If you mention the possibility of Greece exiting the European Monetary Union two years ago, European officials probably would’ve stared at you as they wait for a punch line. Today, not only are some officials talking about it, but markets are actually pricing it in.
Greece has been in hot water over its financial problems for years now, but it wasn’t until a couple of weeks ago when markets seriously considered the possibility of a Grexit. You see, Greek President Karolos Papoulias’ last-ditch effort to form a government went down the drain last weekend, which led to speculations that Greece won’t have a government ready by next month when the next tranche of bailout money is scheduled.
If Greece doesn’t meet its bailout obligations, then it will run out of money in a few months. The government will lose access to European Financial Stability Facility (EFSF) and International Monetary Fund (IMF) funding, which will make it easy for the country (and its banks) to default on their debts.
If Greece gets booted out of the EMU, one of the first things the Greek government will most likely do is install a new paper currency. Otherwise, they won’t be able to pay social security or public wages.
But passing a new currency law is no easy task. Many things need to be done such as re-evaluate ALL domestic contracts and create internal controls to limit capital flight. Heck, even introducing the new paper money into the economy is hard. It’s not like flyers you can just print and hand out!
Unfortunately, installing a new currency is peanuts compared to what the economy would face in a Grexit. Think about it… If you were an investor, would you want to trade in your euro-denominated contracts for a new, risky, and probably depreciated paper currency? The IMF estimates that the new currency will probably have to be devalued 15-20% against the euro zone average.
Yeah, I didn’t think so.
This is why many Greek banks will most likely declare bankruptcy. Meanwhile, businesses will find it impossible to secure loans and face interruptions in their cash flow.
Sounds gloomy to you? Wait till you hear what could happen to the euro zone. As I mentioned in my last Grexit post, investors and policymakers are more worried about what will happen to the region once an economy exits the monetary union for the first time in history.
For one thing, the ECB and other peripheral economies are already holding boatloads of Greek paper. If Greek contracts devalue by as much as 20% as the IMF predicts, then the already struggling EU economies are in for more financial trouble. And that’s even before investors price in their doubts of giving bailouts to these countries!
Of course, a Greek exit still isn’t a sure thing. The decision is on the Greeks and whether or not they can come up with a government that supports the Troika‘s austerity plans. Until then, expect to see more uncertainty (and possibly more sell-off) in markets.