Why now Mr. Papandreou? What a Greek exit means for Europe.



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Tobias S. Blattner, Economic Research
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3 November 2011

Papandreou’s decision late Monday night to call a referendum on the Greek bailout agreed last week took everybody (even his closest allies) by surprise. And it was a move that embarrassed his European partners and sent new shockwaves through financial markets.

With the world still puzzled by Papandreou’s move and markets still hungover from Tuesday’s massive plunge, the situation in Greece remains as uncertain as ever. Markets took Papandreou’s decision at face value, preparing for a disorderly default and a Greek exit from the euro area. But whether or not Papandreou is indeed toying with the idea of leaving the euro area must be in doubt and his motivations are likely to have been driven by a desire to force the opposition to show its support for the deal reached last week.

In fact, it now looks unlikely that a referendum will take place, although Papandreou might still lose the confidence vote on Friday, leaving it to a subsequent government to decide the future path of Greece. What we certainly know, however, is that euro area governments will suspend the payout of the next, €8bn, tranche of bailout cash, which just a few days ago seemed a formality, until there is clarity on whether Greece is willing to implement the fiscal and structural reforms embodied in the bailout package.

What does this mean for markets? It means that November is set to be a difficult month with markets having to prepare for all eventualities, including a disorderly Greek default, a Greek exit from the euro area or a newly-elected government likely to be equipped with a mandate (but almost certainly not the ability) to renegotiate last week’s bailout deal.

What are the chances of each happening? With the chances of a referendum fading as events move on, the likelihood of Greece leaving the euro area shrinks too. But it does not disappear altogether. Even a fast-track general election – instead of a referendum – would still leave fears that a disorderly default of Greece could be on the cards in mid-December. 

Indeed, if any new government attempts to renegotiate any aspect of Greece’s bailout package, a payout of the €8bn tranche will not happen, triggering the disorderly Greek default that euro area leaders have struggled to avoid for so long. And if Greece defaults in a disorderly manner, continued membership of the euro area, although legally possible – as current EU Treaties have no provision to expel a country from the euro – is practically impossible.

So, Greece could well be on a path that leads to eventual euro area exit unless a stronger ‘national unity’ government emerges that accepts the conditions of the bailout package and can implement the reforms demanded by euro area governments and the IMF. 

If it doesn’t, Greece is doomed. A disorderly default would trigger uncontrolled runs on Greek banks, something that could only be stopped by strict capital controls and (probably) military enforcement. The Greek banking system would in any case collapse as its massive holdings of Greek sovereign debt become worthless. The new drachma would plummet in value on foreign exchange markets. The corporate sector, meanwhile, would be left with euro-denominated debts, but drachma earnings. It would buckle under the weight of those debts. And while the Greek central bank will be forced to crank up the printing presses to finance the budget, the resultant inflation will exacerbate Greece’s recession that might see the country’s GDP fall dramatically. Social disorder would be rife.

But what would a Greek default and exit mean for the rest of the euro area (and the world)? First, it would see around €280bn of wealth held by non-Greek residents destroyed. While the ECB, IMF and euro area governments account for around 40% (€115bn) of all outstanding Greek debt, European banks have already made significant write-downs in the vicinity of 50-60% of their holdings, leaving roughly €75bn in additional write-downs for banks, insurance companies and households if Greece were to default. The payout of CDS contracts that would be triggered by Greece’s default would, however, dampen the impact on private bondholders in the banking sector.

But the direct costs from a Greek withdrawal from the euro are likely to be negligible compared to the potential meltdown in financial markets that a looming disorderly Greek default would imply. Without doubt, Italy and Spain, the two countries currently in the forefront of the crisis, will feel the heat from Athens in the weeks running up to the deadline for the disbursement of the next tranche of bailout cash. In the absence of an effective firebreak involving either the ECB directly or indirectly through the EFSF, the pressure on these two countries might rapidly push the yields of Italy to unsustainable levels. And faced with the direct threat of a break-up of the euro, European leaders might finally be willing to take those actions that will stop the crisis from spreading further – give the EFSF a banking licence and let a fiscal union follow the monetary union.  But the deeper the crisis is allowed to get, the more expensive the eventual solution, while the chances that increasingly desperate policymakers end up blowing up the euro as it’s currently constructed, whether by accident or design, grow.


Tobias S. Blattner
Euro area Economist

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