Expert View

Wednesday, 30th May 2012

How would a Greek exit from the Eurozone work?

The effect of a Greek departure would partly depend on whether it was a managed exit or a disorderly departure.

A managed exit, which may well be in Greece's long-term interest, could probably be implemented gradually, with on-going financial support from the IMF. However, the EU will be very wary of setting a precedent that Spain and Italy might one day decide to follow.

A disorderly exit will clearly be chaotic and unpredictable. Banks might need to be nationalised to prevent them going bankrupt and deposits would need to be forcibly converted to Drachma. The new currency could easily depreciate by 50% against the Euro, meaning the cost of imported goods would appreciate sharply, resulting in hyper-inflation. Savers who have not deposited their money overseas would face considerable losses.

Greece would presumably default on its existing debt or repay it using devalued Drachma but the bulk of the impact would fall on Greece's official creditors, including the ECB and Eurozone governments. The ECB is particularly exposed and may need some form of recapitalisation after a Greek exit.

Greece has €150bn of bonds outstanding and they also owe around €80bn to the bailout vehicles. There is also the complex issue of the Target2 clearing system under which the Greek Central Bank has significant liabilities to other national central banks in the Eurozone.

The main risk with a Greek exit from the Euro is the potential impact on the rest of the single currency, particularly Spain and Italy with a rise in their funding costs and a potential loss of access to the markets. Other Eurozone countries would need to 'circle the wagons' to prevent the crisis getting out of hand. The policy options available include rate cuts from the ECB, another Long-Term Refinancing Operation (LTRO), increased purchases of sovereign bonds and a bailout for troubled Eurozone banks. The nuclear option remains jointly guaranteed Eurozone debt but the Germans are very reluctant to go that far.

Other major central banks, including the Federal Reserve and the Bank of England, would probably look to ease monetary policy by undertaking additional Quantitative Easing.