FINANCIAL MARKETS RESEARCH A Greek cliff-hanger May 2012

Economics
25 May 2012

A Greek cliff-hanger
GDP growth (YoY%)

What could happen if Greece defaults

Even if it is still hard to see how anyone in the Eurozone could benefit from a Greek exit, latest developments have shown that politics does not always exclusively follow economic rationale. A Greek exit has again become more possible in recent weeks. While our baseline scenario remains cautiously optimistic that a Greek exit could be avoided, we take a closer look at the practicalities of the unthinkable.
Following the inconclusive result to the 6 May elections, we warned that the subsequent month would likely be characterised by high volatility in markets. Developments since then have confirmed our view. We believe a Greek exit has become possible, depending on the results of the 17 June elections. Even if a Greek default within the Eurozone looks possible in theory, it is doubtful whether the rest of the Eurozone would have much sympathy for Greece staying if it reneges on the entire bailout deal. An exit from the Eurozone is not anticipated in the European Treaties, but the ECB could de facto push Greece out of the euro. While a smooth and orderly return to a new Greek currency looks unlikely, in our view, the direct impact on Eurozone governments and private sector participants could be significant. At the same time, we believe immediate fire-fighting following a Greek exit would be mainly in the hands of the ECB. Although a financial crisis triggered by a Greek exit could have a silver lining, pushing the Eurozone towards greater integration, it is still hard to see how anyone in the Eurozone would benefit from a Greek exit. The Greek cliff-hanger looks likely to continue.

10 5 0 -5 -10 Q1 Q1 Q1 Q1 Q1 Q1 Q1 06 0 7 08 09 1 0 11 12 GDP growth (YoY%)

Source: ELSTAT

Budget deficit (% of GDP)

20 15 10 5 0

Source: Eurostat

General govt debt (%of GDP)

200 150 100 50 0

20 00 20 02 20 04 20 06 20 08 20 10

Political situation
Over the first week of the new campaign, political parties have been positioning themselves for the next polling date. Two opposite fronts have been emerging, even if the debate has not yet been radicalised. On the one hand, a group of parties, led by ND, Pasok, Dimar, and three small liberal parties that could not breach the 3% threshold in May, is moving along the lines of the last campaign. Keeping Greece within the Eurozone is its main objective. Aggregations within this group are already happening, with the Democratic Alliance, a liberal party that gained 2.6% of the votes in the 6 May elections, already merging back into ND, with Drasi, Liberal Alliance and Dimiourgia Xana (DX), three other small pro-bailout parties, announcing they would join forces ahead of the June 17 elections. In principle, parties within this broad group all pledge to renegotiate some aspects of the austerity programme, without reneging on its backbone. The political alternative to the pro-bailout parties is led by Syriza, which came second in the 6 May election, leveraging on Greeks adjustment fatigue with a staunch anti-austerity message. While still campaigning for reneging on the bailout accords, Syrizas leader, Tsipras, has so far maintained that he has no intention of taking Greece out of the Eurozone. In a speech in Berlin, he stated that if in government after the 17 June elections, he would be prepared to negotiate with the Eurozone, but remained vague about the object of such negotiations.

Source: Eurostat

Paolo Pizzoli
Milan +39 02 89629 2648 paolo.pizzoli@ing.it

Peter Vandenhoute
Brussels +32 2 547 8009 peter.vandenhoute@ing.be

Carsten Brzeski
Brussels +32 2 547 8652 carsten.brzeski@ing.be

20 00 20 02 20 04 20 06 20 08 20 10

research.ing.com

1 SEE THE DISCLOSURES APPENDIX FOR IMPORTANT DISCLOSURES & ANALYST CERTIFICATION

A Greek cliff-hanger

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The first bout of the new campaign has thus brought about some repolarisation of the political spectrum, but has not yet transformed into a referendum on the euro. Indeed, according to opinion polls, the Greek paradox on the issue seems to be holding: some 80% of Greeks are reported to be in favour of Greece remaining in the Eurozone, while at the same time two-thirds of Greeks are reportedly against the austerity package. We still expect this delicate and ambiguous issue to enter centre stage in the campaign very soon, as the growing volume of international speculation on contingency plans about a Greek exit will be weighing on the domestic debate. The outcome of the next elections remains highly uncertain. Opinion polls, conducted since the new elections were announced, signal that ND and Syriza are contending for the leading position (which will be worth an extra 50 seats), while recently Syriza seems to have taken the lead. Pasok follows at a distance. The number of reported undecided voters hovers at c.8%. While still too close to call, the campaign has yet to take on the last wave of alarming signals coming from financial markets.

