A Greek exit is in no one's interest
All of Europe is eagerly waiting for the results of the upcoming Greek election on June 17. The Eurozone is once again at centre stage in the world economy, with a financial crisis that has spread beyond Greece.
The inconclusive outcome to the May 6 election has left Greece without a fully functioning government. The "pro-euro" parties (New Democracy and PASOK) fell short of the majority needed, in part due to a strong showing of the Syriza (Radical left) party, which campaigned on a platform of rejecting the European bailout package. After unsuccessful attempts by the political parties and the Greek president to form a coalition government, new elections are now set for June 17.
The election outcome on June 17 is difficult to predict. There are three possible scenarios. First, if a pro-austerity coalition forms the next government, the outcome is likely one where Greece muddles along.
Second, if an anti-austerity government is formed, the outcome will be negative for financial markets, but it is not clear that Greece will exit the euro zone. Indeed, the platform of the left party that gained significant support in the recent election is one that argues for less austerity but continued participation in the euro. The problem is that they need austerity to qualify for financial aid, which is required to stay in the euro.
Finally, there is the outcome where no government can be formed. This would prolong the uncertainty, breeding financial risks until a new government is formed.
It seems likely that all efforts will be made to keep Greece in the euro, even if an anti-austerity government takes power. What could cause a Greek exit from the euro zone?
Greece cannot, under the European Treaties as currently written, be formally expelled from the euro area or from the European Union. However, I can think of at least one scenario under which Greece could be forced to leave the euro zone.
Given the increasingly uncertain situation, the Greek banking sector has suffered significant deposit outflows in recent days. As deposits and other private sector funding sources
have dried up, Greek banks have become increasingly reliant on the central bank funding. While a continued rapid deposit outflow would be viewed with extreme concern, I doubt it would be the event that would precipitate any euro departure by Greece.
If, on the other hand, there is an unfavourable election outcome, the Greek government would likely run out of cash far sooner as its cash position is already very thin. If Greece refuses to live up to the austerity measures and reform its economy, the so-called "troika" (i.e., the European Commission, the European Central Bank and the IMF) likely would be unwilling to approve the next tranche of financial aid to the Greek government. In that case, the Greek government would probably default on its debt.
This could precipitate Greece's departure from the euro and the introduction of a new currency.
If the Greek government decides to abandon the common currency "euro," they would create a new currency and convert all the financial claims in the domestic financial system to the new currency. I believe a new Greek currency could lose 50% of its value vis-à-vis the euro.
What would be the impact on the Greek economy? The Greek banks would see their balance sheets wiped out as their domestic bond holdings would become worthless. Inflation would increase significantly and the new currency would depreciate.
The sharp drop in the value of the new Greek currency would lead to a default by both the Greek public and private sectors on their foreign debt. This would cut the country from any external financing, forcing an abrupt correction on its current account deficit.
What would be the impact of a Greek default on the European financial system? Greece still owes about 300 billion in bonds and multilateral loans from its two bailouts in the last two years. A Greek default caused by the country's exit from the euro zone would imply a very low recovery rate.
Also, the yields on sovereign Irish, Italian, Spanish and Portuguese bonds would increase after the Greek default. It is likely that some banks outside of Greece would need support from their governments.
The worst possible scenario would be that of a Greek exit precipitated by a run on Greek banks, because the risk of the bank run spreading to other Eurozone countries would be very high and difficult to contain. Traditional bank runs can be stymied by a deposit guarantee. However, a bank run fuelled by fears that the currency will be sharply depreciated is more difficult to defuse.
If Greece were to abandon the euro, a roadmap would then exist for an event that once was considered inconceivable: a country's exit from the Eurozone. If Greece can leave, what is to prevent Portugal, Ireland, Spain and Italy from pursuing the same path? Economic collapse and exit from the Eurozone, if confined solely to Greece, would not really matter for the global economy. However, Italy and Spain collectively account for 5% of global GDP. The potential financial and economic fallout of a Eurozone exit by these large economies are significantly more important for the global economy than a Greek exodus.
Thus an exit from the Eurozone likely would have significantly adverse effects on most sectors of the Greek economy. Given the relatively small size of the Greek economy and financial system, Greek default and abandonment of the euro should not have a marked effect on the global economy as long as its fallout can be confined to Greece. However, I am not convinced that the fallout can be so easily contained. Expectations of more exits from the Eurozone would ramp up significantly, and further abandonments of the euro could become self-fulfilling prophecies.
A Greek exit from the Eurozone is, therefore, in no one's interest. The resulting outlook for Europe would be highly uncertain and would pose the number one risk to the global economy.