Exit the Euro Zone? Think Before You Leap

Greece’s departure from the monetary union would be legally difficult and financially ruinous

“The euro area is a community that shares the same destiny” —ECB chief Jean-Claude Trichet Chris Ratcliffe/Bloomberg; Trichet quote: Aachener Zeitung, May 27, 2011

By Carol Matlack and Jeff Black
This Week

September 19, 2011
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“Everything must be done to keep the euro zone together.” That was Chancellor Angela Merkel speaking on German radio on Sept. 13 as she denied reports that Germany was preparing for Greece’s exit from the monetary union.

That the leader of Europe’s biggest economy must dampen speculation of a breakup shows the rising unease about the common currency. Two years ago most politicians and investors believed firmly that the euro area was indivisible. As the finances of Greece, Portugal, Ireland, Spain, and Italy have fallen into crisis, that has changed. It’s still unlikely that any member state will bolt or be banished. Greek Prime Minister George Papandreou, for one, vows to keep Greece in the euro zone. Still, a growing number of policymakers and analysts are talking seriously about an exit.

In Greece, the issue is enmeshed with a possible default on its sovereign debt. Yields on credit default swaps on its short-term debt are at 98 percent, a sign that investors consider default inevitable. “If the Greeks don’t make it despite all of their efforts, you can’t rule out” their leaving the currency union, Horst Seehofer, chairman of Germany’s CSU party, a coalition partner of Merkel’s ruling CDU, said on Sept. 11.

Any country that dropped out of the euro would regain control over its monetary policy. Its central bank could set interest rates and would not be controlled by the European Central Bank in Frankfurt. It could reinstate and devalue its own currency, making exports more competitive. An exit would probably lead to sovereign debt restructuring or default, since the country couldn’t repay all its euro-denominated debt with a cheaper currency. Economists reckon that a reintroduced Greek drachma, for example, would be worth only half as much as a euro. Yet Greece seems likely to default anyway, so what’s the difference?

In reality, leaving could be a lot messier. The treaties that created the euro provide no opt-out mechanism. Legally, an exit would require a unanimous vote by euro member states to change the treaties, says Peter Becker, a researcher at the German Institute for International and Security Affairs. Expelling a country against its will is effectively impossible. A voluntary exit could be negotiated, but could take months.

What spooks Merkel and other leaders is that a Greek exit could unleash a chain reaction of departures from the euro by other weaker members. Also, an inside-the-euro default by Greece would be less complicated and costly than a default outside the zone, because the ECB and other European bodies could help reach a deal with creditors.

Quitting the euro looks even scarier for the Greeks. Their economy would shrink by at least 40 percent after an exit, predicts Stephane Deo, chief European economist at UBS (UBS). The banks and stock market would collapse, government and businesses would be frozen out of global credit markets, and corporate balance sheets and individual savings would be reset in a devalued currency. Devaluation wouldn’t help exports much, Deo wrote in a Sept. 6 note: Other countries would likely raise tariffs to protect, say, Spanish olive oil against cheaper Greek oil. Social turmoil would probably increase. “Greece is going to go decades back” if it leaves the euro, says Vassilis Korkidis, president of the National Confederation of Hellenic Commerce, “This is going to be a disaster.”

Greece spent many decades under foreign rule or domestic dictatorship, including a junta that imprisoned Papandreou’s father and exiled his family. The political class sees membership in the European Union and euro as a sign of how far Greece has come, and as a guarantee against slipping back. With Turkey growing powerful, Greece doesn’t want to be cut loose from its economic and political moorings. Moreover, Greece experienced devaluation and inflation in the 1980s that “not only failed to improve competitiveness but also eroded the value of people’s savings,” says Miranda Xafa, a senior investment strategist at Geneva-based IJ Partners and ex-board member for Greece at the International Monetary Fund.

So if no one wants an exit, how could it happen? Willem Buiter, chief economist for Citigroup (C) in London, offers a scenario in a Sept. 13 report: As Greece resists EU, ECB, and IMF demands for more austerity, the exasperated troika cuts off funding. Greek banks can no longer post Greek debt as collateral for loans from various EU agencies. With no funding available from the euro area, writes Buiter, “Greece could blunder into exiting.”

The default feared by investors would then occur. European banks—which according to the Bank for International Settlements hold a total of $128.8 billion in Greek debt, including $42.9 billion in public debt—would take a hit. Investors would push up the cost of government borrowing in Ireland, Portugal, Spain, and Italy, and funding for those countries’ banks would dry up, predicts Nick Kounis, head of macro research at ABN Amro Bank. “You’d wonder,” he says, “if the euro zone would fall apart.”