Our baseline scenario

While acknowledging that the risk of a Greek exit has substantially increased, our baseline scenario is still for Greece to remain in the Eurozone for the time being, though a Syriza-led government might make this scenario somewhat more challenging. For our baseline scenario to materialise, a trade-off on the concessions/rigour front will be required on both sides. Even if a Greek exit is currently neither in the interest of the Eurozone or Greece Given the high costs that a Greek exit would entail for all players, we think the Eurozone has an interest in promising Greeks some form of softening (or delay) of the requested adjustment and/or expect some form of pro-growth targeted initiatives. In our report, EMU Break-up: Pay now, pay later (December 2011), we tried to assess the economic impact of a Greek exit and concluded with estimates that suggested it would be extremely severe for most of the involved parties. Sticking to the Eurozone, the estimated GDP growth cost (measured by the difference with the base case) varied from c.1.2% of GDP in 2012F for the average core country to c.2% for the average peripheral (ex Greece) and 7.5% for Greece itself. Moreover, a Greek exit would create a precedent that could induce an acceleration of contagion at a time when the Eurozone is not yet endowed with strong enough fiscal and monetary weapons to fight speculative attacks. Still, with the debate on the Greek exit scenario no longer an academic exercise, a closer eye on its financial consequences appears warranted.

the debate is no longer an academic one

Triggering a Greek exit

as a complete anti-bailout stance by a new government would probably end the Eurozones patience How could a Greek exit be triggered? In the event that a new Greek government adopted a pure anti-bailout stance following elections, without any willingness to negotiate, but at the same time insisting on Greek Eurozone membership, we believe Eurozone patience would probably be over. As a result, the Eurozone would most likely stop any bailout payments, probably forcing the Greek government to default. However, a default does not automatically lead to a Greek exit. Note that there are no legal possibilities to push a country outside of the Eurozone (even a voluntary exit is not anticipated in the European Treaties, only an exit from the entire EU). As an alternative to leaving the Eurozone, some commentators moot the idea of introducing a parallel currency, which would still allow Greece to avoid a default and remain within the Eurozone. The Greek government could start paying public workers and bills with IOUs that could be used as a means of payment. At the same time, capital controls would have to be installed to prevent euros flowing out of the country. The IOUs issued by the government would likely fall in value, fostering an internal devaluation in Greece. The trouble with this plan is that all domestic and foreign debts are still denominated in euro, which would create a situation of debt deflation, at least for the
2

Parallel currency unlikely to be a panacea

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private sector. While it may allow the Greek government to avoid temporarily defaulting on its payments, it is unlikely to be a panacea, certainly if Greece does not manage to establish a primary surplus quickly. Similar schemes in Argentina, introduced in 2001, did not prevent the country from eventually having to abandon the currency board with the dollar at the start of 2002. Moreover, it is doubtful that other Eurozone countries would have much sympathy for Greece staying in the Eurozone after reneging on the entire bailout deal. ECB holds the key for Greeces membership of the Eurozone The most likely road towards a possible Greek exit from the Eurozone goes through the ECB, or more explicitly through the banking sector. Greek banks have become increasingly dependent on central bank liquidity (see Figure 1). Cutting off Greek banks from liquidity assistance could force Greece out of the Eurozone. Indeed, the ECB can, with a two-thirds majority, block a steep and unsustainable increase in ELA provided by the Bank of Greece. As ECB Governing Council member Luc Coene put it, ELA is liquidity assistance, not solvency assistance. As long as the ECB is willing to provide emergency liquidity, Greece could probably allow a complete anti-bailout stance without leaving the Eurozone. But without the ELA support, we believe it is unlikely that Greece could remain within the Eurozone.
Fig 1 Greek banks increasingly rely on ELA

180 160 140 120 bn 100 80 60 40 20 0 Jan-10 Jan-11 Jan-12

Open market operations

Source: Bank of Greece, ECB

ELA

* ING estimates

and stopping ELA and shutting Greece out of Target2 would de facto push Greece out of the euro

Even if the Greek central bank were to continue providing ELA without the ECBs official blessing, payments to and from Greek entities would likely be shut out of the TARGET2 system. However, this is not a decision that the ECB would make alone. Ultimately, this would likely be a joint decision made by the heads of state of the Eurozone and the ECB. Shutting the Bank of Greece out of the Target2 system would prevent clearance of crossborder payments out of Greece, de facto pushing Greece out of the euro. Being cut off from sources of financing, we believe an isolated Bank of Greece would probably have little alternative to printing money, recapitalising Greek banks and monetising the state deficit.

