What happens if Greece leaves Euroland? Part 1
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Thoughts on what happens if Greece leaves Euroland and what this might mean for other economies: Part 1
Europe is again entering into a critical period of severe uncertainty and distress, most notably the ongoing Greek political drama and the potential for the country to return to the drachma. A Greek redenomination (and inevitable default) would cause substantial realized losses for both the ECB and the EFSF, as opposed to today’s hypothetical losses. This shifting reality will shine a bright light on policymakers deciding not only who will take the losses and how, but importantly, how much future risk they are willing to endure to keep the monetary union otherwise intact. The precedents set in the next couple of weeks will likely prove critical.
The Greek situation isn’t happening in a vacuum; rather it’s occurring at a time of increasing difficulty across political, fiscal, and monetary dimensions. The most important of these is the severely strained funding situation in Spain, where Prime Minister Rojay recently stated that “being locked out of the markets isn’t theoretical, its happening to the immense majority of regions, our whole financial sector, and most big companies”. Departure of Greece from Euroland would likely hasten further capital flight and require meaningfully greater amounts of public support to the periphery. In light of the substantial costs of Greece’s failure, however, it’s certainly an open question as to whether or not decision makers will be comfortable signing up for “more Europe”. Yet, this is precisely what will be necessary were a run on Spain to occur in a magnitude similar to that which has occurred in Greece. Future commitments to Spain would ultimately dwarf the nearly €400bn of ECB support that has already been provided to the country’s banks and sovereign to stave off uncontrolled deleveraging. At one level, it seems inconceivable that Spain would fail to get the funding it needs from the EU or ECB given its prominence in Europe. But it also seems inconceivable, in light of Greece’s historic losses, that the core would sign up to provide hundreds of billions in further support, especially since the ESM bailout mechanism hasn’t even been ratified in a number of politically volatile environments, including Germany.
Below, we detail who bears the risks in the event of a Greek default and what a similar situation occurring for Spain might entail for its creditors.
Turning first to Greece, we examine the €912bn of total Greek economy debt, by debtor and creditor, in an effort to improve our understanding of who, in the event that Greece does devalue/default, would likely end up on the hook for the losses.
While it’s a pretty straightforward process to figure out how private sector losses will be divvied up, it’s far more difficult to determine exactly how public sector exposures will be dealt with, despite the existence of some protocols which we’ll describe below. How the ECB, EU, and IMF recognize a default were it to occur will be precedent setting, not only because of the potential magnitude of the Greek loss, but also because obviously no central bank has ever departed the monetary union.
Greek Private Sector Exposure
The private sector holds €586bn of Greek debt. The bulk of the debt is held by domestic Greek entities. Domestic debt is primarily in the form of domestic bank deposits, which in turn support domestic bank lending. These Greek banks’ deposits and loans are likely to be redenominated. Private foreign holders of Greek debt have less exposure, €91bn, and have likely marked down some of this exposure, so a Greek default is unlikely to be destabilizing from direct private foreign exposure. However, the bigger impact and the bigger question about a Greek default is its impact on capital flows in other peripheral countries. Italy and Spain still have substantial amounts of foreign credit at risk and virtually all their domestic deposits remaining. Were the Greek redenomination to result in a substantially negative capital flow impact on these countries, it would strain all publicly available sources of backstop funding.
Greek Public Sector Exposure
About a third of total Greek debt, or €325bn, is held by the public sector, which after the recent debt swap now makes up 80% of all foreign holders of Greek debt. This significant exposure could result in large losses in the event of currency redenomination. The IMF has €33bn and would typically subordinate all other non-secured creditors including the EU and ECB further reducing European taxpayer recovery. The ECB has €188bn of exposure, most of it from monetary activities within Euroland, only €50bn of which comes via its ELA exposure (which could be treated a bit differently). The magnitude of ECB losses, combined with the lack of a hardened process for dealing with them, could make a resolution on loss-sharing a question mark and a test for ECB policymakers. The EU, via bilateral and EFSF loans, has about €110bn in credit risk. While Greek losses would be large, they would also be manageable given that they reside with institutions that have a lot of capacity to absorb them. That said, they are also big enough to stimulate a lot of debate about future commitments to periphery bailouts.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
