Financial Times : We must avoid an accidental Greek exit

By Moritz Kraemer

Greece returns to the polls on Sunday in another attempt to elect a viable government, and the outcome of the election remains highly uncertain. Despite the broad-based support for euro membership among all major Greek parties and the general public, S&P is of the view that there is at least a one-in-three chance that Greece will exit.

A Greek exit could be brought about almost by accident. A Syriza-led government that fundamentally rejects the reforms agreed with the “troika” – the

International Monetary Fund, European Commission and European Central Bank – could lead to a suspension of external financial support.

Deprived of its last source of credit, the government would be forced to balance its cash budget immediately. Given Greece’s structural problems of raising tax revenues, the government may have little choice but to cut spending even more vigorously and to run up mounting arrears.

In such an environment, Greece’s economic decline is likely to gain speed, with additional job losses and the political and social crisis worsening. And where hopelessness and despair prevail, populist policy measures, such as a eurozone exit, may come to pass.

From an economic perspective, adopting a national currency is likely to be very costly for the Greek population. While temporarily reducing the cost of Greek exports relative to trading partners, an exit would not in itself sustainably cure any of the Greek economy’s fundamental problems: its small export base, lack of competitiveness and large external imbalances.

A moratorium on foreign debt service would initially improve Greece’s current account deficit via a reduction of outward interest payments. But the remaining underlying trade deficit might prove extremely difficult to finance at an acceptable cost. The main export earner, tourism, is unlikely to create much additional revenue despite a cheaper drachma. This sector might suffer a reputational setback from the economic crisis and dissolving social cohesion.

Any sign of a Greek government seriously considering a eurozone exit is almost certain to lead to a run on deposits at Greek banks as savers try to avoid “drachmafication”. This will bring down the remnants of a debilitated Greek financial system, with state finances in no condition to prop up banks.

The introduction of a new currency would also lead to a likely wave of personal and corporate bankruptcies as debtors fail in their struggle to service euro-denominated obligations on devalued drachma incomes. While Greek lawmakers could legislate a currency conversion of private loans made under Greek law, this may be contested in overwhelmed courts and lead to problems at the creditor level.

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In any case, the Greek private sector has accumulated a large stock of foreign debt, payable in euros irrespective of decisions taken in Athens. The same holds true for the cash-strapped government which would be very likely to default yet again: since the debt exchange earlier in the year, almost all government debt is under foreign law payable in euros. Shut off from access to trade financing and import insurance markets, Greece could find it challenging even to finance the import of basic necessities, such as food, energy and medicine.

With the financial sector insolvent, private sector bankruptcies and litigation paralysing economic activity, the country would face increasing risks of prolonged economic depression. Tax revenues would likely erode further, forcing the government to find additional savings. In other words, a euro exit scenario is likely to foster the downward spiral of economic contraction and fiscal austerity that the critics of the troika-inspired adjustment programme hope to avoid.

In depth

Fear’s mount over Greece’s potential exit from the eurozone and the implications for the wider bloc

It is unlikely that any other eurozone member would follow were Greece to exit. Witnessing the Greek economic and social maelstrom expected to follow drachmafication would likely strengthen the resolve of other EU-IMF programme countries to pursue reforms and avoid the negative economic consequences of an exit.

We would also expect the European partners and the IMF to take a very supportive and lenient stance to prevent additional departures. But it remains unclear whether these efforts would be perceived as sufficient. It is plausible to assume a Greek exodus would establish an understanding among investors that eurozone membership is reversible, implicitly reintroducing currency risk. This might create new market pressures for the peripheral member states, necessitating a swift and forceful European policy response.

Our assumption is that such a response would be forthcoming. But if it were to prove inadequate to restore depositor and investor confidence, economic and financial problems in the eurozone could escalate. And that could have further negative implications for sovereign creditworthiness.

Moritz Kraemer is head of Emea sovereign ratings at Standard & Poor’s Ratings Services

http://www.ft.com/