The fast and the slow route to a ‘Grexit’

Published: Apr 28, 2015 5:09 a.m. ET

By SARA SJOLIN

MARKETS REPORTER

With the risk of Greece running out of cash looming larger by the day, investors are grappling with a key question — what are the consequences of a Greek default?

The fallout really depends on which bond, loan or interest the government fails to repay and to whom, leaving open an array of default scenarios, as UBS sketches out in a note published on Monday. The worst-case outcome has widely been described as a “Grexit”, shorthand for Greece leaving the eurozone, and according to the UBS economists there is a fast and slow path to exit.

The investment bank doesn’t predict a Grexit as its base-case scenario, but if it were to happen, it’s likely to be via one of these two tracks, the strategists said.

The fast route: If the government fails to meet its debt obligations to one of its lenders, such as the European Central Bank or the International Monetary Fund, there’s a risk deposits will start to flow out of the country — and probably fast. This could drain the Greek banks and threaten the solvency levels. That will raise a red flag at the ECB, which is currently keeping Greek banks afloat through the emergency liquidity assistance program, under conditions that the banks are still solvent.

If the ECB cuts off ELA funding that’s basically the death blow to Greece as a member of the currency union.

“The government would then need to refinance (and probably recapitalize) the banking system by creating a new currency to do so,” the UBS strategists said.

However, the fast route could be slowed down if the government imposed capital controls to limit the deposit flight.

The slow route: Aside from scrambling to repay loans and pay bond interest, Athens is struggling to find money to pay public-sector salaries and pensions, which are usually due end-month. As it’s running out of funds, the government could start to pay with IOUs instead of euros, beginning with payments to suppliers and over time expand it to salaries and pensions.

The new IOU notes are unlikely to be valued at their face value, so the purchasing power would probably be weaker than that of the euro. This essentially means that a new, devalued parallel IOU currency has been created.

The more notes that are issued, the more they get integrated in the financial system. Banks could start to clear payments in them. Businesses and citizens would increasingly use the IOUs to pay taxes. All the while “euros would leak out of the Greek banking system and the economy would rely on the new currency to a greater extent,” UBS said.

“Nominally, Greece could (in theory, and just conceivably) remain in the euro under these circumstances, but there would come a point in this process at which it had in a practical sense already left,” they strategist said.