Hazardous Greek-Exit Scenario

The Wall Street Journal

There is no legal provision in European Union treaties for a country to exit the euro zone, putting experts in uncharted waters when trying to assess method and the repercussions. But if Greece were forced to leave after losing financial support, it would show that Europe's historic currency project can disintegrate as well as integrate. Here are some possible answers.

How does Greece leave the euro?

In one scenario, a Greek authority would have to agree on a date with the rest of the euro zone for its departure and for the introduction of a new currency (let's call it the new drachma). It would say that from that date, all public salaries, contracts and pensions would be paid in drachma. Bank deposits would also be redenominated. The authority would likely decide an initial conversion rate on domestic contracts from euros to new drachma—say one-to-one—then it would likely let the exchange rate of the new drachma be decided by the currency market. This would likely result in a sharp devaluation. If Greeks anticipate that, there is a risk of increased bank withdrawals and capital flight. This could trigger capital controls, making an orderly exit unlikely.

Could the drachma ever recover?

Ultimately, it would find a level that made Greek products and services internationally attractive again. What would happen then would depend on how policy makers, the Greek central banks and Greeks themselves reacted to the devaluation, because the competitive benefits of devaluation could be easily inflated away. The two most recent parallels, Argentina and Russia, saw their currencies fall by between 60%-70% after bankruptcy forced them to abandon their currency pegs. But comparisons are difficult. There is no obvious equivalent for Greece to the upturn in oil and commodity prices in 2001 that helped those two countries recover.

What would the ECB do?

The ECB probably would no longer be able to lend to banks against Greek government debt as collateral. That would mean the supply of liquidity to the Greek financial system would stop. With no euros available, this would be the moment when the government would have to distribute another currency as a means of exchange.

Would the euro still circulate in Greece?

Almost certainly. Euros will be in high demand as a store of value until the population has a clear idea of the new drachma's real value. Greece might even want to keep the euro as official legal tender, as in Montenegro. But banks wouldn't have the right to borrow euros from the ECB, and Greece would of course lose its valued seat on the ECB's governing council.

What would happen to the debt?

The debt would largely fall into two categories: money that the government owes to its bondholders and official creditors, and money that the banking system owes to the ECB. As both of these types of debts are under international law, they would have to be restructured by negotiation. Domestic debt would likely be redenominated in new drachmas.

What could a Greek exit cost?

It is very difficult to calculate the cost of a country leaving an interconnected currency union. The Institute of International Finance, an industry group representing some 450 financial institutions from around the world, circulated a confidential note in February placing the costs at €1 trillion ($1.29 trillion). The IIF said, in an internal note to staff that was leaked to the press at the time, that different players would be injured significantly by a Greek euro exit, ranging from the ECB to private financial institutions and other euro-zone countries, which would face higher borrowing costs as the contagion would hit their bond markets.

How are Greek businesses affected?

Businesses, unable to raise funding and facing large-scale disruption in their payment flows, would potentially face closures on a large scale. As soon as the possibility of a Greek exit became clear, there would be a risk of a bank run in the country and a denial of further funding to entities, private or public, through instruments and contracts under Greek law. Holders of existing euro-denominated contracts under Greek law would want to avoid their conversion into the new drachma and the subsequent sharp depreciation of the currency, says Citigroup C -4.30% .

What about Greek banks?

This is where it gets really complicated. At present, the banks are technically insolvent, because they had to realize heavy losses on the bond exchange earlier this year. Under the bailout package, they are supposed to receive new capital, but it hasn't been paid in yet. Meanwhile, the creditors have set aside €35 billion ($45 billion) in what's called "collateral enhancement," a sort of protection which allows the ECB to pretend that it isn't really lending to insolvent banks. That is what allows Greek banks to keep borrowing euros from the ECB. If a new Greek government were to leave the monetary union before the recapitalization process were completed, then things could get very messy indeed. The ECB could end up with up to €160 billion in defaulted loans and bonds on its hands.

What about Portugal and Ireland?

Portugal and Ireland are—like Greece—recipients of financial assistance from euro-zone countries and the International Monetary Fund. A Greek exit from the euro zone would exert more pressure on these two countries. Portugal and Ireland are already expected to get fresh financial assistance of some form. Guntram Wolff, of Brussels think-tank Bruegel, believes that, should Greece exit the euro, the market will turn its attention to these two vulnerable countries.

—Geoffrey T. Smith, Matina Stevis and Stelios Bouras