Europe's Currency Crisis: A Look at Possible Scenarios
June 6, 2012
- A Greek exit from the eurozone has gone from "unthinkable" to a distinct possibility. Years of steep economic decline and unsustainable public debt have increased the odds that the country will once again default on its debt and possibly return to the drachma.
- A Greek default/exit would present risks to the European banking system, could cause a severe downturn in the Greek economy and might trigger contagion that spreads to countries like Spain, Ireland and Portugal.
- The European Central Bank and other institutions theoretically have tools to lower contagion risk, but may lack the time and political will to use them.
- Ultimately, the exit of one country from the euro could lead to the exits of other countries and a breakup of the euro as it's currently known.
- We suggest investors limit exposure to European bond markets and the euro, both of which are likely to experience more downside.
The May 6 elections in Greece ousted the party that had negotiated and agreed to the bailout package offered by the European Central Bank (ECB), International Monetary Fund (IMF) and European Commission (EC). This group, often referred to as the "troika," provided bailout funding to the Greek government so that it could cover its debt payments in exchange for a promise that the country would bring its budget deficit and debt down by reducing spending and raising taxes. Greek voters have effectively rejected the agreement because of the negative impact that spending cuts have on their economy, which is already in deep recession. No party won a majority in parliament in the May elections and a coalition could not be formed. Therefore, new elections are scheduled on June 17.
If the new government insists on renegotiating the terms of the current bailout plan, new talks with the troika will have to take place shortly after the election. If there is no agreement, the troika could decide to deny Greece its next chunk of bail-out money, which would likely lead to a default on Greece's sovereign bonds.
Greece needs to form a new government and reach an agreement with the troika before it runs out of money in July 2012. If they reach an agreement, Greece is likely to stay in the eurozone but would need to stick to the new austerity plan to continue receiving aid.
Greek opinion polls show elections are wide open
According to recent poll results, the June 17 elections are wide open and could very well lead to a government that meets Europe's terms for keeping Greece in the euro. However, it could also put in power a coalition government that's firmly against austerity—positioning Greece for an exit from the euro.
Scenario 1: Coalition around New Democracy keeps Greece in
Although traditionally powerful Greek political parties like the Pan-Hellenic Socialist Movement (PASOK) and New Democracy (ND) have seen their influence wane in recent years, ND has been catching up with the anti-austerity Coalition of the Radical Left (SYRIZA) party since May 6. Should ND be able to get the upper hand in the June 17 elections, it would increase the likelihood of an agreement with the troika.
Source: Greek Ministry of Interior
*PASOK (Pan-Hellenic Socialist Movement), ND (New Democracy), DISY (Democratic Alliance), KKE (Communist Party of Greece), LAOS (Popular Orthodox Rally), SYRIZA (Coalition of the Radical Left), DIMAR (Democratic Left), ANEL (Independent Greeks), XA (Popular Union). ** Projected estimate of vote tally, after disregarding all blank votes and absentees, and after adjusting for the "likely votes" of "undecided voters.
Scenario 2: Coalition around SYRIZA precipitates Greece's exit
SYRIZA, on the other hand, has denounced the current austerity plan. Party leader Alexis Tsipras believes Greece can stay in the euro and continue receiving money while cutting austerity measures—something Germany and other creditors probably aren't going to like. If SYRIZA gains control, it would likely make the negotiations with the troika difficult and increase the risk of a Greek default and exit.
The mechanics of a Greek exit
Phase 1: Announce exit, close Greek banks, determine exchange rate
There is no clause in the European Treaty that would allow the other eurozone members to force a country out of the euro. It is ultimately up to Greece to decide whether to exit or not. The first step would be to determine the exchange rate of the new drachma, to re-establish the Greek central bank's powers, and to immediately close Greek banks for a few days. This would give the banks time to make changes to their systems and to try to hold off the inevitable capital flight.
Capital flight is when investors move their money from an economically or politically risky country to one that's more stable. In the first quarter, overall Greek bank deposits fell 11.7 billion euros ($14.8bn). The chart below shows that almost 40% of overnight deposits have already left Greek banks since the end of 2009.
