What If Greece Defaults

Naturally, Sarkozy must be incensed with Pappy deciding to call for a referendum on the Euro package. This is like you have a relative who is being hounded by loan sharks, so much so that all your other relatives got together and put up a decent package, with a 50% haircut on the debt that the loan sharks have agreed to .... and then to discover that the low life relative may not want the rescue package. Not that he.she has any alternative, I guess he/she does, in not paying at all.

Pappy surprised everyone by declaring the referendum but you cannot call a referendum on a fiscal matter. You may frame it like "Are you in favour of the Euro rescue package?". Pappy is on a double edge sword, barely able to maintain control, I guessed his thinking is the referendum might do one of two things. A YES, he will get control and political will to push through the reforms and possibly save his political career. A NO, he will be out anyway. However, if he goes ahead with the Euro plan without a referendum, he knows that he is bound to be faced with huge strikes, revolts and riots anyway ... which may cause an early fall in politics for him within weeks of implementation.


The key question for us in Asia is how would that affect the markets. There should be an initial knee jerk sell down for a few days, but thankfully the US, Asia and Latin America are not really involved. Yes, there will be indirect hits but the markets have discounted a Greek default a long way. That's why markets shot up like 5% on news of the Euro package. Now we have to give that all back.

A Greek default would be much larger than other recent defaults, like the one in Argentina in 2001 or Russia in 1998. Greek public debt now comes to about $500 billion. Argentina’s debt when it defaulted was $82 billion, and Russia’s was $79 billion.

The size of Greece’s public debt assures that the consequences of a Greek default would ravage the Greek economy. Inside Greece, banks would face huge losses on bonds in their portfolios and would have to close their doors until somebody recapitalized them. The thing is that the men and women on the streets of Athens only focus on the hardships in job losses and pay cuts. When all of your banks close shop, you will see a greater hit on the real economy via hoarding, unrest, hyper inflation and a dire scarcity of goods and services.

The economy would grind to a halt. Some projections put the contraction in the gross domestic product at more than of 25%. ATMs would stop working. Business credit would dry up, and businesses would shut their doors. The government would be unable to pay its bills.

But the damage wouldn’t stop at Greece’s borders. Bond buyers would flee Italian and Spanish government bonds, requiring the European Central Bank and the European Financial Stability Facility—if it’s set up by then—to pour billions into buying those bonds to support the markets.

European banks would take a huge hit as the value of Greek government and corporate debt in their portfolios plunged. Big banks and insurance companies in Germany had a total exposure of $33 billion to Greek government and corporate debt as of the end of March, according to the Bank for International Settlements. French banks had exposure to Greek public and private debt of almost $80 billion.

That exposure is not spread evenly. In France, much of it is concentrated at three big banks: Crédit Agricole, Société Générale, and BNP Paribas. In Germany, the government set up bad banks as part of its bailout of Hypo Real Estate Holding and WestLB. Those bad banks hold more than half of all the Greek debt held by German banks, and would undoubtedly need another infusion of taxpayer cash.

Exactly how far the damage would go depends on the degree to which bond markets would punish the bonds of Portugal, Ireland, Italy, and Spain, which, along with Greece, make up the so-called PIIGS group.

The exposure of US banks to Greek debt alone is relatively small. But US banks have $670 billion in exposure to all five of the PIIGS group. And it depends on whether a default would force Greece out of the euro. That’s not an inevitable result. Greece could default on its huge debt to banks, but pay its relatively smaller debt to international creditors such as the International Monetary Fund, the European Union, and the ECB.

Those institutions might even see a capital infusion into Greek banks—along with a process that rolled up bad banks under new, perhaps overseas ownership—as a better alternative than the end of the European Monetary Union.

The consequences of a collapse of the euro would be huge on even a strong economy such as Germany's. UBS estimates that a collapse of the euro that left Germany on its own could produce a loss of as much as 20% to 25% of German GDP in the first year after a breakup.

Those scenarios seem so grim that it’s hard to imagine any rational politician steering his or her country into that storm. And that’s been the strongest argument—one that I’ve made on more than one occasion—for saying that Greece won’t default and that Europe will figure out a way to rescue the country from its debt spiral.

There is another way to look at the “Why would Greece default?” question. IMF economists studying past sovereign defaults came to a conclusion that turns any approach to answering this question on its head. It turns out that in past defaults—including defaults by Argentina, Ecuador, and Indonesia—a country defaulted when it saw that a default was in its best interest.

Greece needs more money than first expected, and may not be able to produce the deep spending cuts, tax hikes, and sales of public assets necessary to qualify for bailout money. Economic growth that's worse than forecast is making targets even harder to meet. With Greek citizens irate, the internal pressure to escape from brutal austerity measures may become overwhelming. 

If Greece caves, then the bailout payments would stop and Greece would run out of money, forcing it to default on billions in debt. Many taxpayers in Germany and other European nations would welcome that, since they're sick of sending money to spendthrift neighbors. But a Greek default would punish many of Europe's biggest banks, since they're the ones holding the debt. If Greece defaults, investors would fear the same thing from Ireland and Portugal and perhaps even from Italy and Spain. That's the meltdown scenario investors fear, and nobody's sure how bad it would get.

