European finance ministers hope that last night's deal to reduce Greece's public debt will keep the country in the single currency. But if they believe that's the case, they're in a minority. According to betting market Intrade, traders believe there is a 48 per cent chance that some member of the euro will leave before the end of 2014.
Leading economists are similarly pessimistic. Carsten Brzeski at ING Bank says there's a "high risk" that the deal will unravel. Willem Buiter, chief economist at Citigroup, has said that there's a 50 per cent chance that Greece will leave the euro in the next 18 months. Jamie Dannhauser at Lombard Street Research says the country could leave "in short order".
"It is the intention of nobody to have Greece outside the euro area," said Jean-Claude Juncker, head of the Eurogroup. Not everyone, however, shares this confidence. The markets agree.
Investors, then, should start thinking about what would happen if Greece were to ditch the euro.
It would do so by doing the opposite of what it did when it joined the euro in 2001. Bank deposits and loans, along with Greek government debt, would be redenominated into 'new drachmas', whose value would immediately collapse in value relative to the euro.
And that would be the point. "Greece is a hopelessly uncompetitive economy," says Marshall Auerbach at Madison Street Partners. He hopes that a cheap drachma would change this by making Greece attractive as a location for companies wanting to export into Europe. It'd also revive Greece's attractions as a holiday destination and - in making Greek property cheap to holders of euros - the country could become a retirement home in which elderly Europeans will spend their savings. Greece will become like Florida, says Mr Auerbach, living on "the pension income of the elderly and the beer money of the young". It could, therefore, grow its way out of debt rather than rely upon endless austerity that is crushing its economy.
Nobody knows for sure how far the new drachma would fall. But it could be a very long way. Charles Dumas at Lombard Street Research estimates that since it joined the euro in 2001 Greek unit wage costs have risen by 50 per cent, twice the rate of increase in the rest of the euro area. This means that to recoup the competitiveness the country has lost while it has been in the euro the drachma would have to fall 25 per cent. Its actual fall would probably be more than this, because the Greek economy was weak even in 2001, and because foreign exchange markets often overreact anyway. A drop of 40 or 50 per cent is quite possible.
Gross external debt, $bn
|Country||Total||of which, government|
|Source: BIS-IMF-OECD-WB External Debt Hub, Q3 2011|
And herein lie the problems with a Greek exit. Holders of Greek debt that gets redenominated into drachmas would see a 40-50 per cent loss on their holdings. The fact that some Greek debt is denominated in currencies other than euros is no use here. A Greek company trying to repay a US dollar loan with low-value drachmas would quickly find it impossible to do so, and so would default.
Fortunately, British banks have only very light direct exposure to Greece. The Bank of England estimates that they've lent a mere £6bn to the country. A 50 per cent loss on this would be only 1.5 per cent of their tier one capital base - nothing to worry about. The table shows their exposure to other weak economies; Ireland, predictably, is the most worrisome.
|Country||UK banks' exposure, £bn||Greece||6.0|
|Source: Bank of England|
However, the world's exposure is much greater. Greek external debt stood at $546.9bn in September, which means international investors could lose more than $250bn (£158bn), including the "haircut" they took as part of this week's deal. Banks, which have $167.7bn of exposure, could lose more than $80bn. The table below shows how the world's banks are exposed to the weaker eurozone economies:
|Source: BIS, Q3 2011|
This has knock-on effects for the UK. As banks worry that other banks might be heavily exposed to losses, they'll be reluctant to lend to each other. The interbank market would thus freeze up even more than it already has done. British banks would then be even more reluctant to lend to companies and households, because of the greater cost and difficulty of funding those loans.
In itself, these effects should not be severe; $250bn might sound a lot, but it is only 0.7 per cent of global banks' total assets; Greece, remember, is a very small economy. Such a loss should be an inconvenience, not a disaster.
Except for two things. One is that the international financial system is far more fragile than it should be in theory. We learnt in 2008 that losses that are small in a global context can have catastrophic effects if they are concentrated in a few institutions.
The other problem is contagion. If Greece leaves the euro, the question will arise: who's next? Investors will try to dump Portuguese and possibly Spanish or Italian bonds. Yields on those bonds will soar. And this could cause massive losses for banks.
Serves them right, you might think. But there are four reasons why this would be a problem for investors:
1. Almost all shares are correlated with bank shares, so if the latter fall, so do non-financial stocks. This isn't just because they rely on external finance. It is simply because shares are substitutes for each other, and so if some fall, others do. Historic correlations suggest that most sectors fall by 3-5 per cent for every 10 per cent fall in banking stocks, as the table below shows.
|Sector||Average response to 10% change in bank sector|
|Oil & gas||3.6|
|Based on annual changes in monthly data since Jan 1987|
2. Trouble in the financial sector reduces investors' appetite for risk, simply by depressing sentiment. For this reason, there has been a strong correlation between the St Louis Fed's financial stress index and Aim shares in recent years.