Source: European Central Bank
In order to prevent further capital flight, the announcement of a return to the drachma would have to be a surprise and the return would have to be executed essentially overnight. If people have enough time to transfer their money out of Greece, it could push Greek banks towards a collapse. The temporary closing of banks would have to be accompanied by capital and currency controls in order to limit how much money citizens could withdraw from bank accounts or take out of the country. There might also be limits and/or tax penalties for transferring funds abroad.
But Greece is only part of the problem. We are already seeing a slow-motion bank run on the much bigger Spanish and Italian banks.
Source: European Central Bank
Two powerful tools to stem capital flight would be a pan-European deposit insurance similar to the US Federal Deposit Insurance Corporation (FDIC), and the provision of a banking license to the European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) so it can directly recapitalize banks. Ratification would require parliamentary approvals, and could therefore take a while to get implemented.
Phase 2: Convert holdings in euros to new drachma
In this phase, all savings and checking accounts, credit card debt, pensions and life insurance policies, mortgages, and company balances and contracts would have to be converted from euros to drachmas.
Cross-border debt would either remain in euros or be converted into drachmas, depending on the law they were issued under: About 85% of Greek debt was issued under Greek law and could therefore be converted into drachmas. The rest would remain in euros. However, the recent debt restructuring happened under English law, which presents another complication. Whether cross-border debt is denominated in euros or in drachmas would matter because the drachma would likely depreciate significantly, reducing the value of the debt. A lower drachma would therefore be beneficial for Greece but bad for foreign holders of Greek debt.
Phase 3: Pull euros out of circulation
It would probably take at least a month to print new coins and notes, and the transition phase to replace Greek euros in circulation with drachmas could take between two and six months. In the meantime, old Greek euros would likely be stamped and used as drachmas.
Phase 4: Devaluation of the new drachma
The new drachma would likely, at least initially, be very weak relative to the euro because of the combination of capital flight and Greece's lack of competitiveness when compared to other European countries.
In a free-floating currency market system, a country's currency will adjust for lack of competitiveness. Competitiveness is a country's ability to produce goods and services at a price and quality that makes them reasonably attractive in comparison with those of other countries on the global markets. Due to a variety of factors including higher wage growth, lower productivity and a lack of technical innovation, Greece's exports have not been competitive on the world markets when priced in euros. As a result, the country is running a large deficit with its trading partners in Europe. With a weaker currency, Greece's exports could become more competitive and imports would be very expensive, so the trade gap would most likely narrow. Greece could then grow again, much like many emerging markets after their defaults and devaluations (Mexico 1993-94, Thailand 1997, Russia 1998 and Argentina 2002).
Source: Schwab Center for Financial Research with data from Bloomberg
It's difficult to predict the extent of possible decline in the drachma, as investor panic tends to cause currency markets to overshoot when a country leaves a currency union or abandons its peg to the US dollar. Recent estimates of current-account imbalances based on the work of Rogoff and Obstfeld point to an estimated depreciation of 45%, while Roubini Economics estimates a 50% depreciation could eliminate the current-account deficit. Capital Economics' estimates are 40% for the Greek drachma and the Portuguese escudo, 30% for the Italian lira and the Spanish peso, and 15% for the Irish punt.
However, if history is any guide, a steeper decline is likely, in our view. In the mid-nineties, the Mexican peso depreciated by 115% within three months after the peg to the dollar was abandoned. The Argentine peso lost 286% in 6 months in 2002, and the Thai baht and the Russian ruble depreciated 115% and 330% in 9 months, respectively, in the late nineties (chart above).
Phase 5: Haircut on Greek sovereign debt
The exit from a currency union only makes sense for Greece if it is accompanied by an orderly default on sovereign debt and a large depreciation of the new drachma. The default would allow Greece to reduce the interest payments on its bonds and pay back the principal on its sovereign debt in a cheaper currency. In conjunction with a boost to the export sector from currency depreciation, the country could have the chance to grow out of the crisis.
