Speculations were rife this morning about Greece leaving the European Union. News of this possibility caused the Euro to tumble as low as $1.4315. The Euro has dropped as much as 3.5% this week and this was its worst performance since the start of the year. Greek officials however deny the report of Greece abandoning the Euro.
A small group of Eurozone finance ministers are meeting in Luxembourg on Friday evening to decide on Greece’s future and extending the maturity on their loans. There is also a possibility of the Eurozone exchanging Greek bonds for EU bonds.
Greece became a member of the EU in 1981 and in 2001 the Euro replaced the drachma. Since then the Greek economy flourished fuelled by heavy government borrowing and increased public spending coupled with income tax evasions. Over the past decade, the Greek government went heavily into debt with a budget deficit that exceeded Eurozone rules.
In 2009, Greece’s credit rating was downgraded as rating agencies doubted the government’s ability to pay off its huge debt. Eventually, the EU and IMF stepped in with a $160 billion bailout.
Greece’s economy has been in a downward spiral ever since its market collapsed. And its economic problems are far from over. Despite the bailouts and the spending cuts, Greek bonds have yields of over 15% signaling skepticism among investors.
The country’s debt will be 160% of its GDP by 2012. If Greece decides to exit the EU and reintroduce its drachma, it will end up with a currency that will be highly depreciated against the Euro, possibly increasing its debt to 200% of GDP.
If Greece withdraws from the EU, the ensuing default on their debt will have to be borne by the other EU members. The European Central Bank (ECB) owns a large chuck of Greek bonds and EU member countries and their taxpayers will have to bear the brunt of Greece’s default.
On the other hand, leaving the EU completely will be a very expensive process as Greece cannot afford to pay off all its debt. Greece's refinancing needs over the next few years is covered by the loan it has received from the European Union and the International Monetary Fund.
Greece can go bankrupt if it leaves the EU.
Leaving the EU will also take away Greece’s safety net and they may be viewed as a very unstable and unsafe investment. They can get cut off from capital markets around the world and witness a capital flight.
The failure of Greece’s economy and that of Ireland and Portugal has brought to the forefront the dangers of the European experiment of creating a single unified Union represented by a single currency - the Euro.
The major challenge faced by the EU is how they plan to balance the progressive economies of France and Germany with the debt ridden economies of Greece, Ireland and Portugal. The Euro is one of the world’s strongest currencies and the European Commission has to keep the Eurozone from falling apart. Greece’s departure may create widespread panic and concern that the debt crisis will spread across the EU countries.
Restructuring of its debt may be inevitable but will not be in Greece’s best interest. It remains to be seen what the outcome of the meeting will be.