Leaving the euro

My big fat Greek divorce

How and whether Greece might exit is the biggest and fattest uncertainty of all

Jun 9th 2012 | from the print edition

The Economist

(From the blog: After two year of stubborn fighting any kind of reform, the coalition of the memorandum opponents will finally meet reality. The fear is that it wont embrace it, it will rather collide, devastating Greece.)

ON JUNE 17th the brinkmanship on the Aegean will take another twist. Even if the New Democracy party manages to form a government it will seek to renegotiate the terms set earlier this year by European creditor nations for Greece’s second bail-out. If instead the victor is Syriza, the left-of-centre group bent on scrapping the deal, the markets fear that this will lead ineluctably to Greece leaving the euro and inflicting heavy collateral damage on the rest of the euro zone on the way. But there is nothing automatic about the precise timing and mechanism of a “Grexit”.

If Alexis Tsipras, Syriza’s leader, were unilaterally to announce a debt moratorium, as he has threatened to do, then this would almost certainly precipitate a swift exit. All bail-out funds would be cut off. With Greece defaulting on its debt, the European Central Bank (ECB) would no longer be prepared to permit the provision of liquidity for Greece’s tottering banks. If the Bank of Greece did not comply with the ECB’s ruling, Greece could in the last resort be cut off from the euro zone’s payments system, points out Malcolm Barr, an economist at JPMorgan. The Greek government would have to reintroduce the drachma, which would immediately plunge in value against the euro.

But Mr Tsipras would have to form a coalition and would be constrained by his partners. And he has not campaigned to leave the euro, which remains popular in Greece. He is calculating that Angela Merkel, the German chancellor, will blink at the prospect of the wider costs of a Greek exit. He believes that she will not want to be seen as forcing Greece out of the euro, not least since on strict legal grounds a country can neither leave nor be forced to leave the currency union.

Even a Syriza victory will thus probably lead in the first place to negotiations. While these are taking place, there would be no bail-out money to fill the hole in Greece’s primary budget (ie, excluding interest). But Greece would still need funding to avoid default, since it must also service debt and redeem maturing bonds, notably one held by the ECB due to be repaid in August. One suggestion is that the Europeans could channel bail-out financing to meet such payments through the “escrow account”, a segregated account at the Bank of Greece set up as part of the second bail-out to ensure that Greece honours its debts. A precedent for this was set in May, after the first inconclusive election, when a payment of €4.2 billion ($5.3 billion) was made to Greece, most of which went to cover another maturing bond held by the ECB.

Even if this tortuous routing of European bail-out money to the ECB helped avoid an immediate default, any new Greek government would face huge strains. When the second rescue was approved, Greece looked close to balancing its primary budget. In March the IMF envisaged a 2012 deficit of just €2 billion (1% of GDP) and a surplus of €3.7 billion in 2013. But such forecasts have been overtaken by events. Fearing the worst, the Greeks are holding back on taxes (revenues were €495m below target in the first four months of 2012) and the government is postponing payments to suppliers.

Some economists think that Greece could nonetheless avoid a sudden departure from the euro. The government could pay some of its bills by issuing its own IOUs direct to its domestic creditors. These notes (“scrip”) would start to circulate at a steep discount to euros. In effect, argues Thomas Mayer, an adviser to Deutsche Bank, Greece could create its own parallel and depreciated currency while still remaining in the monetary union.

Something similar happened in Argentina as it struggled to retain its rigid link between the peso and the dollar before the link eventually snapped in early 2002. Bankrupt regional governments started to pay their workers in scrip, such as the patacones issued by Buenos Aires Province. But these desperate measures were desperately unpopular because the patacones immediately fell in value. Within just a few months, the Argentine government restricted withdrawals of bank deposits, defaulted on its debts and broke the link with the dollar, allowing the peso to devalue.

Mario Blejer, who was Argentina’s central-bank governor in the middle of the crisis, says that resorting to scrip would be even worse than creating a new currency outright (which he thinks would be disastrous). It would create monetary chaos and generate inflationary pressure before the exit that would inevitably ensue.

Any negotiations between Mr Tsipras and Greece’s creditors may in any case be short-circuited. Greece’s bank run could turn into a sprint after the election, making the country ever more reliant on the ECB for emergency funding. If the condition for further support is compliance with the terms of the bail-out, then it may be Mr Tsipras who blinks after all. If he doesn’t, then Greece could indeed leave the euro in a rush after the election.