UK: Greece Approaches The End Game

Last Updated: 2 July 2015
Article by Ian Stewart

Most Read Contributor in UK, August 2017

My apologies for the length of this week's Monday Briefing which reflects the complexity of events taking place in Greece. As usual, we cover the macroeconomic side of this story here; for advice on the potential business risks associated with a country exiting the euro area please contact my colleagues, Rick Cudworth or David O'Neill, in Deloitte's Risk Advisory Practice, at or

Last week Greece's Prime Minister, Alexis Tspiras, rejected the latest bailout offer by Greece's international creditors and sought endorsement of his decision in a referendum, due to be held next Sunday, 5th July. Mr Tsipras appears to be calculating that a rejection of the proposals by the Greek people will strengthen his hand in negotiations with Greece's creditors. There is, of course, a fair chance it could have the opposite effect.

Greece has no replacement to the current bailout programme which comes to an end on Tuesday evening. Without an extension of the existing bailout – which has been ruled out by Finance Ministers - Greece will be unable to meet a 1.6bn euro payment due to the International Monetary Fund on Tuesday. Though not technically a default, the failure to make the payment would be another blow to Greece's credibility in financial markets.

Given the risk of a Greek exit from the euro Greek depositors have been withdrawing their money from banks at an increasing rate. In a move that highlights the dependence of Greece on outside support the European Central Bank yesterday announced it would not increase its emergency liquidity assistance to Greek banks.

Without extra European assistance, and facing a rising tide of withdrawals, the Greek government responded last night by announcing that banks will stay closed on Monday and that controls will be imposed on bank withdrawals and the transfer of funds overseas. The BBC has reported that banks will be closed for six working days.

Events are moving swiftly and unpredictably. The risk of Greece exiting the euro looks greater than ever. Rather than trying to second guess the next moves in this crisis we instead have sought lessons from the past about the break-up of monetary unions – and how they might apply to a possible Greek exit from the euro area.

We tend to see Europe's monetary union as a fixed and permanent entity, but history suggests that monetary unions come and go. A recent paper by Jens Nordvig of Nomura Securities identifies 67 examples of monetary unions breaking up in the period since 1918.

Historically breakups of monetary unions have tended to be disruptive and traumatic. Much would depend on the degree of planning for an exit. An exit for which there had been careful preparation would be less disruptive than a rushed or accidental exit. Given that the euro crisis has been rumbling on for more than five years, the European Central Bank's contingency plans for a Grexit will be complete. (On this subject a sceptic might cite the nineteenth century Chief of the Prussian General Staff, Helmuth Von Moltke: "No battle plan ever survives contact with the enemy").

Leaving the euro area has two attractions for Greece. It would enable Greece to devalue its currency and to write off much of its public debt. The hope is that a weak currency would restore competitiveness while default would provide an escape from years of punishing debt repayments.

But to get there the country would face great uncertainty, disruption and change. In a well-planned exit the decision to leave the euro might be announced by the Greek authorities without warning late on a Friday evening once US markets were closed. The aim would be to act with stealth and limit capital flight.

With luck Greece (or, indeed, one of its creditors) would have drafted a new currency law beforehand. Ideally it would be published, debated and agreed at an emergency meeting of the Greek Parliament over the weekend.

The Greek Parliament would need to agree all the necessary details: the name of the new currency, its exchange rate with the euro, capital controls and the redenomination of all contracts and debts from the euro to the new currency. Banks and corporates would have to switch bank accounts, wages, debts and assets into the new currency.

If the exit is extremely well planned, new currency might be printed and available for distribution. When Slovakia broke away from Czechoslovakia in 1993, it emerged that it had started printing its own currency six months earlier. Such a high degree of preparation seems most unlikely in the Greek case, not least because of the risk that the news that a new currency was being printed might leak out.

Without a new currency to hand, Greece's central bank would have to consider alternatives.

It might launch an operation to stamp or mark all existing euro notes with the name of the new currency until new notes could be printed. However, given that holders of euros would hardly wish to trade them in to be stamped as drachma this would be problematic - the result might well be the creation of a parallel, euro economy in which most transactions took place.

An alternative, suggested by Capital Economics, would be to rely on non-cash transactions for major purchases and euro coins for minor ones until the new drachma notes and coins were ready.

The uncertainty about how Greece would replace the euro illustrates the need, once such a decision was taken, to publish a clear and convincing roadmap for exiting the euro.

If Greece were to secede, its replacement currency, the new drachma, would almost certainly devalue sharply. This would mean a reduction in the external purchasing power of consumers and corporates and rising inflation at home. Corporates would face swings in the external values of assets and liabilities depending on the performance of the new currency on the foreign exchanges.

Contracts written in national law such as for public sector wages or pensions could relatively quickly be switched over to the new currency. But there would be probably protracted legal disputes about contracts made in foreign law. Those outside the jurisdiction of the courts of the exiting country and payable outside the exiting country would be most likely to avoid conversion.

Doubts about the stability of the new drachma and an accumulation of euro notes and coins by households could encourage the development of informal transactions in euros or other foreign currencies.

If Greece were to exit the euro it would probably default on its euro debt and, unless it secured aid from the IMF or the European countries, could face difficulties financing everyday public services.

The disruption and uncertainty caused by secession would probably trigger a sharp contraction in Greek GDP and a bout of high inflation. Outside the euro and the EU, with historically low levels of productivity and poor competitiveness, Greece would still need to earn its way in the world. Eventually the Greek economy would adjust, but it would be a socially and politically wrenching business.

Of course once Greece made the decision to secede the central aim of the European Central Bank would be to limit the degree of contagion to the rest of the euro area. As we argued in last week's Monday Briefing, we think the risks of contagion have been greatly reduced since the last euro crisis in 2012.

Most 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. Crucially, holders of Spanish, Portuguese or Italian government bonds can be fairly confident that the ECB would fight speculative selling by buying up government bonds in large quantities.

The euro area economy looks in better shape to withstand Grexit than in 2012. The decline in the euro, falling inflation and the launch, in January, of euro area Quantitative Easing, have all helped bolster euro area growth. The region grew at a faster pace than either the US or the UK in the first quarter of this year.  The European Central Bank could respond to a Greek exit which seemed likely to threaten euro area growth by stepping up its programme of Quantitative Easing.

And finally, 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.

For the rest of the euro area the risks of Grexit are greatly reduced, though far from trivial. Financial disruption and rising risk aversion alone could knock euro area growth for a few months, though we would expect activity to bounce back. The worry, as we noted last week, is that we cannot be sure that we have identified all the transmission mechanisms through which a Greek exit could affect the rest of Europe.

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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