It’s a tradition of Greek theatre that the real action takes place off-stage. Much the same might be said of the euro drama.
A second bailout and last week’s repayment of a €14.5bn (£12.1bn) bond has produced a dramatic lull in proceedings. Even the president of the European Central Bank said last week that the worst of the crisis is over. But does anyone actually believe there is not another Act to come?
Not if you look at what is going on behind the scenes. Whatever the politicians may pretend, governments, banks and companies continue to make contingency plans for a Greek exit from the euro. And, arguably, the terms of the latest bailout make one easier.
A quick recap of the state Greece is now in highlights the challenges ahead. Athens has got its debt down from €368bn – or a ruinous 163pc of GDP – by strong-arming the private holders of €206bn of bonds into accepting an effective 74pc loss on their loans, once lower coupons are taken into account.
That’s been enough to trigger a second bail-out from the European Union and International Monetary Fund of €130bn – on top of the €110bn already advanced to Athens. But there the good news ends. The quid pro quo for all this dosh is the promise from Athens of unprecedented budget cuts. But, even after all the money and pain, by 2020 Greece’s debt will still top 120pc of GDP, according to official estimates from the EU, IMF and European Central Bank troika. That is, as Open Europe puts it, “more or less where Italy is today”, which is “not exactly a hugely positive result after a decade of adjustment and hundreds of billions in taxpayer-backed bailouts”.
Worse, the troika’s estimates look horribly optimistic because, as the think tank points out, “the austerity targets are wholly unrealistic and kill off growth prospects”.
Already into its fifth year of recession, more than half of Greece’s under 25s are now out of work. Yet the government is promising to cut another 150,000 public sector jobs over the next three years. With protests on the streets and an election in April, who knows how much austerity is even deliverable.
The ink on the bailout terms is barely dry, but Germany’s finance minister, Wolfgang Schaeuble, is already openly remarking that this is “perhaps not the last time that the German Bundestag will need to address the question of financial assistance for Greece”.
Open Europe believes a third bailout or full-scale default is all but inevitable within “three years’ time” – the price for Greece remaining in a currency it can neither print nor devalue.
The euro, says US economic researchers Variant Perception, is like a “modern day gold standard, where the burden of adjustment falls on the weaker countries”, forcing changes “in real prices and wages instead of exchange rates”. Growth becomes “unlikely if not impossible within the euro straightjacket”.
Hence the planning for an eventual Athens exit – not least by the Greeks. Some €16bn has been sent abroad since 2009, with Britain the favoured destination – as the mini-boom at the top of London’s housing market might testify. Meanwhile, bank deposits in Greece have fallen by €70bn over the same period.
As the country’s outgoing finance minister Evangelos Venizelos noted, while this is partly due to families or businesses raiding savings to cope with the crisis: “Many billions are kept in homes. They are, as we say, in mattresses or boxes.”
Greece represents just 2pc of eurozone GDP. Yet, thanks to the interwoven capital flows of monetary union, extricating even a tiny member from the currency bloc has some Rumsfeldian “unknown unknowns”. For starters, it’s illegal, thanks to 1992’s Maastricht Treaty compelling all euro members to transfer “irrevocably” monetary sovereignty to the European Union.
There are contagion risks – to other countries and banks – and funding issues for the ECB, Bundesbank and IMF, among others. Politically, it would take a huge swallowing of euro pride. And then there’s the cost – though probably much less than the €1 trillion bandied around by scaremongers.
But, at least it would not be the current sticking-plaster solution. And, though less complex, both the break-up of the USSR’s rouble zone (1992-95) and Czechoslovakia (1992-93) provide blueprints for how Greece’s exit could be handled.
In the next month we should start seeing the first entries to the Wolfson Economic Prize, the £250,000 award for “the person who is able to articulate how best to manage the orderly exit of one of more member states from the European Monetary Union”. Many of the world’s top economists are sweating the numbers. In Greece’s case, it might go something like this.
It would start with a shock weekend announcement. First question: would it be an agreed or hostile exit? Assume agreed, as a hostile one would unleash chaos, with runs on eurozone banks, not least in Portugal, Ireland, Spain and Italy. But who would Greece agree it with – given the dangers of leaks?
Miles Saltiel, the lead author of the Adam Smith Institute’s entry for the Wolfson prize, envisages Greece holding a “relatively last-minute conference call with about a dozen people”. They might include ECB chief Mario Draghi, Germany’s Angela Merkel and whoever is then in charge of France – or, more likely in Saltiel’s view, their civil service representatives. The IMF would probably be in on the call too.
It would take place late on a Friday night, after the markets closed, or possibly Saturday morning. It would also signal the start of what Saltiel sees as the “containment” phase of the operation – before the lengthier “resolution” stage.
Much would then happen simultaneously. Greece would announce its decision, declare a two-day bank holiday – as Argentina did when it defaulted in 2002 – and convene an emergency session of Parliament. Assuming MPs rubber-stamped the exit (admittedly no foregone conclusion in Greece), new laws would be passed governing the details of an exit. These would include, according to Variant Perception, “currency stamping, demonitisation of old notes, capital controls and redenomination of debts”.
First, Greece would create a new currency and give its central bank new powers. The new drachma would initially be set at 1:1 to the euro for the purposes of conversion – but swiftly collapse. All money, deposits and debts held by locals within Greece would be automatically converted to the new drachma. Deposits and debts outside Greece would not convert.
