European Union: Grexit - Why Markets Think It's Different This Time

Last Updated: 24 June 2015
Article by Ian Stewart

Most Read Contributor in UK, August 2017

During the last Greek crisis, in 2011/12, many economists believed that Greece's exit from the single currency could trigger a Europe-wide recession. Today the assumption is that the impact would be milder and more limited. Why do economists and financial markets appear to be so sanguine?

The answer lies in four changes that have taken place in the intervening two-and-a-half years.

First, the European Central Bank (ECB) and the International Monetary Fund (IMF) have bought up huge quantities of Greek government bonds and, by doing so, they have transferred risk from the private sector to the public sector.

Roughly 83% of Greek government debt is now held by official creditors; if Greece defaults on its debt most of the pain will be felt by these creditors, not banks and private sector institutions. This has reduced the risk that a crisis in Greece would spread into the financial system and bond markets of other euro area nations.

Second, in 2012, the European Central Bank unveiled a programme to purchase the government bonds of at-risk nations. Again, this reduces the danger that a Greek default would cause panic selling of sovereign bonds issued by other nations which the market judged to be at risk. Holders of Spanish, Portuguese or Italian government bonds can be fairly confident that the ECB would fight such speculative selling by buying up government bonds in large quantities.

Third, the euro area economy looks in better shape today than in 2012. The decline in the euro, falling inflation and the launch, in January, of euro area Quantitative Easing, have all helped. The euro area economy grew at a faster pace than either the US or the UK in the first quarter of this year.

Fourth, the other so-called "peripheral" euro area nations which, in 2012, looked vulnerable to contagion from a Greek euro exit, are on a growth path. Ireland has become the IMF's poster child for successful adjustment, and this year its economy is expected to grow by a heady 3.7%. The pace of reform has proceeded with varying degrees of speed and success elsewhere. But growth is now coming back, and rather faster than expected. Since the start of the year growth forecasts for Spain have risen by a third, faster than in any other European nation. Growth forecasts for Portugal and Italy are also on the rise.

No one can be certain about how Grexit would happen or be complacent about its effects. It would be an unpredictable and hugely risky event. Much would depend on whether European policymakers were able to assert leadership and provide reassurance. A well-executed exit – and the ECB has had plenty of time to make contingency plans – could significantly reduce contagion effects and the impact on the wider European economy.

For Greece an exit would trigger economic, political and financial turmoil. Depositors would try to withdraw money from banks to avoid the redenomination of their euro holdings into a devaluing drachma. Capital controls would almost certainly be necessary to stem the flow of money out of the country. A new drachma would devalue rapidly, fuelling inflation. And, at least in the short term, economic activity would be likely to contract sharply.

For the rest of Europe, and indeed the global economy, Grexit would cause financial market volatility, triggering a rush to safe haven assets, such as the dollar, the Swiss franc and US government bonds. Business confidence would suffer.

But the lasting economic effects on the wider European economy are likely to be limited, partly for the reasons described above. Moreover, just as previous shocks, such as the 9/11 attacks in the US or the failure of Lehman in 2008 triggered an easing of policy, so policymakers would be likely to counter the effect of Grexit by loosening monetary policy.

Rising risk aversion and uncertainty would hit euro area growth, possibly pushing it close to recession, or back into recession. But these negative effects are likely to be temporary and limited, with growth being displaced, rather than destroyed. Our expectation is that after one or two quarters of weakness, growth would bounce back.

So we think the collateral damage from a Grexit today would be less than in 2012. But the uncertainties and risks are legion, not least because we do not know all the mechanisms through which a Greek euro exit might be transmitted to the global economy. Nor can we discount the possibility that a Grexit might embolden anti-austerity, secessionist parties elsewhere in Europe, creating new risks to the euro area. No wonder European policymakers are so keen to avoid testing the firewalls they have put into place to prevent contagion from a Greek euro exit.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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