Europe's woes are similar to the U.S. subprime crisis that percolated for a couple of years, then erupted in 2008. Greece and other overindebted nations are like huge subprime borrowers who spent more than they could afford by racking up debt they now can't pay back. Like big U.S. banks during the housing boom, many European banks had shoddy underwriting standards and bought debt that was far riskier than they realized. A Greek default could be the European equivalent of the Lehman Brothers bankruptcy in 2008, which started a run on the whole U.S. financial system.

But there's a key difference between the United States in 2008 and Europe in 2011: American officials promptly came up with TARP, the Troubled Assets Relief Program, which allowed them to inject capital into banks that would have imploded without it. In Europe, it's far harder to devise a systemwide financial bailout, since there's no centralized fiscal authority comparable to the U.S. Congress or the Treasury Dept. So every bailout maneuver requires negotiations among 17 sets of politicians, each answerable to restive taxpayers and rival political parties in their home nations.

The European bailouts are now faltering because politicians there can't muster a bazooka. Instead of a huge, open-ended commitment to do whatever's necessary to save Greece and preserve the Eurozone, Europe has come up with piecemeal solutions meant to buy time and delay the day of reckoning. That's why edgy markets react wildly to small-bore pronouncements that might signal more or less political resolve.

European politicians won't say so, but they're basically stalling for time as they wait for the enactment of a stronger, TARP-like bailout fund that would be able to cope with the ramifications of a Greek default. "An eventual Greek default seems certain," writes Mark Zandi of Moody's Analytics, "but European policymakers must provide enough financial aid to ensure that it happens after it is no longer a macroeconomic threat." Instead of the roughly $605 billion that's been pledged so far, he thinks it could take about $1.4 trillion. 

Meanwhile, investors are scrambling to protect themselves and gauge the impact of a European financial crisis. Here's a broad outline of that would happen if Greece defaults:

Government takeovers of European banks. French banks have the most exposure to Greece, and severe losses could basically force the French government to nationalize the banking sector which has happened before. Shareholders would be wiped out by nationalization, which is why shares of big French banks like BNP Paribas and Societe General are down by more than 40 percent this year. If France did it, other nations probably would, too. 

EuroTARP. First, there would be a newer, more flexible bailout fund that European parliaments are likely to approve by the end of October. That would be the TARP equivalent, and it could be used to inject money into banks as well as to bail out specific countries. If bank bailouts happen, the European Central Bank might also go on a bond-buying spree similar to the Federal Reserve's "quantitative easing" programs that ran from 2009 through mid-2011. If it worked, that would stabilize the market for European sovereign debt and boost the value of stocks and other risky assets, just as the Fed's QE programs did for awhile in the United States. If Europe really got its act together, it would also announce a plan to create a unified fiscal authority able to issue "eurobonds" that would help all member nations raise funds, make tax policy, and exercise real fiscal authority over member nations. It would take years, maybe decades, to enact such a bureaucracy, but a credible plan to do so might reassure markets.

A smaller Eurozone. If Greece defaults, that would probably mean the end of its membership in the Eurozone. The drachma would return as Greece's currency, and Greece would set its own fiscal and monetary policy without having to answer to bailout masters in northern capitals. Of course, Greece would be out of money and unable to borrow, so its economy would get hammered. The drachma's value would be very low against other currencies, which would make Greek exports cheap and help reduce unemployment. But imported goods would become vastly more expensive. Martin Hutchinson of Reuters Breakingviews estimates that Greek living standards would decline by 30 percent or more. Great Depression-style bank holidays may be necessary, to prevent people from withdrawing all their money. Other debt-laden nations could follow Greece out of the Eurozone and take a chance on default, but the economic pain in Greece might also produce popular support for more thorough austerity measures meant to remain part of the club. Foreign tourists, it's worth noting, would benefit from default, since travel to Greece or any other nation kicked out of the Eurozone would suddenly become one of the world's great bargains.

A fresh European recession. Measures needed to stabilize Europe's financial system would most likely curtail lending and other economic activity, as banks beefed up their capital reserves and dealt with writedowns. Several countries would also need to hike taxes and cut government spending, to cover losses caused by defaults. Many companies and even some countries would see their credit ratings downgraded, which would force them to pay more to borrow money. Europe is already on the verge of recession, and wider austerity measures would probably clinch another downturn.

A ripple in America. "Europe's problems pose a serious threat to the U.S. economy, but not necessarily a mortal one," says Zandi. Unlike their French and German counterparts, U.S. banks own only a tiny portion of the debt issued by the most troubled European nations. American banks are also in much better shape generally than those in Europe, thanks to the aggressive action in 2008 and to the 2009 "stress tests" that forced many of them to raise more capital and strengthen their balance sheets. Big U.S. companies are also healthy, with strong profits, and few if any are dependent upon European banks. Still, a recession and financial crisis in Europe would weaken demand for American goods and services in one of the world's biggest markets, at a time when the U.S. economy is struggling, too.

A stronger Europe, someday. Traders focused on the short term have a lot to worry about, but Kirkegaard argues that the mounting crisis in Europe may be the only way to create the stronger fiscal union needed to forestall or address the kinds of problems that are tearing Europe apart. "Reform is only politically feasible in the midst of a crisis," he says. "It's going to take quite a long time, but the odds are good that this crisis will not be wasted, and will in fact be used to solve long-term institutional problems in Europe." So if your investment horizon happens to be a decade out, Europe might just turn out to be a good bet.