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What Happens if Greece Leaves the Euro Zone?

At the beginning of May, elections held in France, Greece, and Germany signaled a clear and resounding rejection to the current plan of austerity in the south of Europe and bailouts orchestrated by the north of Europe.  The bailout plan will not be supported in the northern countries without some semblance of austerity in the southern countries, and the southern countries most likely cannot survive in the Euro Zone without some form of monetary or fiscal support.  In Greece recent elections left the country without a coalition government.  Although a coalition government is not a necessity to receive subsequent bailout money from the EU/ECB/IMF, a government that is opposed to the current austerity cannot come to power without the country risking an abrupt end to its monetary lifeline.  Besides the Left Coalition, SYRIZA, and its leader Alexis Tsipras, the rest of the Greek leaders seem to have come to the same conclusion.  European leaders have repeatedly stated that there is no alternative to the bailout if Greece wants to stay in the euro.  Therefore, there is no alternative to the impending spending cuts in Greece without putting its euro zone membership in jeopardy.  More spending cuts in Greece will only make the austerity plan even more disliked than it currently is.  The elections only confirmed this unpleasant reality.  In future elections – which could come as soon as June – the electorate could be more inclined to vote for members of the leftist anti-austerity party if the economic conditions continue to worsen. 

[i]

Because of this possibility, Credit Suisse recently put the possibility of Greece dropping the Euro within a year at 15 percent.[ii]  In the short term, a Greek exit from the Euro Zone would most likely lead to increased economic turmoil in the country.  The new Greek currency could see an immediate devaluation of up to 60 percent.  At the same time local banks and depositors could see their accounts decrease by the same amount.  This could lead to a run of bank failures and collapse in business lending.  When Argentina dropped its fixed exchange rate with the dollar in 2001, a subsequent devaluation and bank funding crisis caused a 15 percent drop in its GDP in the first quarter of 2002.[iii]  A similar depression could occur in Greece.  However, Argentina’s GDP has increased approximately 5.9 percent annually since 2001.  In the long term, devaluations have historically shown to be an effective mechanism to restore competitiveness in the global market.  While the short term prospects appear dire for Greece if the country were to leave the Euro Zone, the long term benefits might be worth the short term pain.  Does the forecast for the Euro Zone appear similar?

Increase in the LTRO Program

The long term refinancing operation (LTRO) was a loan scheme announced by the European Central Bank in December with the intention of loaning out money to the region’s banks at a low fixed rate.  These three year loans had the effect of ending the liquidity problem that many European banks were beginning to experience.  In essence, the LTRO was the European version of the United States’ Quantitative Easing program.  However, the LTRO increased market contagion between countries and their own banks.  When the regional banks received the loans from the ECB, they used the money to buy the sovereign debt of their own country – the potential profit would be the difference in interest that they were paying the ECB for the loans and the higher interest payments that they would receive from owning the sovereign debt.  The increased purchases of the sovereign debt drove the interest rates down for a handful of countries, including Spain and Italy.  Recently, the interest rates on their debt have begun to rise again as the Euro Zone problems continue to pop up.  In the worst case scenario, a government default would almost certainly take down the local banks holding their debt as well.  In the event of a Greek default, the other peripheral countries could see their interest rates rise sharply.  This could cause investors to question whether or not the other countries could afford to continue to afford their large debt amounts.  What could be a temporary European solution?  Increase the amounts immediate available in the LTRO!  Article 123 of the Lisbon Treaty – the constitutional basis of the European Union – prohibits the ECB from directly monetizing the debt of any member country.  In other words, the ECB cannot buy a country’s debt at a primary auction (countries typically issue debt through auctions).  Yet, the ECB can purchase sovereign debt on the secondary market.  Throughout the latter half of 2011, this is actually what the ECB did. 

[iv]

As demonstrated by the chart, the “lending to euro area credit institutions related to MPOs denominated in euro” – the LTRO – and the “securities of euro area residents denominated in euro” – the sovereign debt purchases – significantly increased the size of the ECB’s balance sheet near the end of 2011.  By buying large amounts of government bonds in the secondary market – or by having the banks act as intermediaries through the LTRO – the ECB could push down the interest rate for the debt of the peripheral governments.  Although this wouldn’t change the structural problems of those economies, this strategy could buy those countries time.  Since austerity measures force economic growth lower in the short term, time is exactly what these countries need.  By not having to worry about the short term vagaries of the government bond market, these countries could focus on implementing strategies that could help their economies in the long run. 

