IMF’s Greek Euro Exit Analysis

January 31, 2013, 9:57 AM

By Matthew Dalton

The Wall Street Journal

We’re a tad late getting to this, but the International Monetary Fund in its latest report on the Greek bailout took an interesting look at how far euro-zone economic output would fall if Greece ditched the common currency. The fund’s answer: Maybe a lot, maybe not so much – though even the “not so much” scenario looks pretty bad.

The immediate problem for the euro zone is that a resurrection of the drachma would leave many of Greece’s public and private-sector debts to foreign creditors denominated in euros. The drachma would devalue sharply against the euro, helping solve Greece’s competitiveness problems but also making it difficult to repay its foreign debts.

Even so, the direct costs of Greece exiting the euro zone (Grexit) would be small, the IMF says. That’s because private-sector exposure in the rest of the euro zone to Greece has been falling for some time, as Greek government debt held by the private sector has been restructured and imports purchased by Greece’s pancaked economy have plunged; the IMF says Greece’s liabilities to the private sector in the rest of the currency area have fallen to less than 1% of the euro zone’s gross domestic product.

The Greece exposure of the euro zone’s public sector has risen, reflecting the huge sums lent to the country in the form of bailout loans for the government and cash for banks via the euro zone’s central banking system. But this exposure is relatively small, only about 2% of the rest of the euro zone’s GDP, leading to “relatively modest” increases in government debt, the fund says.

The IMF doesn’t mention this, but Greece defaulting on money lent by the European Financial Stability Facility, the euro zone’s temporary bailout fund, would have only a small impact on member state debt burdens. That’s because Eurostat, the EU statistics agency, ruled in 2011 that each government backing the EFSF must register its share of loans made by the EFSF as government debts when the loans are made. The same is true of the bilateral loans made to Greece under the country’s first bailout.

So almost all the damage to government debt levels done by outstanding bailout loans to Greece has already been done (there would be a small hit from Greece defaulting, because the EFSF would no longer receive income from the minimal interest Greece is now paying on its EFSF loans). The EFSF is expected to lend €144.7 billion to Greece through 2014, and the member states have already lent Greece €52.9 billion in bilateral loans through December 2011.

The real risk, the IMF says, is contagion. Grexit could spark a run on countries across the euro zone periphery. Depositors might yank their deposits from banks in Portugal, Ireland, Spain and Italy. Foreign banks would refuse to extend credit to companies in these countries; foreign companies could refuse to trade with them. In short, an economic catastrophe that could result in a breakup of the euro zone.

Yet even the risk of contagion appears to have fallen in recent months, the fund says. Movements in the price of credit-default swaps on sovereign bonds indicate an increasing disconnect between Greece and the rest of the euro-zone periphery. “Market–based proxies of contagion risk suggest that the likelihood of spillovers in case of exit and default has fallen over time,” the fund writes, with a Mount-Olympus-sized caveat: “The simple statistics presented here should nevertheless be interpreted with caution: they do not imply causation, they are not robust to common shocks affecting both Greece and other vulnerable countries and, in the case of correlations, across-the-board spikes in volatility can bias the statistic upwards.”

That’s not very comforting.

What’s the range of economic output losses projected by the IMF if Greece leaves? The fund sees nearly a 2% loss to euro-zone real GDP in the first year, under a low-impact scenario like what happened when the giant hedge fund Long-Term Capital Management collapsed in 1998; and around a 6% hit under a high-impact scenario rivalling the collapse of Lehman Brothers

So, even the IMF’s best-case analysis of a Greek exit sees the euro zone probably being dragged back into recession – if, that is, it has managed to emerge from its current recession.

Not very comforting.

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The IMF report on the Greek Bailout
The 2011 rule on "The statistical recording of operations undertaken by the European Financial Stability Facility"

http://blogs.wsj.com/brussels/2013/01/31/imfs-greek-euro-exit-analysis/