Then Greece would impose capital controls to stop, for example, electronic transfers of old euros in Greece to foreign bank accounts. It could also institute border controls, though as Saltiel points out: “Even if you packed your suitcase with €500 notes, there’s a limit to how much damage you can do.”
What of the bank notes? It seems ironic today that the ECB once made much of the euro symbol being “inspired by the Greek letter epsilon, reflecting the cradle of European civilisation”. But all notes would be stamped as new drachmas – a technique used in previous currency break-ups. Stamping offices would be set up for all notes in circulation.
ATMs would deliver only stamped notes, while being reconfigured for the new currency. Meantime, Greece would print new drachma notes as quickly as possible. They would be exchanged for stamped notes, which would be gradually phased out.
Some say Greece could avoid stamping notes because all euro bills have a serial number according to where they were printed. Greece’s start with a Y, Germany’s with an X. But, notes circulate across the zone. Without a stamp, there would be a risk of a black market, where Germany’s notes started trading at a premium, say, to Portugal’s.
With the new currency comes what, before the latest bailout, was one of the trickiest legal issues – determining whether Greece’s debts would remain denominated in euros or the new drachma. It’s crucial because most share PricewaterhouseCoopers’ view that the “new drachma would depreciate by at least 50pc overnight once floated”. But the significance has changed.
Before the bailout, Greece would have been expected to apply the legal principle of “lex monetae” to how billions of euros of debt contracts were written. Broadly, lex monetae means the state determines its own currency at the point of payment. Athens would, therefore, be expected to claim that the 85pc of sovereign debt contracts written under Greek law would be redenominated in the new drachma, with those under foreign law remaining in euros.
The latest restructuring has been done under English law, which ostensibly makes redenominating Greece’s debts a bigger legal challenge. But, thanks to the bailout, the proportion of its loans held by taxpayer-backed institutions – rather than litigious private owners – rises dramatically.
Open Europe believes the share held by the ECB, IMF and the European Financial Stability Facility was 36pc at the start of this year but could reach 85pc by 2015. So, Greece would now largely be negotiating with governments, not private bondholders – arguably an easier proposition.
The issue doesn’t stop there, however, as the Institute of International Finance (IIF) – the body that negotiated on behalf of bondholders with the Greek government – outlined. Based on its figures, at the end of 2011, Greek banks owed €91bn to foreign lenders and depositors, while non-financial companies owed €21bn. They would want repaying in euros – potentially making banks and companies bankrupt.
This is one reason Saltiel reckons the containment phase should include “some sort of standstill” agreement to thrash out the legal issues, coupled with “regulatory forbearance”, such as a temporary relaxation of such things as a banks’
Tier 1 capital to enable them to keep trading. Further containment policies would be required, both in Greece – and across the eurozone.
In Greece, the consequence of rapid devaluation, in PwC’s view, is that “inflation would increase to about 30pc in the first quarter and average 10pc in the first year, due to the loss of a credible monetary anchor and imported inflation.”
A “deep recession” would then ensue – not unlike the immediate aftermath of the Argentinian default, where a country already in recession shrank by a further 10pc in year one.
There would be two immediate challenges. Greece would need to recapitalise, and probably nationalise, its banks – already suffering, on IIF figures, 15pc non-performing loans from the €247bn lent to Greek companies and households. The latest bailout compels Greece to provide another €23bn to recapitalise the banks, though Open Europe believes they need €36bn to €46bn. More would be needed if Greece exits the euro. And, while the new central bank could provide liquidity, that could only come at the risk of further devaluing the new currency.
Greece would also have to fund its budget deficit, at least in the short term – one possible outcome being fresh IMF loans, with strings attached to accelerate such things as labour reforms and privatisations. Of course, exit would leave Greece locked out of the capital markets for the foreseeable future. But, after two bailouts, that’s the case anyway.
Ten years on, Argentina still cannot access the capital markets. But, while inflation may be touching 10pc, on possibly understated official figures, there has been significant growth, with GDP up around 9pc last year. In Greece’s case, PwC estimates that “growth would resume within four years” of an exit, “led by a rebound in net exports”.
What, though, of the dreaded contagion? Richard McGuire, senior fixed-income strategist at Rabobank, says a Greek exit would have the psychological effect of demonstrating to other periphery members that “the euro is a two-way street – you can join and you can leave”. It would, therefore, require a show of political force from eurozone leaders and the ECB to prevent a run on other banks, particularly in the periphery – and the markets betting on who might be next.
That would be supported by further monetary easing and, potentially, another long-term refinancing operation (LTRO) from the ECB – to the annoyance of the Bundesbank, already aghast at how the ECB’s balance sheet now exceeds €3 trillion. Variant Perception recommends that “in order to counteract the inevitable stresses in the financial system and interbank lending markets, central banks should co-ordinate to provide unlimited foreign exchange swap lines to each other and expand existing discount lending facilities.”
Some eurozone banks may also need to be recapitalised – though this may be much less painful than is widely thought because they have been cutting their exposure to Greece since the start of the crisis.
The latest figures from the Bank of International Settlements show that the total exposure of European banks to Greece (excluding Greek banks) was $105bn at the end of the third quarter of 2011, some $70bn of which was lending to the non-bank private sector. France and Germany have the biggest exposures. But, in the scheme of things, the figures are manageable.