Euro exit: the final card in Greece's hand

This might sound surprising to many, but last week’s events have strengthened Greece’s bargaining position. In its current state, Greece, having reached rock bottom, has little to lose by exiting the eurozone. Let’s do some back-of-the-envelope calculations of the costs and benefits of Greece remaining a member of euroland. Greece is being forced to take more fiscal austerity that will sink the country into even deeper recession, without any prospect of reducing the debt significantly. It is being forced into fire-sale privatizations, which will do more to undermine its sovereignty than reduce its debt. Add to that the excessively high interest rates that Greece is paying on its debt. These have more to do with the bad policies that are being inflicted on it and the uncertainty of being a member of a currency union that cannot get its act together than with economic fundamentals; according to some recent estimates, Greece is paying 400 basis points for the privilege of being a member of the eurozone. That is equivalent to 6.0% of its shrinking GDP. What are the benefits from remaining a member? An over-valued currency? The inability to control one’s monetary and now fiscal policy? Ooops, these are actually costs. More trade with the eurozone because of less exchange risk? Surely not, if the country is forced to use an over-valued currency. Less inflation? That may well be the case, but with a debt of 150% of GDP, higher inflation is a sure way to make it more sustainable – not to mention the fact that in a deep recession, what should have more weight in monetary policy is reducing high unemployment, which is crippling the country and causing social unrest. Convergence with the eurozone? This has clearly not happened. Lower transaction costs? No exchange-rate uncertainty vis-à-vis other eurozone members? Maybe, but these benefits are probably pretty low – amounting to around 1% of GDP, if that. To sum up, in the country’s present state the costs for Greece remaining a member of the eurozone far exceed the benefits. However, the costs to other countries of Greece exiting are much higher. Greece, by exiting, could turn itself into a source of a massive externality for the rest of the eurozone. If Greece exits, it is likely that Portugal will be forced to exit next. Then it could be Ireland, Cyprus, Italy, Belgium, Spain and Malta. Not necessarily in that order. France and Germany themselves cannot be ruled out. A disorderly unravelling of the eurozone could have massive costs for all its members, especially so for countries such as Germany, whose export sectors have benefited most from the union. Some economists seem to believe it is possible to create a firewall around the other countries, even most of those in the periphery. That argument is flawed. It underestimates the strength of financial contagion and the turmoil that will ensue when Greece exits. When the first domino falls, the rest will fall rather quickly. It is all a matter of the confidence, or lack of confidence, in the eurozone. Of which not a lot exists at the moment. If Greece abandons the euro, there will be massive losses in countries whose banks have lent to it, including France, Germany, Cyprus and others. This is true however Greece exits. If Greece is able to change the currency in which its debt is denominated (some analysts believe it can), it will be in its interest to do so. As the drachma depreciates or is devalued, foreign creditors will be hit by massive foreign-exchange losses. If Greece is unable to re-denominate its debt into drachmas, Greece’s exit from the eurozone will need to be accompanied by a massive haircut of her creditors in order to make the debt sustainable (otherwise the external debt burden will become even less sustainable as the drachma depreciates). A 50% haircut is clearly on the low side. If a country is to default, why not go all the way? An 80% or even 90% haircut is therefore more likely. Bank losses themselves will spread quickly and even banks that might have appeared healthy could get into trouble, if they made the mistake of lending to banks that lent to Greece. Bank bailouts will make more sovereign debts look less sustainable, raising interest rates throughout the eurozone. As confidence in the euro evaporates quickly, bank runs will ensue. Suddenly, other currencies such as the Swiss Franc and US Dollar will become more appealing, even in countries such as Germany. Such bank runs will no doubt test the European Central Bank’s ability to maintain financial stability. The ECB can easily make matters worse by continuing to hide behind its price-stability mandate and not print enough money, as this could be considered inflationary. Everything we have seen so far does not inspire much confidence in the institution. It is perfectly capable of allowing the eurozone to unravel in order to achieve its 2.0 per cent inflation target (as I have explained in ‘The suicidal tendencies of the eurozone’). The exit of Greece from the eurozone could, therefore, make the collapse of Lehman look like child’s play. At this point, Greece has first-mover advantage. It has a strong card to play before the end of this game.

This article was originally published on Euromoney Country Risk (ECR). Professor Demetriades is a contributing expert to ECR. He currently submits country risk scores for Greece, the UK and Cyprus. To join ECR go to www.euromoneycountryrisk.com and register. Euromoney Country Risk is an online service from Euromoney dedicated to sovereign and country risk.