Tuesday 8 May 2012

Chances and Consequences of a Greek Default within the Eurozone

Greek politicians and journalists tend to present a dichotomy of policy choices in terms of Greece’s future in the Eurozone:

·       Continue austerity and remain in the Eurozone
·       Unilateral cancellation of the “Memorandum”, and Eurozone exit

In fact, this bilateral choice conceals the likely course of events, which contains far more danger that what may be apparent. I will try to describe how such a scenario would occur.

The scenario begins with either a voluntary Greek repudiation of the lending agreement enshrined in the first and second bail-outs, or a delay due to elections which leads to an equivalent situation.

This triggers an immediate response from foreign creditors (private and sovereign), as follows:

·    The International Monetary Fund (IMF) ceases loan disbursements to Greece; Eurozone governments follow suit. The immediate consequence is that Greece’s primary deficit, which in 2011 reached EUR 7.7 billion (not counting interest payments of EUR 16 bln), must be financed through domestic sources. On a cash flow basis, I estimate that Greece’s primary deficit is much higher-probably at least 10-15% of GDP, or between EUR 20-30 bln.

·    As a result, the government can no longer pay pensions, government salaries, state hospital procurement or other critical needs. Given that state worker compensation accounted for EUR 19.8 bln and social security costs were EUR 48.3 bln, we can assume that approximately 30% of these payments will be in arrears. This means a delay of at least 4 months in pensions and salaries, or a commensurate cut in payment levels.

·    However, this optimistic scenario will be exacerbated by the fact that the government apparatus will stop working, meaning that taxes will not be collected. Companies and individuals will stop paying taxes, wages and suppliers due to the political uncertainty.

·    Greece’s private sector creditors will immediately launch legal proceedings to recover their loans. This will lead to yet further expenditure, but will also mean that Greek companies will be cut off from international credit. Expect to see Greek government assets seized. This will exacerbate an already uncontrolled crisis, particularly in areas such as agriculture and tourism.

·    In order to prevent a banking panic, the government will have to freeze bank account deposits. This will primarily affect the poorer, less-informed depositors: the more mobile, well-informed companies and managers will already be informed in advance of such a move, and will take steps to withdraw their deposits much earlier. This means that a weekly withdrawal limit will be in effect, while international transfers will probably be banned or subject to a large-scale withholding tax.

·    Despite these efforts, the Greek banking system will be faced by collapse in any case. Its operation today depends on access to ECB credit lines and Bail-out II funds. Greek banks will be cut off from both. They will be technically insolvent, and will have to be nationalised and amalgamated. This will create significant popular and political resistance.

·    Foreign investment in Greece will cease. Most companies will default on debt to suppliers. Many companies will shutter or idle operations. Foreign tour operators will transfer bookings to other sun-sea-sand destinations. Ferries and airlines will cease operations because they won’t be able to cover their fuel costs. Imports to Greece will only be sold on a cash-first basis.

·    Greece will suffer international outrage as the country that broke every single one of its promises, causing a major loss of taxpayer money in other Eurozone countries. The political consequences at the European level will be intense. Greek politicians should not convince themselves that it will be business as usual. Greek representatives will be excluded from meetings and decision-making. An embargo similar to that which Austria faced over the Joerg Haider government participation may be implemented. A freeze on EU structural funds will likely occur.    

These are the short-term impacts that will occur within 2 weeks of an uncontrolled default. Depending on the political situation, Greece’s next step may be to voluntarily withdraw from the Eurozone. This will involve:

·    A mandatory conversion of all salaries and loans into a “New Drachma”, which will immediately lose between 35-40% of its value against the Euro and US Dollar.

·    Bank nationalisation and strict limits on hard currency deposits as well as withdrawals or foreign transfers.

·    Inflation will shoot up between 25-30% in the best case within 1 month. Greece imports a large number of products, ranging from food staples (meat, dairy products, vegetables) to fuel to consumer durables and fast-moving consumer goods. These will continue to be denominated in hard currency, while people will have to convert New Drachma at a devalued exchange rate.

·    All loans will be benchmarked at a floating rate against the Euro. This means that as the New Drachma devalues, families with mortgages or loans will have to pay increasingly more of their salaries to service their loans, at the very time when inflation is (a) making the loan appreciate at unprecedented rates, and (b) causing a dramatic loss of purchasing power for basic household goods.

·    As assets rapidly devalue, desperate families will put property and other goods on the market at dramatically reduced prices. This will lead to a downward spiral on asset values that will take 2-3 years to work through.

·    Unemployment will rise to over 35% as companies close, unable to cope with the new inflationary environment, and unable to pay for inputs and working capital.

·    The rate of business closures will accelerate to depression-scale proportions.

·    Mass migration will have to occur, as younger people and others emigrate in search of stability elsewhere.

In fact, I consider a Eurozone exit irrelevant. There is no benefit for either the Eurozone or Greece which could not be achieved by alternative means. The idea of devaluing to regain competitiveness will be far more painful that people imagine, particularly given the problem of existing Euro-denominated loans. A Greek default within the Eurozone is looking increasingly likely for this very reason.

However, having made one mistake of historical proportions, there is absolutely nothing to say that a second mistake will not be made.

Unfortunately, the first mistake alone will be sufficient to set off an economic firestorm of unprecedented dimensions for Greece. No amount of political debate or advertising will be enough to conceal this. Yet it is precisely this scenario which is now rapidly unfolding, and may occur by June absent a firm decision on continuing the austerity measures and the loan conditionality.

© Philip Ammerman, 2012


  1. I've been following your blog for the past couple of weeks! The posts are always very informative and in harmony with my opinion. It's really sad how a nation that comes from great people and even greater history is in such a state right now. The attitude is often annoying, but one who lives in the middle of all this, tries to ignore it and wishes that things will somehow fall back into their places and everything will be back to normal ...

  2. Barring divine intervention, Greece is heading to the abyss you describe.

  3. Barring "devine" intervention, Greece is speeding toward the abyss you described.