Practicalities of a Greek exit

Introducing a new currency can turn out to be a burdensome process Historical evidence shows that break-ups or exits from monetary unions can turn out to be a burdensome process. For starters, the decision to leave the Eurozone, be it voluntary or forced, would involve a logistical nightmare. The conversion of vendor machines, parking meters and other machines using coins and notes from euro into drachma would take many months. The conversion of software for electronic payment systems and contracts would not only take time, but in the case of contracts, this could also give rise to legal battles (while the introduction of the euro guaranteed continuity of contracts, the same cannot be said of a switch back to a national currency). Unless the
3

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Greek central bank was already secretly printing new drachmas, there is likely to be a difficult transition period where new cash would have to be brought into circulation, which could take several months. and would probably lead to two currencies: a new legal tender and the euro as tender in the shadow economy The immediate period following a Greek return to a new currency would probably see a longer bank holiday period, as in the US in the 1930s (four days). During this period, the government could decide to only accept stamped euros as legal tender (stamping has been a common practise in earlier break-ups). However, it is very unlikely that many private holdings would be offered for stamping, as an unstamped euro would be considered to be worth more. In our view, the euro would therefore likely be used on the black market or shadow economy, but disappear from official circulation. Moreover, Greece would need to install capital controls or even freeze bank accounts just to prevent savings denominated in euros to leaving the country. This might even include strong border controls to counter the smuggling of euro bank notes out of the country. To try to remedy the lack of cash, the Greek government might execute all of its cash payments initially in IOUs (that could be later exchanged into the new drachma), which could also be considered as legal tender. Following default and exit from the monetary union, we believe the Greek government would set the conversion rate on a 1:1 basis, meaning that all prices, loans and deposits would initially be converted at par into new drachmas. However, this parity would be unlikely to last very long. We anticipate a potential depreciation of up to 80% against the euro over the first two years. Important capital controls in combination with the ensuing logistical chaos would likely have a deterring impact on tourism, limiting at first the potential positive impact of significant drachma depreciation. and a smooth or orderly return to a new Greek currency looks unlikely More generally, it is hard to see a smooth or orderly return to a new Greek currency. The introduction of the euro for example was a result of many years of preparation and a smaller period of double-pricing, not a couple of weeks.

Capital controls would be required

Measuring the direct impact of a Greek exit

The default that a Greek exit would entail would leave many players exposed to substantial potential losses. Eurozone governments would be hit both directly and indirectly by a Greek exit Eurozone governments would be hit both directly and indirectly through their central banks. Eurozone governments have direct exposure of 52.9bn through bilateral loans disbursed in the first Greek package and of 72.9bn through EFSF exposure put in place with the second Greek package. EFSF exposure would also likely include 35bn lent to Greece for collateral enhancement. Losses to the ECB would materialise through its SMP exposure to Greek government bonds, which is estimated at c.40bn and through losses on collateral in refinancing operations. The net liabilities of the Bank of Greece to the Eurosystem (Target2, including banknotes) amounts to c.120bn, or 113bn when excluding the 7bn held by the BOG under the SMP. The private sector would be affected, too, with the Greek banking system first in the line of fire. Having suffered a substantial outflow of deposits (c.35bn or -17% in the 12 months to the end of March), following Februarys haircut Greek banks are still exposed to Greek government bonds to the tune of c.23.7bn. Non-Greek banks would also take a substantial hit, but here the cost would be concentrated on France and Germany. According to BIS data, at the end of December 2011, the outstanding exposure of non-Greek reporting banks to Greek government bonds was c.US$23bn (17.1bn), with European banks taking the lions share (96%) of this. Taking into account the haircut, exposure might still be in the region of US$11bn (8.4bn). When looking at exposure to the Greek non-bank private sector, France emerges clearly as the most exposed country. Out of the total US$69.4bn of foreign claims, c.US$37.6bn pertain to France, mainly due

while losses in the private sector would mainly be carried by the Greek banking sector

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to its direct involvement in the Greek banking system through a big local bank fully owned by a French parent bank. Could the IMF stay out of the fire? Lastly, the IMF, which has 21.7bn of exposed to Greece. As a Greek exit would likely prevent any substantial financing from the Eurozone/EU, the IMF would presumably be the first external source of emergency funding for an exited Greece. In this light, a Greek default procedure could possibly see the country making extra efforts not to default on IMF loans to keep the door open for future IMF financing. Moreover, and perhaps ironically, as long as Greece remains a member of the European Union following an exit from the Eurozone, it could still apply for the EUs so-called balance of payment assistance.
Fig 2 Eurozone governments and IMF exposure to Greece (bn)
52.9 72.9 35.0 120 40 21.7 342.5

