By David Schawel, CFA, Economic Musings

A number of hours per week for me are spent reading through various pieces of sell-side & independent economic and macro research.  The merits of such a practice can be debated, but it no question provides me a “consensus” view of current economic views.   Over the last week or two the sell-side has increasingly raised the likelihood of a Greek exit from the Euro.  Take for instance:

JP Morgan raised the odds of a Greek exit to 30-50%.

“The fear scenario is as follows…massive capital flight in anticipation of exit force capital controls in Greece, and new IOUs to pay public workers which starts the process to a new currency; capital flight from rest of periphery. If periphery countries then impose capital controls, the monetary union is effectively dead, as one country’s euros are then not the same as another country’s euros.

We have already seen capital flight within the EU.  As Richard Koo stated this week, “…Spain has a private sector that is deleveraging in spite of near-zero interest rates.  But the resulting savings surplus has not remained within the country.  Instead it has fled to Germany, causing Spanish yields to rise and forcing the Government into austerity.”  The average observer can see this in action with Bund yields plummeting to ~1.50% as of Friday.

Now back to Greece for a moment.  Their future is less certain given the recent elections and now the previous bailout is uncertain.  Is an exit now possible or probable?  What would an exit from the euro look like, and how would it be accomplished?  Furthermore, are there any historical examples we could point to that would give us a clue to the repercussions? John Hempton, a brilliant hedge fund manager from Bronte Capital, touched on this very topic in an underrated blog post last September.  Below is an excerpt:

Variant 1 – the Argentine option: Default and de-peg the currency.

When Argentina defaulted not only did the government default but they forced a private default. If you had a debt in US Dollars in Argentina prior to the default you were forced to pay it back in Peso. Indeed it was illegal to make payment in US dollars.

Likewise if you had a US dollar asset you got back Peso. A dollar deposit in Citigroup in Buenos Aires  became a peso deposit. If you really wanted to keep your dollars you needed to make your Citigroup deposit in New York.

The forced private sector default was necessary for Argentina. The Argentine banks all had lots of US dollar funding. If you devalued without forcing their default then they would all have uncontrolled defaults (a true disaster) and the country would lose its institutions. Telefonica Argentina would have failed too – failing to replay USD debts.

The same applies in Greece. If the Greek Government were to devalue the new Drachma (to perhaps a third the value of the Euro) then the banks (which are loaded with Greek Sovereign paper) would default. Even Hellenic Telecom would default because they would be forced to repay their billions of Euro borrowings whilst collecting only Drachma phone bills.

The Argentine economy was doing quite nicely after the devaluation. The lesson was that devaluation worked – provided you simultaneously forced private sector default.

If you were Greece you would take this option without hesitation. However this option has explosive implications for Europe. You see a bank deposit in Athens is going to turn your Euros into Drachma. Overnight it will lose 70 percent of its valuation.

So it has to be done quickly and with an element of surprise (as per Argentina when most people did not get their dollars over the border). Without surprise people will rush their money to Deutsche Bank in Munich.

One weekend we will just find that the Greeks have done it. But now suppose Greece does pull this trick. The day after we have a Drachma – deposits are in Drachma. We might print a single 10 drachma note and allow it to settle against the Euro – then over time print more. This should work for Greece.

Now if you are Irish or Italian or Portuguese (or even Spanish) you know the rules. You get to get your Euro out of the PIGS and into the core (Germany) as fast as possible. So max all your credit cards (for cash), draw all your bank deposits and load them in the boot of your car and make the drive to Switzerland or Germany. Somewhere safe. Otherwise you are going to lose half the value the day that the rest of the PIGS do a Greece.

And this bank run – a run including tens of thousands of Italians driving their Fiats – will surely blow apart every Italian bank. And their Euro-skeloritic compatriots will sign the death knell for for all their banks too.

If you are going to go the devaluation route you are going to have to do it all at once. Like the big-bank weekend (maybe coinciding with a week long bank holiday) in which all core European countries get their own currency back.

There is a precedent. It is not a pretty one. When the Austro-Hungarian empire collapsed there was a single currency over a huge area covering much of what is now Euroland. In this case the rather Germanic Austrians were in charge (or rather were in charge until their empire collapsed).

What they did was put troops on all the borders and made it illegal to take cash (or wire cash!) across borders. Then all Austro-Marks in each country was stamped – converted to Drachma for Greece, Marks for Germany, Peseta for Spain or whatever the currencies of the day were [If someone remembers the 1918 border splits better than me they are welcome to say…]

In this conception all Spanish debts become Peseta debts. All German debts become Mark debts. All Greek debts become Drachma debts. Unstamped currency goes worthless.

If you are going to split the currency I see no alternative to a big bang – and if you do that I see no alternative to troops at the border stopping transfers (and wire transfers) because shifting cash North looks so profitable against a sudden devaluation. Suddenly – and against all historic hope – its time again to guard the French-German (and every other European border) with troops for a week whilst the money is stamped.

Note however almost every country borrowed in hard currency (Marks) and got to repay in soft currency (Drachma). This is a scheme which shifts the loss home to Germany and with little compensating benefit except that they get their beloved Mark back. Its a scheme that is way better for the periphery because they get to keep their institutions. In two years they should bounce back like Argentina bounced back after their default.

Unilateral Greek default and devaluation without planning for the periphery to do the same – well that is a true mess. Too ugly almost to think about – and it would be unilateral for less than a week. The rest of Europe falls into that abyss with maximum movement of deposits and cash in the meantime.

