Grexit Would Be A Black Swan For The Eurozone

by: Christopher Mahoney
Summary

Greece and Europe are, once again, playing chicken.

This time, both sides are digging in as never before.

Grexit, were it to occur, would be destabilizing for the eurozone.

On Wednesday, Bloomberg published a rather ominous report about Greece's cash situation:

Unless the 15 billion-euro limit on short-term borrowing set by Greece's troika of official creditors is raised, the government may run out of cash on Feb. 25...Greek banks lost at least 15 billion euros in deposits in the two months before the election, about 9 percent of the total. Beyond that, the ECB is reaching its limit for funding Greek banks. Greek banks have maxed out the 3.5 billion-euro limit on the total amount of treasury bills the ECB will accept as collateral from them...To stay liquid, Greece needs the troika to lift its 15 billion-euro cap on the amount of short-term debt it can issue, and it needs the ECB to lift the 3.5 billion-euro limit on the volume of bills it will accept from Greece as collateral. The funding limits give the power to the ECB to turn off liquidity and effectively impose Grexit.

Grexit would be a Black Swan for the eurozone. First of all, Greece owes a lot of people a lot of money: the ECB, the EFSF, the IMF, the European banking system, and all of the hapless depositors in Greek banks. Their claims would all be defaulted upon, with varying consequences. Just because we have all "known" that this would happen in the event of Grexit doesn't mean that Europe won't be thunderstruck when it does. The eurozone will be as "prepared" for Grexit as the US was for Lehman to go bankrupt.

Let's assume that Greece runs out of money in the next few months (which is up to the Troika to decide). Then what? Greece will have two choices: (1) stay in the euro and default on everything, or (2) redenominate into drachma. They will have to opt for redenomination if they want to preserve the domestic financial system, since Greece cannot print euros to meet depositor outflows.

How would the process of redenomination work? I can't think of any exact precedents, but the closest I can come up with would be Argentina's 2001 move from the dollar currency board into the New Peso.

Here is one scenario:

  1. By presidential decree, freeze all deposits, debts and financial contracts, foreign and domestic.
  2. Impose currency and capital controls prohibiting any movement of financial assets out of the country.
  3. Temporarily close all land, sea and air borders to prevent the smuggling of euro notes.
  4. Announce the redenomination of all deposits, debts, contracts, and currency notes into drachma on a one-to-one basis. This would include all foreign debts, claims and contracts with the possible exception of the ECB.
  5. Require that all euro notes be exchanged for drachma notes.
  6. Allow the drachma's external value to float, since the Bank of Greece will have no international reserves and no international credit, assuming that the ECB does not make credit available.
  7. Sell drachma bonds to the Bank of Greece in order to pay the state's bills.
  8. Nationalize and recapitalize the banking system with government bonds.
  9. Impose permanent capital and exchange controls to prevent capital flight and speculative attacks on the drachma.
  10. Pay external claims in drachma.
  11. Operate with a balanced current account, since external credit will be unavailable.

Debts incurred under foreign (i.e., English) law would have to be litigated in foreign courts. There are mixed legal precedents for successful repudiation of external debts and contracts. Indeed, Germany itself defaulted on and repudiated its external debt in the 1930s.

Once the redenomination exercise has been completed, Greece will be effectively debt free, will be able to pay its bills (in newly-printed drachma), will have a solvent and liquid banking system (internally), and will have a more competitive currency. However, its international trade lines will be eliminated and it will have to accumulate enough foreign currency to finance imports on a cash basis for the foreseeable future.

The terms of trade will shift dramatically in favor of Greek exports (tourism) and against imports. The importation of oil and gas (which requires dollars) will be a particular problem, unless exporters (e.g., Russia) are willing to extend credit. This could prove to be a big problem, although Greece would not be the first country in such a fix. Over time, as Greek exports grow, foreign currency receipts would be able to pay for more imports. (Currency controls will allow the Bank of Greece to prioritize imports and prevent capital flight.)

The standard of living would decline as inflation would exceed nominal wage growth. The real price of domestic tradeable goods will rise with the real cost of imports. The need for fiscal austerity will be a function of the regime's willingness to tolerate inflation. Given the Greek social model, the government will choose inflation (and perhaps rationing) over austerity, and there will be no external pressure to do otherwise. We have already seen this in Russia, Venezuela, Argentina and elsewhere. While it is true that the middle class's domestic savings will be wiped out, most Greeks have their wealth elsewhere, so the social impact may be muted.

A Greek exit presents much food for speculation. For example:

  • Will foreign governments freeze Greek banks' assets and liabilities under their jurisdiction?

  • Who will be the receiver for Greek bank branches in London and elsewhere?

  • How will Greece treat Greek citizens with euro deposits in foreign banks?

  • Will Greece close its borders and confiscate all euro notes?

  • Where will Greece bank its foreign currency reserves?

  • What kind of exchange controls will Greece impose?

  • How will foreign courts adjudicate claims against Greece?

  • What will become of euro notes issued by the Bank of Greece? (Note: The identification code letter is Y.)

  • What will be the accounting treatment for claims on Greek banks?

  • How will Greek bank and government bonds be valued on banks' books?

  • What will the Bundesbank's balance sheet look like after Greece repudiates its TARGET2 liabilities--and does it matter.

  • How will the ECB treat the Bank of Greece and the Greek banking system after exit?

  • How will Greece pay for essential imports (such as oil) on Day Two?

  • Will European governments have to intervene and purchase at par all Greek assets held by their banks?

  • How big a dollar swap line will be required by the ECB from the Fed?

  • Can Congress prevent the Fed from lending to the ECB?

  • How soon before foreign creditors try to seize all Greek government assets outside of Greece?

  • Will European banks do business with Greek banks who are in default on external claims?

And so on. You get the idea. A Greek exit, if it occurs, will be a Black Swan with many unanticipated consequences--and lessons. If it goes badly, that could be destabilizing for the periphery. If it goes well, that could tempt the periphery to follow suit. My view is that it will be ugly enough to discourage any further escape attempts by the remaining inmates, and that it will encourage the ECB to do more to reflate the euro.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long stocks and bonds.