A scenario for Greece’s exit from the euro
June 5, 2012
The spectacular gains made in Greece’s general election on May 6 by the Coalition of the Radical Left (Syriza), which is opposed to the severe fiscal austerity measures demanded by the EU, have led to predictions that Greece would leave the euro. Since there are considerable political obstacles to be overcome, and it would also make little sense in economic terms and would create a huge burden in practical terms, Greece leaving the euro must still be regarded as a “risk scenario”. Nevertheless, the probability of this risk occurring has risen, and this report considers the likely scenario if Greece does leave the euro.
In Greece itself, the Greek people will certainly be less well off. Other countries that have been forced to default in the past — Russia, Argentina — saw their currency fall in value by around one-quarter. This currency depreciation led to a rise in import prices, and inflation rose to over 120% in Russia and 40-50% in Argentina.
In the eurozone at large, trade with Greece (excluding Cyprus) accounts for less 1% of all trade, and the direct impact on the real economy will probably be limited. On the financial side, however, it is possible that a sharp fall in the value of the new currency will drive Greece into effective default on its external debt of just under 400 billion euros, and the eurozone could then suffer losses equivalent to around 3.4% of GDP. However, the damage will mainly be to the European Central Bank, the central banks of member states and international institutions, and in the short term the negative impact on the eurozone economy will be slight. Given that the ECB has effectively been providing full-scale support to the finances of southern European banks since December 2011, it is highly unlikely that the impact via financial institutions (defaults on loans to Greece, etc.) will lead to a severe financial crisis.
However, if Greece leaving the euro causes cracks to appear in the euro system, which until now has been regarded as having no way out, there will inevitably be concern that other countries may leave. In particular, concern will grow over Portugal and Spain, whose current account and primary balances are both in deficit.
To prevent the crisis from spreading to Portugal and Spain, in addition to the ECB buying government bonds and supplying long-term funds, firewalls must be farther strengthened by such means as increasing the amount that the European Stability Mechanism (ESM) is able to lend. It will also be necessary to fully cure the sicknesses affecting heavily indebted countries. The heavily indebted countries must strengthen fiscal discipline and take steps to increase their competitiveness within the eurozone by reducing the unit cost of labor through deregulation measures geared to increasing labor market fluidity. At the same time, it is vital that determined steps towards fiscal integration be taken, including measures to boost economic growth in Portugal and Italy, which have fallen into chronic slow growth, and measures to stabilize the financial system in Spain, which is facing unprecedented levels of bad debt due to the collapse of the housing bubble, such as issuing joint euro bonds, and expanding the ESM and the European Financial Stability Facility (EFSF) with a view to increasing bank capital.
If the eurozone countries fail to show determination to achieve fiscal integration, it is likely that they will be unable to escape from unstable exchange rates. At present, the only way for heavily indebted eurozone countries to avoid a deflationary spiral and boost their economies is to devalue the euro relative to other currencies, and the eurozone countries are highly likely to continue with policies aimed at reducing the value of the euro. If the eurozone countries fail to move towards fiscal integration and faith in the euro as a currency is lost, it is even possible that, as a result of the reduction of euro holdings, the exchange rate will fall below 1 euro to the dollar. Until there are prospects of a fundamental solution to the European debt problem, there is little hope of a sustained appreciation of the euro against the yen.