Eurozone bilateral loans EFSF second package EFSF collateral enhancement ECB Target2 + banknotes ECB holdings of Greek sovereign debt IMF Total Eurozone + IMF exposure
Source: ING, various sources

In the wake of a Greek default, the question remains how big the ultimate losses of creditors could turn out to be. Since most Greek debt is now governed by foreign law, it would be hard for Greece to redominate this in new drachmas. With the need to continue to service its debt to the IMF, there seems to be little to recoup for the other creditors. There is a very slim chance that PSI bond holders would still be serviced through the escrow account created under the second bail-out plan, though it is almost unimaginable that the terms of the second bail-out plan would still be applicable in the case of a Greek exit and default. Non-IMF creditors could be wiped out almost entirely If Greece manages to redominate its debt in drachmas, creditors are likely to lose close to 80% through depreciation alone, not even taking into account a potential haircut. Under most scenarios, it therefore looks likely that non-IMF creditors would be nearly entirely wiped out.

Fire-fighting after a Greek exit

A Greek exit would likely cause bank runs in other peripheral countries The fall-out of a Greek exit and it effect on the rest of the Eurozone countries would be hard to contain. Bank runs in other peripheral countries would seem unavoidable, threatening to collapse the banking system. But even core countries such as France would not escape the turmoil, as French banking exposure to Greece is important. In our view, contagion would likely spread to other banks in the Eurozone as well, creating a panic potentially dwarfing the crisis precipitated by the Lehman bankruptcy. At the same time, we believe peripheral debt would likely plunge, closing capital markets for countries such as Spain and Italy. In these circumstances, we feel the ECB is likely to act decisively to save the Eurozone. As such, we believe a rate cut to 0.50% looks a near certainty (an even lower rate cannot be excluded). On top of this, we expect the ECB to have to provide the needed liquidity to keep weaker banks afloat. Special longer-term liquidity operations would appear very likely. This might also involve the loosening of collateral rules to make sure that there are no limits on liquidity injections. This would likely apply to the normal refinancing operations (since here funds are lent at the refi rate), although it is not impossible that some of the emergency financing would run through ELA. At the same time, we believe the ECB will have to assume directly or indirectly the role of lender of last resort for vulnerable Eurozone sovereigns. A reactivation of the SMP programme looks likely, although its effectiveness has been hurt by the de facto preferential creditor status of the
5

A rate cut to 0.50% would follow

combined with unlimited liquidity injections into the banking sector

and support for peripheral bond markets

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ECB. In this regard, the EFSF could also help, eg, by guaranteeing short-term debt from peripheral countries to get them through a period of liquidity shortages. Lastly, the ECB might decide to give the ESM access to ECB liquidity to create a wall of money to deter speculation against peripheral debt. While this might be seen as monetary financing of public deficits, it is essentially not dissimilar from the LTRO operations. Proposals for a European bank resolution and deposit guarantee scheme would likely get traction Despite the financial crisis, a Greek exit could prove to have a silver lining, as we believe European leaders would realise that a more integrated financial framework is needed to ward off financial mayhem in the future and to preserve the advantages of an integrated financial market. Already there are signs that Eurozone capital markets are fracturing with both banks and multinationals trying to manage their European exposure along national lines, a practice that is likely to exacerbate the credit crunch in countries with an insufficient deposit base. In this regard, there is a potential role for the ESM as a bank resolution scheme is likely to be considered, with the ESM having the possibility of directly recapitalises systemic banks across Europe. In the same vein, discussions on the European Deposit Guarantee Scheme would likely get a new impetus, in our view. That said, these more structural changes are only likely to be discussed after the more immediate fire-fighting has been carried out.

Greek cliff-hanger likely to continue

In our view, it is still hard to see how anyone in the Eurozone would benefit from a Greek exit. As we have stated, both the direct and indirect cost to the Eurozone would be enormous. At the same time, a Greek exit would hardly be better than austerity and reform for the country itself. However, latest developments have shown that politics does not always exclusively follow economic rationale. Some commentators even suggest that to prevent member states from blackmailing the rest of the Eurozone in future, it might be worth let Greece go to make an example of the country. In this sense, one might wonder whether, with hindsight, the Fed would still opt to let Lehman brothers go bankrupt. The Greek cliff-hanger looks likely to continue.

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