Domestic banks would need to be recapitalized, as would other European banks with large losses. It is difficult to see Greece getting aid from the ECB for this, so it would have to come from the Greek central bank.
Would a Greek exit lead to the departure of other countries?
A full euro break-up can probably be avoided with action from the troika, but time is not on their side. To date, the lack of coordinated action from the various European institutions has raised the risk of other countries exiting the euro. Contagion can spread through rising sovereign bond yields and through exposure to Greek assets. Italian and Spanish yields have already begun to rise and are approaching levels where it may be difficult for some countries to issue new debt or roll over existing debt.
The good news is that there is a difference in 2012 compared to earlier stages of the crisis, due to two main improvements:
- European Central Bank engaged in long-term repo operations (LTROs), reducing the risk of a systemic collapse of the banking system by increasing liquidity.
- Many countries have reduced their sovereign budgets and agreed to austerity measures. However, implementation has been slow in many cases and weak economic growth is making budget cuts difficult.
If the ECB were to commit to buy bonds on the primary market or take a step toward a closer fiscal union by providing euro bonds, it would be much more comforting for investors—but it would be against the current law. Overall, to prevent contagion to other countries, Europe needs to provide more financial firepower to lower interest rates and boost confidence in the other peripheral European markets.
Global impact of a Greek exit
The direct economic impact on global growth would probably be relatively small if there is an orderly Greek exit and if contagion to other financially weak countries is limited. (Those are big "ifs," however.) Greece constitutes less than 2% of the total euro area economy and accounted for a bit more than 0.3% of global GDP in 2011, according to the World Bank.
If the exit led to rising bond yields in other European countries and further problems in the banking sector in other European countries, it could force the weaker countries out of the euro against their will. The exit of other smaller countries such as Portugal and Ireland would probably be feasible and not hamper global growth too much. However, if larger countries such as Spain or Italy were forced to leave the euro, it could endanger the survival of the whole currency union and could lead to significant disruptions in the global financial markets and probably a global recession.
Contagion is already happening to a certain degree in Europe, as illustrated by the rising Spanish and Italian sovereign bond yields compared to the falling German sovereign bond yield. The wide spreads between the highest quality sovereign and the financially weaker Italy and Spain indicate a rising risk premium on their sovereign debt. Investors are increasingly concerned about the risk of default in these countries as well. Another way to gauge contagion risk is to look at European and US bank claims on the banks of Portugal, Ireland, Italy, Greece, and Spain (PIIGS).
Source: Bank for International Settlements
A look at the exposure of European banks to the PIIGS shows that their claims have been markedly reduced since their peak in the first half of 2008. Overall, European banks have reduced their claims to Italy, Spain and Ireland by about 50% since the peak exposure in 2008. Exposure to Irish and especially Greek banks was also reduced. This shows that risk of contagion through banks has eased somewhat since 2008.
Source: Bank for International Settlements
US banks' exposure to the PIIGS banks are a fraction of the European banks' claims, on average. Collectively, they had much lower exposure to the PIIGS banks to begin with and reduced exposure in the past few years, especially on Italian and Greek banks. In our view, the risk for US banks to be directly "infected" with the European virus through bank-related losses is relatively small, while the danger for European banks is much higher. This suggests that the US would be relatively better off should the smaller countries (Greece, Portugal and/or Ireland) need to default and leave the euro.
The direct effect of a bank collapse in Spain and Italy would be much more difficult to digest, however. For the US, bank failures in Europe could lead to a credit crunch, putting stress on large global banks and weakening global economic growth.
There is some evidence that the market is pricing in a small degree of contagion risk. The chart, which depicts US and European swap spreads, shows that US and eurozone spreads spiked during the Lehman collapse back in 2008, reflecting contagion concerns. This means that the risk premiums of debt assets compared to government bonds increased, showing the fear of systemic risk.
