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Grexit? What Does It Actually Mean?

At Tuesday's Eurozone summit, the Greek government was given a strict deadline to come up with a set of concrete and implementable reform and fiscal measures. If this list satisfies the demands of the Eurogroup members, a renewal of financial support would be forthcoming. If not, the much-discussed "Grexit" scenario may materialize.

There is substantial confusion over what Grexit really means. Many observers equate it with a – seemingly simple – switch from the euro as the legal tender in Greece to another legal tender, e.g. a "new drachma." In the longer run, such a change in legal tender may indeed come about, but the key to assessing the economic effects of a Grexit is to understand the process that would unfold if the negotiations between Greece and its creditors break down.

Tightening of ELA and a Worsening Cash Crunch

If these negotiations fail, the first result would most likely be a decision by the European Central Bank (ECB) to further limit its emergency liquidity assistance (ELA) for Greek banks. This decision would be made on the grounds that the prospects for a refinancing of Greek debt will have worsened. Lending standards ("haircuts" on collateral posted at the ECB) would be tightened, which would in turn further limit the ability of Greek banks to borrow from their own central bank (the Bank of Greece). As a result, cash withdrawals by depositors would have to be restricted even further.

Greek Default on ECB, Declaration of Bank Insolvency and Ending of ELA

The formal end of ELA would likely only be declared on 20 July if Greece fails to repay the 3.5 bn euro owed to the ECB itself. However, if Greece fails to repay a JPY-denominated bond that is due on 14 July, this could already be the trigger, even though a short grace period might apply. Given that Greek banks hold Greek government bonds as assets on their balance sheet, if only to a limited extent, a default would render the banks insolvent in the view of the ECB in its role as bank supervisor.

Difficult Bank Resolution Process with Further Economic Disruption

In the context of the European banking union as legislated by the Bank Recovery and Resolution Directive, an insolvency of member state banks needs to be followed by a resolution process. Note, however, that there is some uncertainty here because the banking union is not yet fully operative. However, it seems very likely that the banks would no longer be able to operate as private sector entities. One solution would be a merger of these banks and their split into a "good" and "bad" bank, most likely also involving a "bail-in" of local depositors. However, it is quite unclear how either of these entities would obtain capital to be operative. One possibility would be support from the European Stability Mechanism (ESM), although this would require a rescue program. What does seem quite clear, however, is that the payments and credit system in Greece would remain highly disrupted, worsening the economic downturn. 

Financing Government Expenditures with IOUs...

Given the worsening of the economy and the further deterioration of government finances, it seems quite likely that the government would need to begin paying some of its bills with IOUs. This would amount to a gradual introduction of a parallel currency. It is to be presumed that these IOUs would quite rapidly lose value relative to the euro. A formal decision to abandon the euro and introduce a new currency seems unlikely to us, however, at least in the short run. First, such a step is illegal under the EU Treaties. Second, it would be highly complex to achieve technically. More importantly, it would require a decision of the Greek parliament – given the strong support for euro membership in the Greek population, opposition to such a step would likely be fierce.

...But Resistance to a Change of Legal Tender Is Expected

Moreover, it is difficult to imagine that the government would push through a re-denomination of euro assets into new drachma; this would amount to a dramatic expropriation, especially of the poorer segments of the population. With regard to assets (bonds or equities) that were issued under international law, such a re-denomination would anyway not be possible legally. Finally, a re-denomination would imply that Greek citizens and companies with euro liabilities and new drachma assets would face a mismatch, which would likely trigger a wave of defaults and a further worsening of the economy. In sum: if a Grexit occurs, it is likely to be a gradual and prolonged process, but nevertheless with severe economic consequences for Greece. The unlikely alternative of a rapid switch to the new drachma – i.e. massive money printing – would likely result in high inflation and an even worse economic disruption.

Impact on the Eurozone

What would be the impact of a Grexit scenario on the rest of the Eurozone? Essentially, there would appear to be three channels. First, the economic downturn in Greece would have some effect on economic activity in the rest of Europe. However, given that Greece constitutes less than 2 percent of Eurozone GDP, this effect would likely be very minor. The second, and more important effect would, in our view, be via sentiment and financial market contagion. Continued uncertainty over Greece might lead to a further widening of credit spreads, especially in countries such as Italy and Spain. However, we believe that decisive intervention by the ECB would limit such contagion.

Financial Losses for the Eurozone

The third channel through which Grexit might affect the Eurozone would be via direct financial losses resulting from a Greek default. Here several components must be distinguished: the first is a possible default by the Greek government on its debt. As Figure 1 shows, Greece owes about 225 bn euro to EU countries, the ESM and the ECB. Another 21.5 bn euro is owed to the IMF, and 36 bn euro to private bondholders (excluding Treasury bills).

Losses via TARGET2

Another channel is the ECB's TARGET2 payment system, through which Greece had run up uncollateralized liabilities of about 100 bn euro versus other Eurozone central banks (Figure 2). This exposure of each Eurozone member state can be broken down by each country's share in the capital of the ECB, with Germany's exposure of 25.6 percent being the highest. Apart from the TARGET2 system, the ECB is also exposed to Greece via its lending to Greek banks, with the ELA program standing at 89 bn euro and another 30 bn euro outstanding through main refinancing operations (MROs). The latter two are collateralized, i.e. the claims are backed by assets, although asset quality in the ELA program is likely much lower (and thus harder to recover) than in the MROs. Figure 3 summarizes the estimated absolute exposure of Eurozone governments to Greece via loans and shares on the ECB's capital. While both the direct liabilities of the Greek government to Eurozone institutions as well as the liabilities of the Greek banking system are very large in absolute terms, they are limited in size relative to the overall debt of the Eurozone and its GDP. An explicit recognition of losses can thus most likely be delayed, or possibly avoided completely. We would therefore not expect any significant fallout via this channel.

Long-Term Political Fallout

The economic and financial fallout of a Grexit on the Eurozone would, in our view, be limited. However, some neighboring countries such as Romania and Bulgaria might be more strongly affected. The longer-term political fallout is much harder to assess. It would remain to be seen whether trust in the euro project would be undermined more lastingly. This would to a large extent depend on the reaction of the various political actors in other countries to such an event.

Higher Risk Premia on Peripheral Assets?

As our strategists point out, doubts regarding the long-term viability of the euro could be reflected in permanently higher risk premia on assets of high debt countries within the Eurozone. That, too, will nevertheless depend on the institutional changes that a Grexit might trigger. For example, if a negative "demonstration effect" of a Grexit were to result in heightened fiscal discipline within the Eurozone, such risk perceptions would be mitigated.