DSIJ Mindshare

Greece: The Austere Effects Of Parting

Despite a 240 billion euro bailout package, Greece seems to be tottering on the verge of an economic collapse and a possible exit from the Euro zone. The fallout of such a situation for the Euro zone as well as for the global economy may throw the global economy into a tailspin, says Shashikant.

The impossible is looking highly inevitable as time passes by. Interestingly, a growing number of people are changing sides in favour of this conclusion. Yes, we are referring to the exit of Greece from the Euro zone. Even two years after the crisis first erupted and after doling out 240 billion euros in a bailout package, all efforts by the member countries of the Euro zone to keep Greece afloat are faltering.

What Happens When Greece Defaults

Recently, the Eurogroup Working Group (EWG), a body of experts who work for the bloc’s finance ministers, said that the Euro zone countries should prepare a contingency plan individually for the potential consequences of a Greek exit from the Euro. This is further reflected in a research report by Citi, in which the estimate of the likelihood of Greece dropping out of the Euro zone has been raised from 25-30 per cent in the month of February to 50-75 per cent in the month of May.

It is not just bad economics that is hurting in this case, but the politics is not helping either. There is a political vacuum in Greece - the last elections remained inconclusive and the citizens of Greece gave a fractured mandate, with no single party being able to form a government. Moreover, a majority of votes went to the party that is against austerity measures, which is considered to be anti-growth. The next round of elections is scheduled to be held on June 17, 2012. We believe that depending upon the outcome of the next election we could see Greece exiting from the Euro zone, which many observers are terming as the ‘Grexit’.

Many analysts are comparing this situation with the collapse of the Lehman Brothers. Is the ‘Grexit’ such a big crisis that it will again push the shaky recovery of the global economy into the next round of recession? Here is what we believe the Greek exit from the Euro zone could possibly mean going forward.

From the latest opinion poll held in Greece, it is evident that the Syriza party, which is opposed to implementing the international financial rescue package, is building on its lead in voter support ahead of the elections to be held June 17. The building up of such support is not unfounded, as the country’s standard of living has fallen by 20 per cent from 2009 and the overall unemployment has reached nearly 22 per cent. Among the country’s youth, unemployment is at an alarming high of 51 per cent, and remains the highest in Europe.

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Key Points:

  • In the current situation, it seems that Greece will choose the lesser of the two evils, i.e. an exit from the monetary union rather than the austerity measures that have already affected the economy.
  • Greece’s exit from the Euro zone is likely to have a domino effect across the European banks, as the country owes substantial amounts to the French, German, UK and US banks. A default will hit the other indebted states particularly hard, including Italy, Spain, Portugal and Ireland.
  • A default by Greece might set a dangerous precedent for other larger economies. This may lead to catastrophe – the ultimate breakup of the Euro.

If the Syriza party gains an overall majority, it seems unlikely that Greece will want to get into a reconciliation with the European Union and favour a continued presence in the single monetary union. As the German Chancellor, Angela Merkel, has already said, the austerity measures are “not negotiable”. Therefore, in the current situation, it seems that Greece will choose the lesser of the two evils, i.e. an exit from the monetary union rather than the austerity measures that have already affected the economy. But what will the impact of its exit be? According to Doug McWilliams, Centre for Economic and Business Research, a planned breakup of the single currency would cost two per cent of the Euro zone’s GDP (USD 300 billion), but a disorderly collapse would result in a five per cent drop in output, i.e. a loss of USD 1 trillion.

The brunt of such an exit will not be borne by Greece alone, but will have a cascading effect on the entire global economy. Nonetheless, the immediate impact will be surely be felt by the Greek economy. According to the Greek think tank, Foundation For Economic And Industrial Research (IOBE), such a move would hit the people of the nation hard – and quickly. Greece will have to return to its old currency, Drachma, and the new Drachma would lose half or more of its value relative to the Euro. This will increase cost of imports, which in Greece, includes a lot of food and medicine. It will also drive up inflation and reduce the purchasing power of the average Greek. All of this could lead to social and political turmoil, which will severely hamper the tourism industry that contributes about 16 per cent of the USD 342 billion (CY11) Greek economy.

Also, without austerity measures in place, the Greek government will receive no bailout loans. Thus, it will be forced to stop all repayments of its debts, which include the 240 billion euros it received in bailout loans from the IMF and the EU. Such default will have a direct and immediate impact on Greek banks – who are big lenders to the government. As any default on payment will lead to a sharp fall in the value of bonds and a rise in the yield, people’s saving will be frozen, and that might lead to banks going bust.

Greece’s exit from the Euro zone is likely to have a domino effect across the European banks, as the country owes French banks 41.4 billion euros, German banks 15.9 billion euros, UK banks 9.4 billion euros and US banks 6.2 billion euros. A default will hit the other indebted states particularly hard, including Italy, Spain, Portugal and Ireland. The European banks already have a large exposure to sovereign debt, which has increased since the commencement of the Long Term Refinancing Operations (LTROs). Spanish banks are thought to have purchased around 90 billion euros, a jump of around 26 per cent in their exposure to sovereign debt to 220 billion euros. Italian banks are thought to have purchased 50 billion euros, a jump of 31 per cent in the exposure to 270 billion euros. Should Greece bow out and one or more of the above follow suit, it could cause panic amongst investors, many of whom would be quick to withdraw their deposits from banks in these countries. This could leave banks short of capital, heightening the risk of an overall national default. What is more, the borrowing costs for these governments would rise significantly as the risk premiums attached to their sovereign debt increases, severely impeding their ability to meet the existing debt obligations. Therefore, a default by Greece might set a dangerous precedent for other larger economies. This may lead to catastrophe - the ultimate breakup of the Euro.

We believe that the forthcoming election results in Greece will be a key factor not only for the future of Greece but also for that of the Euro zone. Although the European leaders have agreed to a 700 billion euro firewall to protect the zone from a full-blown Greek default, we doubt that this will be enough to contain the contagion. This impact will not only be limited to the Euro zone, but will spread to the global economy as a whole. One of the possible ways of lowering the impact could be the issuance of IOUs (I Owe You’s) to pay key bills such as salaries and medicine for a limited period until things settle down. However, it is debatable as to how the big lenders will react to any such proposal. Therefore, all possible efforts should be taken by both parties, the European as well as the Greek leaders, to come to an agreement that can save the global economy from another seismic shock.

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