Wow.  What a great piece by Hempton, and awesome food for thought.  But this could be reality in a matter of weeks or months.  Could you imagine troops at borders preventing the transfer of euros to places like France and Germany?  Like he said, it would need to be done quickly.  As stated above, capital flight has already started in earnest as brisk flows into Germany have depressed bund yields.

Can anything be done now to help?  The issue is greater than just Greece.  Richard Koo and others have recommended that eurozone governments prohibit selling bonds to people outside of their own borders.  Private Spanish savings, for instance, could be invested into Spanish bonds instead of German bonds.

It’s clear that the dynamics between heavily indebted peripheral countries and creditor nations such as Germany are inextricably linked.  The capital flights into Germany are affording an already “healthy economy” (unemployment at a 20yr low, industrial production approaching record highs), to potentially overheat.  Koo speculates that this could lead to a German housing bubble.

There’s obviously a ton of different dynamics happening here, but from everything I’ve read it appears the actual implications of a Greek exit are being underestimated.  Thanks again to John Hempton for a vivid description of what that might look like.  Furthermore, could that possibly be in the cards for additional peripheral countries if things continue to deteriorate?


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

David Schawel

Economic Musings was founded by David Schawel. David is a husband and father of two living in Raleigh/Durham NC. He currently works as a fixed income portfolio manager. He spent time in NYC in both investment banking and equity research. He is a current CFA charterholder.

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  • bena gyerek

    1) the greek authorities do not have an incentive to prevent a run on their own banks, so long as the bank run continues to be financed by the ecb. unlike argentina, the greek cb does not have a limited supply of hard currency reserves. it has its own euro banknote printing press, and it has automatic target2 claims on the ecb to cover electronic capital flight. the big question is whether the ecb would pull the plug.

    2) the consequences for greece of leaving the euro are much more traumatic than the argentine dollar depeg. it creates a legal mess (challenges over what gets redemoninated), a logistical mess (there are no physical notes or coins), greece is massively dependent on imports of food and medicine, and greece’s biggest export (tourism) is very sensitive to social upheaval.

    3) if there is a bank run in italy / greece / etc, it will not be met by troops at the borders. germany and france will reach a grand bargain: german fiscal transfers in return for a directly elected european presidency. do not underestimate the emotional commitment of germany to the european project. it is more important to them than the money.

  • Nico

    I guess whoever is holding greek bonds…….really? who would want to still hold them!

  • http://www.macro-investing-strategy.com Macro Investor

    Opinion polls in Greece overwhelmingly support retention of the EURO. The Greek Drachma was a disaster: they experienced continued periods of boom and bust, just as they would with a new devalued Drachma.

    Devaluation doesn’t solve any problems. It simply kicks the can down the road. If that were not so, then the most successful countries would be the ones with the weakest currencies. In practice, we observe the exact opposite.

  • bahar

    Devaluation will make their labour cheap. Cheap labor more jobs. Isn’t that the reason why China pegs RMB to dollar?

  • REN

    China pegs to the dollar in order to steal jobs, and also to prevent bear raids by private western banks. Remember the asian currency collapse? That was a bear raid, which collapses economies, and then the holders of dollars can swoop in and buy real assets on the cheap. China stabilized Asia during the collapse, as they held lots of dollars in reserve.

    China has a peg, state banks, a mix of private banks, and high dollar reserve ratios. So, it is totally unlike Greece, which is not a sovereign creator of money. Greece is more like a State in the U.S., which can only spend what it taxes.

    China steals jobs by pegging at a low rate, which makes it attractive to manufacture there. This allows wall street to send jobs overseas, taking wage abitrage as profits. In other words, captains of industry and wall street take the delta in wage profits and put in their pockets, and some of the “profit” is cycled back into your 401K account via wall street. You look like a hero for awhile, but really you are a zero, as your job and innovations are stolen to be monetized for today.

    This is allowed because the dollar is reserve, and the U.S. enjoys the power to spend (deficit spend) overseas. There is a reason why we have some 800 military bases overseas, as they are funded with deficit spending, slightly inflating the foreign economy as a stealth tax.

    Being the reserve currency means keeping tariffs low, as dollars must be supplied to the world. Those countries that don’t have military bases, need to acquire dollars to prop up their currency. So, they need to sell something to acquire dollars.

    Since tariffs must be held low in the U.S., that means that exporters (China) have a constant and ready market. Mercantilists like China want to export more than they import. That means that extra dollars come into China and they need to do something with them. China tends to lock away dollars as T Bills, thus propping up the dollar artificially (reduced supply), making U.S. mainstreet less competitive.

    Other dollars not saved as T Bills are put into Chinese banks as reserves. Some dollars are spent by China, acquiring real assets in dollar zones around the world.

    China issues debt free Yuans from their state banks to purchase dollars from their exporters. The government then holds dollars and the spent Yuans enter the Chinese economy. This can be non inflationary if the economy grows at the same rate as productivity and wealth generation. (Which it does because of the stealing of jobs and climbing up the learning curve so quick…because we are teaching them…to monetize our historical knowledge for today’s profits in arbitrage).

    Basically, China can use long term planning with their state money control (state banks). In the U.S. we have markets driven by “banker” and wall street planning. Government planning in the U.S. with regards to money is the third rail, because the U.S. likes its status as the reserve currency provider. It’s great to deficit spend money and demand resources from foreign countries. However it always screws over mainstreet.

    The situation is deadlocked.