Now that the possibility of a Greek exit from the euro is back to being topic #1 of discussion, just as it wasback in the summer of 2012 and the fall of 2011, and investors are propagandized by groundless speculation posited by journalists who have never used excel in their lives and are merely paid mouthpieces of bigger bank interests, it is time to rewind to a step by step analysis of precisely what will happen in the moments before Greece announces the EMU exit, how the transition from pre- to post- occurs, and the aftermath of what said transition would entail, courtesy of one of the smarter minds out there at the time (before his transition to a more status quo supportive tone), Citi’s Willem Buiter, who pontificated precisely on this topic previously. Three words: “not unequivocally good.”
What happens when Greece exits from the euro area?
Were Greece to be forced out of the euro area (say by the ECB refusing to continue lending to Greek banks through the regular channels at the Eurosystem and stopping Greece’s access to enhanced credit support (ELA) at the Greek central bank), there would be no reason for Greece not to repudiate completely all sovereign debt held by the private sector and by the ECB. Domestic political pressures might even drive the government of the day to repudiate the loans it had received from the Greek Loan Facility and from the EFSF, despite it having been issued under English law. Only the IMF would be likely to continue to be exempt from a default on its exposure, because a newly ex-euro area Greece would need all the friends it could get – outside the EU. In the case of a confrontation-drivenGreek exit from the euro area, we would therefore expect to see around a 90 percent NPV cut in its sovereign debt, with 100 percent NPV losses on all debt issued under Greek law, including the debt held, directly or directly, by the ECB/Eurosystem. We would also expect 100 percent NPV losses on the loans by the Greek Loan Facility and the EFSF to the Greek sovereign.
Consequences for Greece
Costs of EA exit for Greece are very high, most notably the damage done to balance sheets of Greek banks and nonfinancial corporates in anticipation of EA exit.
We have recently discussed at length what we think would happen should Greece leave the euro area (Buiter and Rahbari (2011)), so we shall be brief here. Note that we assume that Greece exits the euro area and does not engage in the technical fudge discussed in Buiter and Rahbari (2011), under which it technically stays in the euro area but introduces a second, parallel or complementary currency.
The instant before Greece exits it (somehow) introduces a new currency (the New Drachma or ND, say). Assume for simplicity that at the moment of its introduction the exchange rate between the ND and the euro is 1 for 1. This currency then immediately depreciates sharply vis-à-vis the euro (by 40 percent seems a reasonable point estimate). All pre-existing financial instruments and contracts under Greek law are redenominated into ND at the 1 for 1 exchange rate.
What this means is that, as soon as the possibility of a Greek exit becomes known, there will be a bank run in Greece and denial of further funding to any and all entities, private or public, through instruments and contracts under Greek law. Holders of existing euro-denominated contracts under Greek law want to avoid their conversion into ND and the subsequent sharp depreciation of the ND. The Greek banking system would be destroyed even before Greece had left the euro area.
There would remain many contracts and financial instruments involving Greek private and public entities denominated in euro (or other currencies, like the US dollar) that are not under Greek law. These would not get redenominated into ND. With part of their balance sheet redenominated into ND which would depreciate sharply and the rest remaining denominated in euro and other currencies, any portfolio mismatch would cause disruptive capital gains and losses for what’s left of the Greek banking system, Greek non-bank financial institutions and any private or public entity with a (now) mismatched balance sheet.Widespread defaults seem certain.
As discussed in Buiter and Rahbari (2011), we believe that the improvement in Greek competitiveness that would result from the introduction of the ND and its sharp depreciation vis-à-vis the euro would be short-lived in the absence of meaningful further structural reform of labour markets, product markets and the public sector. Higher domestic Greek ND-denominated wage inflation and other domestic cost inflation would swiftly restore the old uncompetitive real equilibrium or a worse one, given the diminution of pressures for structural reform resulting from euro area exit. More