Bankers, governments and investors are preparing for Greece to stop using the euro as its currency, a move that could spread turmoil throughout the global financial system.
GLOBAL ECONOMIC COLLAPSE – STARTING WITH GREECE
How shock waves will reach the US if Greece drops the euro
Greeks will have to wrestle with a crucial dilemma when they go to the polls for the second time in as many months on June 17 to elect a new government.
Greeks will have to wrestle with a crucial dilemma when they go to the polls for the second time in as many months on June 17 to elect a new government.
A Greek election on Sunday will determine whether it happens. Syriza, a party opposed to the restrictions placed on Greece in exchange for a bailout from European neighbors, could do well.
If Syriza gains power and rejects the terms of the bailout, Greece could lose its lifeline, default on its debt and decide that it must print its own currency, the drachma, to stay afloat.
No one is sure how that would work because there is no mechanism in the European Union charter for a country leaving the euro. In the meantime, banks and investors have sketched out the ripple effects.
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 suffer losses on complex trades.
ACT I
What would Greece’s exit look like? In the worst case, it starts off messy.
The government resurrects the drachma, the currency Greece used before the euro, 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 it imports.
Greece’s government and banks currently survive on international loans, and if it dropped the euro, the country would probably be locked out of lending markets, says Athanasios Vamvakidis, foreign-exchange strategist at Bank of America-Merrill Lynch in London. So the Greek central bank would need to print more drachmas to make up for what it could no longer borrow from abroad.
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, too. Why would Greeks pay off foreign debts that effectively double when the drachma drops by half?
Say a small shop owner in Athens has a €50,000 business loan from a French bank. She also has €50,000 in savings in a Greek bank. The Greek government turns her savings into 50,000 drachma.
If the new currency fell by 50 percent to the euro as expected, her savings would suddenly be worth €25,000. But she would still owe €50,000 to the French bank.
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.
The European Central Bank and European Union would have to persuade investors in government bonds that they will keep Portugal, Spain and Italy from following Greece out the door. Otherwise, borrowing costs for those countries would shoot higher.
The main way European leaders have tried to calm bond markets is by lending to weaker governments from two bailout funds. Experts say these two funds, designed as a financial firewall to stop the crisis from spreading, need more firepower.
Much of the €248 billion ($310 billion) left in one of them, the European Financial Stability Facility, was pledged by the same countries that may wind up needing it, Vamvakidis says.
There’s also a €500 billion European Stability Mechanism that’s supposed to be up and running next month, but Germany has yet to sign off on it.
“If they fail to reassure bond investors, all of the nightmare scenarios come into play,” says Robert Shapiro, a former U.S. undersecretary of commerce in the Clinton administration.
The biggest danger is a fast-spreading crisis 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,” says Mark Blythe, professor of international political economy at Brown University.
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 debt. Plunging bond prices also would imperil Europe’s troubled banks. The banks are big holders of government bonds, which they bought when the bonds were considered safe.
At this point, the risk would be high for a run on banks throughout Europe. People would worry that the banks might fail and would rush to withdraw what they could. 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.
“People see their banks in trouble,” Shapiro says.
In less frantic times, the government would come to the rescue with cash or take over the banks. Individual European countries insure bank deposits, so if one bank fails people can still get their money out. But all this is happening in the middle of a government debt crisis, and if the crisis gets worse, the Spanish or Italian government couldn’t raise enough money in the bond markets to save the day.
“They can’t afford to guarantee deposits or money market balances,” Shapiro says. “They don’t have the ability to borrow internationally from bond markets. Where are they going to get the funds?”
From here, the crisis could get much worse: Banks could fail, the surviving banks could stop lending to each other, and a credit freeze could shut down commerce in Europe as assuredly as a blizzard did last winter.