The once-taboo topic of Greece's exit from the common currency is now being openly discussed. Two years of pushing cash into the country have barely kept it afloat and Greece's political instability has injected a new urgency into the situation. Greece, which is facing its fifth year of recession, will go to a second election June 17, after its vote May 6, left no single party with more than 20% support and negotiations to create a unity government failed. An interim government has now been sworn in. According to Doug McWilliams, of the Centre for Economics and Business Research, an unplanned exit from the eurozone could cost up to $1 trillion.
Greece exiting the euro and a follow-up default of its debt would be very costly on all counts - economically, politically and socially. Also, the economic benefits of such a decision over the short- to-medium term are also questionable. Though it is difficult to quantify the costs for Greece of a euro exit, we can look at what the economic implications of such a decision are likely to be
- The exit would result in substantial devaluation of the new currency. A devaluation of 50% could lead to erosion of half the value of its domestic savings and wealth. This could be followed by a significant contraction of GDP as a result of decline in domestic demand and investment, which the IMF forecast at 10% in the first year, in line with international experience.
- Greek imports, which account for 30% of GDP, are mostly inelastic. About one-third of these imports are oil, food and pharmaceuticals. According to credit Suisse estimates, a currency devaluation of 50% would possibly lead to an inflation of more than 30%, negating a large part of the competitiveness gain from the devaluation and suggesting a huge fall in real disposable income.
- Exports account for only 25% of GDP. More than 50% of them are related to inelastic industries. These include shipping, agriculture and metals, which are not affected by devaluation. Thus the benefits on the export side would be rather minor. For example, shipping, which accounts for close to quarter of Greece's exports, is a dollar-denominated business, unaffected by the devaluation. On the other hand, tourism, which also accounts for a quarter, is expected to benefit from the new currency, once the political situation is stabilized.
- By the end of 2011, Greece ran a primary budget deficit accounting for 2.5% of GDP. It is running out of financing options and there is a pressing need to close this gap quickly. This would imply either significant reduction in expenditures or money printing, with the latter putting further upward pressure on inflation. Also, given that Greek banks' heavily rely on the ECB for liquidity and their need for a capital increase following the debt restructuring, an exit from the euro would imply that the country would have to meet these needs with further money creation.
- EU transfers to Greece (structural funds and agricultural funds) amount to more than 2.5% of GDP each year.
IT COULD come sooner; it might well drag out longer; it can still be averted: but the week following the next Greek election on June 17, still looks set to be the time when the eurozone's debilitating fever peaks, and the patient's prognosis becomes clear.
Investment Options: The bets are running high on the speculation around the possibility of Greece exiting the European Union as seen from the Gold prices staying firm. One who is very bullish on Greece's exit could invest in Gold as a safe haven asset or trade any Euro Currency ETFs.
- SPDR Gold Trust (NYSEARCA:GLD)
- iShares Gold Trust ETF (NYSEARCA:IAU)
- Market Vectors Gold Miners ETF (NYSEARCA:GDX)
- Market Vectors Gold Miners ETF (NYSEARCA:GDXJ)
- Currency Shares Euro Trust ETF (NYSEARCA:FXE)
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.