and less as each day passes and as one or the other (or both) sides of this conflict get closer and closer to just walking away in anger.
I wonder what kind of odds I can get on an orderly default at Paddy Power?
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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