US swap spreads decoupled from European spreads during the course of 2009, as market participants started to see the risk to the US as much smaller than that of the eurozone. The two lines continued diverging more strongly in the middle of last year and the gap has remained about the same since. The graph suggests that the risks for the US are moderate, while they are elevated for the eurozone.
* Swap spreads are the difference between the swap rate on a contract and the yield on a government bond of the same maturity. They are used to represent the risk associated with the investment, since changes in interest rates will ultimately affect returns.
Investment implications for bonds
The European crisis has already led to a divergence in bond yields between countries that are believed to be good credit risks and those that are not. The yield spreads between German bunds and the bonds of the weaker countries have risen in recent weeks as the threat of a Greek default and exit has grown.
In the near term, we expect German bunds to outperform the sovereign bonds of financially weaker European countries. However, yields on German bunds are already extremely low in nominal terms and mostly negative in real terms (nominal yield minus inflation).
We also believe that US Treasuries will continue attracting investors due to the likely continuation of market turmoil and uncertainty. Many investors hold bonds of relative safe-haven countries like the US as portfolio hedges against a possible drop in equities should the European crisis worsen.
For investors, we typically suggest maintaining exposure to international bonds to help provide diversification in portfolios. However, under the current circumstances, risk-averse investors may want to limit their exposure to European sovereign bonds in general due to the uncertain outlook. Within the eurozone, we think German bunds should continue to outperform.
Implications for currencies
Should Greece and/or other smaller countries leave the euro, their new currencies would likely fall steeply against the euro and other currencies. The Greek drachma would probably depreciate the most, together with the Portuguese escudo, according to their economic and structural imbalances. The euro, however, could experience some appreciation if worries about the financially weak countries no longer burden the currency.
Should countries such as Greece, Portugal and Ireland choose to stay in the euro area, the euro's performance would likely be hampered by crisis flare-ups in the short- to mid-term. Longer-term, the euro’s prospects would depend on these countries' ability to stick to reform and austerity programs, create growth and increase productivity, and bring debt and budget deficits under control. In the medium-term, the US dollar and the Japanese yen would likely benefit, whereas riskier currencies such as many emerging-market and commodity currencies could decline due to lower growth and investors seeking a relative safe haven.
The US Federal Reserve and the Bank of Japan could act to counter the rise in their domestic currencies through more quantitative easing and/or intervention in the currency markets. The Bank of Japan has recently intervened in the markets in an attempt to slow the rise in the yen. The Swiss franc would also likely experience safe-haven inflows, which would test the Swiss National Bank’s ability to defend the threshold of 1.20 to the euro.
Greece leaves, triggering contagion
Should the Greek exit lead to contagion and force bigger countries such as Italy, Spain and France out of the union, the euro's survival probably would be threatened and its value would likely drop. The US dollar and the yen could benefit significantly from such a scenario, while riskier currencies would likely fall more quickly than in the "Greece stays" scenario. The Swiss National Bank could be forced to give up its threshold and, like the yen and the dollar, the Swiss franc would likely appreciate against other currencies.
The bottom line
It appears likely that market turmoil in the eurozone will continue for the near term, at least until the outcome of the Greek elections. Given the changing political landscape in Europe and the slow pace of European officials in dealing with the crisis, we would limit exposure to the euro and its assets for the time being.
Investors who feel they have too much exposure to the euro can either reduce European assets denominated in euros and/or hedge some of the currency exposure away by using currency ETFs, for example. (If you go this route, we recommend being very cautious with inverse and negatively correlated ETFs because their performance can deviate from the underlying exchange rate over time.)
Emerging markets that are most exposed to the eurozone debt crisis are the former Eastern European countries like Poland, Hungary, the Czech Republic and Romania. As the eurozone debt crisis continues, growth may falter and risk aversion may rise. Those economies and their assets are likely to suffer and experience capital outflows, probably resulting in further a weakening of their currencies. Slowing growth combined with mostly weak fiscal positions will probably increase their public debt ratios towards critical levels. We would therefore be careful with exposure to these currencies and their assets as long as the crisis persists.
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