Impact of Possible Greece Exit

 | June 18,2012 11:27 am IST

Bankers, governments and investors are starting to prepare for Greece to stop using the euro as its currency, a move that could spread turmoil throughout the global financial system. The worst-case scenario envisions governments defaulting on their debts, a run on European banks and a worldwide credit crunch reminiscent of the financial crisis in the fall of 2008.

A Greek election on Sunday went a long way toward determining whether it happens. Syriza, a party opposed to the restrictions placed on Greece in exchange for a bailout from European neighbors, could do well. In the meantime, banks and investors have sketched out the ripple effects if Greek were to leave the euro. They think the path of a full-blown crisis would start in Greece, quickly move to the rest of Europe and then hit the U.S. Stocks and oil would plunge, the euro would sink against the U.S. dollar, and big banks would uncover losses on complex trades.

Possibility I : What would Greece's exit look like? In the worst-case scenario, it starts off messy ?
The government resurrects the Greek currency, the drachma, and says each drachma equals one euro. But currency markets would treat it differently. Banks' foreign-exchange experts expect the drachma would plunge to half the value of the euro soon after its debut. For Greeks, that would likely mean surging inflation -- 35 percent in the first year, according to some estimates. The country is a net importer, and would have to pay more for oil, medical equipment and anything else coming from abroad. The Greek central bank would also need to print more drachmas once the country got locked out of lending markets. Greece's government and banks currently survive on international aid, without access to markets, they have to print money. That's one reason analysts say the switch to a drachma would lead the country to default on its government debt, possibly triggering losses for the European Central Bank and other international lenders.


Most assume foreign banks would have to write off loans to Greek businesses. If the new currency fell by 50 percent to the euro european banks would take a direct blow. They've managed to shed much of their Greek debt but still held $65 billion, mainly in loans to Greek corporations, at the end of last year, according to an analysis by Nomura, a financial services company. French banks have the most to lose.

Possibility II : Here's where things get scary ?
The European Central Bank and European Union would have to persuade bond investors that they will keep Portugal, Spain and Italy from following Greece out the door. Otherwise borrowing costs for those countries would shoot higher. Experts agree that the so-called firewall built to stop the crisis from spreading needs more firepower. Much of the ?248 billion ($310 billion) left in the European Financial Stability Facility, one European bailout fund, was pledged by the same countries that may wind up needing it. There's also a European Stability Mechanism that's supposed to be up and running next month, but Germany has yet to sign off on it. A fast-spreading crisis is known in financial circles as contagion -- a term borrowed from medicine and familiar to anyone who has watched a disaster movie about killer viruses on the loose. 'It's like a disease that spreads on contact'. The bond market, where banks, traders and governments cross paths, provides the setting.


If Greece dropped the euro, traders would become more suspicious of Spain, Portugal and Italy and sell those countries' government bonds, pushing their prices down and driving their interest rates up. Higher borrowing costs squeeze those countries' budgets and push them deeper into recession. Plunging bond prices imperil Europe's already troubled banks, which stockpiled government bonds when they were considered safe. At this point, the risk would be high for a run on banks throughout Europe. People would stampede to their banks to withdraw what they can. Analysts and investors say that's the biggest fear. People in Spain, for example, have already seen what's happened in Greece and have started pulling euros out of their accounts in fear the country will switch back to cheaper pesetas. In less frantic times, the government would come to the rescue with cash or take over the banks.


European countries have already committed to lend up to $125 billion to Spain's banks to help save them. But all this is happening in the middle of a government debt crisis, and if the crisis gets worse, the Spanish or Italian governments couldn't borrow enough cash from investors to save the day. From here, the crisis could easily snowball: Banks could fail, the surviving banks could stop lending to each other, and a credit freeze could shut down Europe as assuredly as a blizzard did last winter. One way to stem the contagion would be to create so-called eurobonds -- bonds backed by all 17 euro countries. They could be sold to raise money for troubled European governments. Germany, which has the strongest economy of the euro countries, has slowly warmed to the idea but wants weak governments to fix their finances first. Cash-strapped European governments should be able to turn to the IMF for help, but the IMF's money comes from its 188 member countries. U.S. and other countries may balk if the IMF asks for help supporting Europe.

Possibility III: A full-blown crisis would cross the Atlantic through the dense web of contracts, loans and other financial transactions that tie European banks to those in the U.S., experts say ?
Blythe, the professor at Brown, believes credit default swaps, the complex financial instruments made infamous by the 2008 financial crisis, would provide the path. The swaps were created as a sort of insurance for loans. After lending money to a business or government, investors take out insurance on the loan. If the borrower runs into trouble and can't pay -- say, the government of Spain defaults -- the banks that sold the insurance cover the loss. A $2 billion trading loss that JPMorgan Chase revealed in May, traced to a hedge against the Europe crisis, shows just how easy it is for even the safest and savviest of banks to slip up. And it doesn't even take a default for a credit default swap to go bad. If traders think other countries will follow Greece, they'll drive up borrowing rates by selling government bonds, which also pushes up the cost of insuring their debt.


That's similar to how your neighborhood insurance agent handles a teenage driver. In the derivatives market, where credit default swaps are traded, there's a twist. When markets treat Spain like a bad credit risk, those who took out insurance on Spanish debt to protect against a default can force the banks that sold the insurance to prove they can make good on the claim. To do that, banks cash out something else -- U.S. government debt, gold, or anything easy to sell. In normal times, it's no big deal. In a crisis, it can lead to a cascade of selling, spreading trouble from one market to another. Another problem: It's not clear how much U.S. banks have at risk to Europe through credit default swaps, because regulations let banks keep that information a secret.