3. A Greek departure could depress UK economic activity not merely by depressing exports to Greece - which are inconsequential - but because the fear of not being able to get reliable credit lines, and the fear of a banking crisis elsewhere in Europe, could further depress business confidence and capital spending.
4. Markets hate uncertainty. It's a cliche, because it's true. And the impact of Greece leaving the euro would be genuinely uncertain, in the sense of being an unquantifiable danger - if only because the scale of contagion would be unpredictable. This, too, would depress sentiment towards shares generally.
All of this helps explain why European politicians regard a break-up of the euro with such horror. It would not just kill off their vanity project, but would have unpleasant economic effects.
But wouldn't a system of national currencies, with floating exchange rates able to cushion economies from recession, be better for all in the long run? Possibly. But such a system is rather like Oscar Wilde's opinion of the Giant's Causeway: "Worth seeing, but not worth going to see."
Why should Greece leave the euro?
There's a simple reason why Greece might consider leaving the euro – because the alternative, of staying in, is just not feasible.
Even if the mix of bail-outs, debt rescheduling and cuts in public spending go to plan, the country will have a national debt equivalent to 120 per cent of GDP by 2020. This might not be sustainable. To keep the debt-GDP ratio at this level, the country will either have to have real GDP growth higher than the real interest rate on government borrowing, or it will have to run a budget surplus before interest payments - something that it is not even doing now.
And things might well not go to plan. The latest deal requires that Greece suffers the humiliation of having "permanent" monitors from the European Commission to ensure that it implements spending cuts. And there's a danger that those cuts keep the country in the recession that saw GDP shrink by 7 per cent in the final quarter of last year. The Eurogroup's belief that Greece will soon return to growth is, says Mr Brzeski, "wishful thinking". Public anger at this humiliation and enforced recession could drive the nation out of the euro.
Some cynical economists suspect that the troika agreed upon a target debt-GDP ratio of 120 per cent not because it will solve Greece's problems, but because it was the only number they could agree upon. If their plans entailed higher debt, markets would have perceived it to be no solution at all, and would have continued to fear a default on Greek debt. But if they had demanded lower debt, they would have signalled that a debt-GDP ratio of 120 per cent is unsustainable. Because this is Italy's debt-GDP ratio, such a signal would have been official endorsement of the view that Italy cannot pay its debts – and this would have sent the markets into a nosedive.
Can Greece leave the euro?
Although membership of the eurozone was originally intended to be "irrevocable", it is legally possible for a country to leave, as long as it leaves the European Union as well. Article 50 of the Lisbon Treaty says: "Any Member State may decide to withdraw from the Union in accordance with its own constitutional requirements."
The "insurmountable obstacle to exit", says Barry Eichengreen at the University of California at Berkeley, is a procedural one. It will, he says, take time for contracts such as wages, bank loans, and taxes to be redenominated into drachmas. During this time, Greeks would anticipate that the drachma will collapse against the euro, and so shovel all their savings out of Greek banks and into gold or overseas banks. This, says Professor Eichengreen, will cause "the mother of all financial crises" as the banks collapse.
Some Greeks might already be anticipating this. ECB figures show that, in the 12 months to December the Greek money stock fell by 18 per cent - more than can be explained by the recession.
Could such a crisis be prevented? It would require tough capital (and border) controls to stop money leaving the country. Even if these succeed, they would cause unrest as savers resent being impoverished at the point of a gun by their own government.
Can contagion be contained?
If Greece leaves the euro, all eyes will be on Portugal, which is generally regarded as the second-weakest economy in the region. The country "would come under immense pressure after a Greek exit," says Mr Dannhauser.
If investors fear that their holdings of Portuguese debt will be repaid not in euros but in escudos, they will dump Portuguese bonds, sending their yields up to levels at which the government could no longer service its debts. In this case, Portugal would, in effect, have to leave the euro.
Compounding this risk, says Mr Dannhauser, is the weakness of the country's banks. Because these have lent much more than they have received in deposits, they are heavily dependent on wholesale funding. But this could dry up if banks in other countries fear that their loans to Portuguese banks will be repaid in escudos rather than euros. The result would be a widespread banking collapse.
What could stop this? One thing, says Ralph Solveen at Commerzbank, is that Portugal is in better shape than Greece. Its government debt is forecast to peak at 118 per cent of GDP next year, and to fall thereafter, whereas Greek government debt is now over 160 per cent of GDP and might not reach 120 per cent for another eight years.
Another thing is that the ECB can, in theory, offset selling of Portuguese government debt by buying it itself. It can, in theory, print limitless amounts of euros with which to buy bonds. And if the rest of the euro area agrees to subsidise the Portuguese government on better terms than it is bailing out Greece, the country could also stay in the currency. In this sense, it could stay in the euro as long as other members want it to.