WHAT IF GREECE LEAVES THE EURO?

I know these are all rumors at this juncture, but I’ve covered this all pretty thoroughly in the past so it’s worth touching on again.  This morning’s Spiegel report on a Greek defection makes for a timely reminder with regards to the potential ramifications of a Greek exit.  This comes courtesy of ING (attached below).  It’s older (first posted last year), but the broader ramifications still fit.  In short, a Greek exit would be a strain on Europe, but nothing close in magnitude to the Lehman catastrophe.  It would allow Greece to deal with their financial crisis internally rather than having Germany impose austerity on them.  This would allow Greece to right its own ship and potentially rejoin the Euro at a later date when they have resolved some of the flaws in the currency union.  So, it could cause some short-term turbulence, but in the long-run it’s likely best for all involved.

I’ve maintained that Europe is moving towards some form of greater unity (at least needs to).  Whether that involves Greece, Ireland, Portugal, etc is unknown.  But it must be done in order for the Euro to remain a viable currency. For now, I think it’s wise for these periphery nations to consider leaving the Euro and focus on their domestic affairs (as opposed to allowing German bankers to push them around).

Where things would get interesting is if this turns into a widespread run on the Euro (Ireland + Portugal).  Then, we have the real potential for serious turbulence (see here for more).  As I’ve stated before, this puzzle has so many moving parts that I am not sure that anyone can predict how it will end. The Germans will fight any defections as it is their banking system that will be most impacted.  Sooner or later, however, these periphery countries are going to realize that Germany is essentially stepping on their throats and imposing depression on them via austerity.  I don’t see how that can persist.  This could all lead to a rather serious banking strain if several defaults and defections were to occur, however, I think it is likely in the best interest of all involved.  It’s not all that dissimilar to the controlled demolitions I was in favor of for the US banks.  Managed defections and debt restructurings don’t have to be catastrophic and could prove quite constructive in the long-term.   This could cause some market strains, however, it’s time for the world to stop worrying so much about the financial markets and more about the actual state of their citizens.

The ING piece (with my comments) follows:

I have often said that Greece would be able to better serve its citizenry in the long-term if it regained its monetary sovereignty by leaving the EMU and restructuring its debt.  ING recently detailed a potential scenario should that occur.  According to ING, while the results would be harmful, they would not be the end of the world as many presume:

1. Scenario I: a ‘stage-managed’ exit of Greece

• At the mild end of the spectrum, the most plausible scenario is that Greece is the only country to exit the Eurozone.

• Greece is the most challenged from a solvency and a competitiveness perspective, and it is most observers’ favourite candidate for leaving EMU.

• The modest size of the Greek economy means that its departure would be far less disruptive than if one of the bigger economies were to leave.

• Our assumption is that Greece’s exit does not happen in a chaotic manner. The Eurozone and IMF would provide medium-term funding to ease the pain of Greece’s  exit.

• The Greek exit gives further impetus for reforms in other highly-indebted countries such as Spain and Portugal.

in scenario 1, Greek exit, the impact  is clearly heaviest in Greece itself, there would be non-trivial effects on the rest of Europe. Greece suffers a deeper recession in 2011 than in our baseline, with GDP 7½% lower. Other Eurozone countries suffer falls in output of up to 1%Given Greece’s large twin deficits we see the new Greek Drachma falling 80% against the EUR.

What would be the impact on specific markets?

• Credit spreads in core countries widen but less than their periphery counterparts.  General spread widening is muted in comparison to the credit crisis of 2008.

• Nonetheless, even core German corporate credit spreads widen by 90bp in 2010.

• Contagion sees spreads rise by some 130bp in other peripheral markets for A rated corporate debt. In terms of BBB ABS the periphery sees spreads blow but by 200bp in RMBS, 400bp in credit cards and 700bp in auto loans.

• But none get close to credit crisis peaks. Later in 2011 there is some retracement, but not towards current levels.

Source: ING