Euro exit-ology

November 8, 2011

Whether or not it’s likely or even a good idea, talk of Greece leaving the euro is no longer taboo in either financial or political circles.  What is more, anxiety over the future of the  single currency has reached such a pitch since the infection of the giant Italian bond market that there are many investors talking openly of an unraveling of the entire bloc. But against such an amplified “tail risk”,  it’s remarkable how stable world financial markets have been over the past few turbulent weeks — at least outside the ailing sovereign debt markets in question.

Yet, focussing on the possible consequences for Greece of bankruptcy and euro exit has now become an inevitable part of investment reseach and analysis. In a note to clients on Tuesday entitled “Breaking Up is Hard to Do“, Bank of New York Mellon strategist Simon Derrick sketched some of the issues.

One issue he pointed out,  and one raised in the September Spiegel online report, was the chance of invoking Article 143 of the Treaty on the Functioning of the European Union, which permits certain countries to “take protective measures” and which could be used to allow restrictions on the movement of capital in order to prevent a flight of capital abroad.

Derrick then went through six potentially dramatic features surrounding a sudden euro exit by Greece and likely collapse — temporary or otherwise — of any new “drachma”. 1) Extended market closure surrounding the announcement 2) Capital controls and possible travel bans to prevent a run on banks 3) Instant bankruptcy and default for many Greek companies and households with euro-denominated debts and need for a massive support operation for the private sector  4) a need for temporary banknotes and possible “overstamping” of existing notes 5) need for a balanced budget in the absence of EU support or capital market borrowing 6) reintroduction of price controls to cap soaring inflation.

And it’s perhaps because this relatively conservative list of consequences is so scary that the wider financial world remains so relatively calm. Despite the elevated risks of euro breakup, very few people really think it will happen as long as it remains a “choice” for the governments in question.

Derrick himself reckons you can’t ignore the tail risk, but neither can this be a central scenario.

Is any of this likely to happen? No. As we have noted before, although it is a possibility that Greece could leave the Eurozone, it most certainly isn’t a probability. Indeed, our own guess is that the current crisis will limp to a resolution over the next month with Greece doing just enough to ensure that it gets the next tranche of aid. Next year will then see a move by the northern states to start talking about treaty change (as we have highlighted before). However, as we have learnt all too well over the past four years, considering seemingly remote possibilities is always wise.


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