The consequences of Greece quitting the euro zone would be disastrous, according to research that draws on lessons learnt from the financial crisis in Russia in 1998 and in Argentina in 2001.
At the beginning of the year the European Central Bank (ECB) provided a massive three-year liquidity injection that made it possible to avert a Greek banking crisis. The ECB also persuaded European banks to become holders of sovereign debt and there was an agreement between Greece and private creditors regarding a relaxation of repayments. Overall, Europeans are mainly in debt to Europeans, with this inter-dependence conducive to co-operation, at least in theory.
A withdrawal of Greece from the euro zone may produce growth, but a devaluation of its currency would not resolve Greece’s problems. This is Greece’s fifth consecutive year in recession and we at Coface forecast a further 6 percent economic contraction this year.
With public and private external debt still substantial, Greece withdrawing from the euro zone would result in default on sovereign debt and on debt held by private entities. According to our calculations, a 50 percent devaluation coupled with a scenario of a relatively speedy resumption of modest economic growth, public sector debt would peak at 330 percent of gross domestic product in 2014.
In the case of Argentina and Russia, the devaluation of the peso and the rouble – by 40 percent and 60 percent, respectively – resulted in a decline in imports of goods and services, down 60 percent for Argentina and 30 percent for Russia in two years.
Devaluation gave rise to a phenomenon of substitution of national production for imports with foreign products becoming less price-competitive. In Russia, the nominal rouble peg caused a real appreciation of the currency resulting in an “eviction” effect that virtually wiped out the market for Russian consumer products that were not competitive in quality terms. Consumer demand switched to imported goods.
After August 1998, Russian food products reappeared as their prices had become reasonable again. Argentina and Russia subsequently enjoyed strong growth that owed little to the effects of devaluation. The two countries benefited from a rise in prices of their key exports – oil in Russia’s case and soya beans for Argentina – that made it possible to sustain the boost derived from devaluation.
Devaluation in Greece would ultimately have major negative consequences. Besides making it virtually impossible to settle foreign currency debt, a withdrawal from the euro zone would give rise to imported inflation, flight of bank deposits and subsequent bank failures and a discontinuation of financing from abroad.
Devaluation cannot resolve Greece’s structural problems, which have limited its economic potential and are ultimately responsible for the financial crisis. In common with Russia of 1998 and Argentina of 2001, Greece has a major failure in the collection of taxes. Fixing this is a priority of Athens’ current agreement with the International Monetary Fund (IMF).
But devaluation does not necessarily mean completely giving up on reforms. In Russia’s case, Vladimir Putin’s administration undertook tax reform in 2001 that was mainly responsible for the establishment of effective tax collection.
The consolidation of Russian public sector finances accomplished between 2001 and 2008 cannot be attributed solely to the rise of oil prices. Far-reaching institutional reform, including an overhaul of the tax code, underlies the spectacular improvement in Russian sovereign risk.
A withdrawal by Greece from the euro zone would trigger a massive default by residents holding euro debt. It would leave the country de facto debt-free. The tax collection question would remain posed. Resolving it would be crucial in establishing fiscal sustainability in the medium term.
That calls into question the government’s ability to impose financial rules and discipline on economic agents. Devaluation enables a speedier resumption of growth, but cannot determine the government’s commitment to reform.
A withdrawal from the euro can provide an opportunity for a positive “shock” by creating conditions ripe for undertaking vast structural reforms. Or it can be the way to escape from the constraint of reforms perceived as being imposed by the troika of the European Commission, ECB and IMF. But there is a risk that keeping Greece in the euro zone would prove so costly in economic and social terms that a unilateral repudiation of the euro and the stringent conditions would result in a disorderly shock.
At this stage there are two options for a withdrawal: it could be co-operative, meaning it can be done with the help of EU institutions and member states. The euro’s convertibility into the new Greek currency would very likely be assured by the ECB. But such a “concerted” withdrawal is not very probable. The euro zone member states have rejected the idea, not only because of the principle of the irreversibility of the integrity of the monetary union, but also because of the risk of contagion. Once Greece is out of the euro, will Portugal, Spain and Italy be tempted to follow suit?
The other option, which Coface believes is more likely, is that the Greek government will decide to leave the euro unilaterally. Austerity will then no longer be legitimate, growth will fail to materialise, and the social impact of the programmes will have become intolerable. A withdrawal could trigger a collapse of the euro and an increase in the sovereign spreads of all members. The crucial question remains whether economies like Portugal, Ireland, even Spain will be tempted to exit as well.
Just as the Greek debt restructuring question was posed to all sovereign euro zone members, the monetary union integrity question has to be dealt with.
This question is so crucial for the future that it calls today for urgent responses from the EU in sober recognition of the current fragility of its most impressive achievement: the single currency. page 27
Yves Zlotowski is the chief economist of Coface group, an international credit insurer.