Contagion

At the end of June, inspectors from the ECB, IMF, and the European Commission will have to decide whether Greece is doing enough to receive the next 11.5 billion euros of bailout funds.[v]  If Greece does not receive this payment, the country would default on its 200 billion euros in debt.  Since Greece would not be receiving any money to continue paying its debt payments, there would be no reason for Greece to continue to pay its debt payments on any of the debt held by the ECB or private investors.  In this scenario, the fear is that if Greece defaulted and caused investors to take losses on those holdings, then investors would probably pull their money out of Spanish and Italian government bonds.  Since the fixed conversion rate at which the Drachma joined the euro in 2001 would be retracted, there would be nothing keeping the other countries from doing the exact same thing.  Similar to the situation in the early 1990s when currency traders forced several countries, including Britain and Sweden, to withdraw from the currency bands forced by the European Monetary Union, traders would set their eyes on the bonds of the other peripheral countries.  In this scenario, traders would most likely sell the debt of Spain, Portugal, and Italy, and then convert the euros they received from the sales into dollars.  Furthermore, this trade would result in an increase in the interest rates in these countries and a depreciation of the euro against the dollar.  It is hard to argue against this occurring if Greece chose to leave.  Throughout the rest of the peripheral countries and in some of the core countries, such as France, there is a resistance to structural reforms and the austerity needed in the short term to lower their deficits.  Currently, the euro zone bailout fund has the potential to save Spain, but would need to be much larger in order to rescue Italy and its 1.9 trillion euros in debt.  Furthermore, both European banks and governments that have lent money to Greece over the past couple of years would have to write down the value of their Greek sovereign debt holdings.  Therefore, there could be tremendous fallout from Greece leaving the euro zone. 

[vi]

Would a collapse of the Euro Zone be a difficult pill to swallow for the global financial markets?  In all likelihood, there could be a worldwide risk-off trade in which equities – European, US, and emerging markets – are all sold in large amounts.  With correlation between equities at record highs in recent downturns, there probably will not be a sector that does not feel the brunt of a euro collapse.  However, U.S. banks and money markets do not hold much Greek debt.  This insulates these institutions and funds from any irreversible losses (the odds of Greece paying off any foreign debts are slim).  Would a collapse of the Euro Zone make European countries stronger in the long run?  This is a difficult question to answer.  On the one hand, European countries with debt issues could devalue their currencies and print more money.  Through these actions, their goods would become more competitive in the global marketplace (i.e. their exports would be cheaper to buy).  However, the synergies – the free movement of goods and labor, the lower interest rates for a majority of the countries, the unified monetary policy – would also be lost during this trying process.  Most likely, the ECB will do anything in its power to prevent a complete breakdown of the currency union.  Thus, an increase in the LTRO or in the amount of sovereign debt bought directly by the ECB could alleviate the short term liquidity and credit problems for the remaining countries. 

Conclusion

If Greece were to default on its debt and leave the euro zone, then more volatility in the financial markets would most likely accompany this event.  This rise in the volatility could produce decline in stock prices.  Could this present buying opportunities?  In the long term, this is certainly a possibility. Recently, Warren Buffett made a similar claim: “If you own a good business locally in Omaha and somebody says Italy's got problems tomorrow, do you sell your—do you sell your business? Do you sell your apartment house? No. But for some reason, people think if they own wonderful businesses indirectly through stocks, they've got to make a decision every five minutes…I want—I'm going to own those businesses for years just like I would own a farm or an apartment house and they'll be all kinds of events and there'll be all kinds of uncertainties and in the end, what will really count is how that business or farm or apartment house does over the years.”[vii]  In the short term, most investors should continue to focus on high quality names with limited exposure to Europe.  With this focus, investors can remain stock holders of companies with strong profit margins and dividend payments that can withstand a global slowdown.  Moreover, by allocating approximately 3 percent of your current investment portfolio to cash, investors can remain defensive but obtain the versatility to act if stock prices decline to cheaper valuations.

*The opinions and forecasts expressed are for informational purposes only and may not actually come to pass.  This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan.  The representative does not guarantee the accuracy and completeness, nor assume liability for loss that may result from the reliance by any person upon such information or opinions.

 

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