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Managing a Greek Default

Author: Christopher Alessi
Updated: September 29, 2011

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German lawmakers voted today (DeutscheWelle) to approve a plan agreed on by EU leaders in July to increase the lending capacity of the eurozone's temporary bailout mechanism, the European Financial Stability Facility (EFSF). The fund's powers will be expanded signficantly, allowing it to buy up the government bonds of countries facing sovereign debt contagion. The measure--which must be ratified by seven remaining eurozone states in order to be enacted--paves the way for an increasingly urgent second financial rescue package for Greece.

Greek Prime Minister George Papandreou and German Chancellor Angela Merkel met in Berlin September 27 to discuss the burgeoning Greek debt crisis that is leading many analysts to see default as ultimately inevitable.

Merkel and Papandreou addressed Greece's progress in meeting its austerity commitments--a prerequisite for obtaining the next tranche of the country's original €110 billion EU-IMF bailout. Representatives of the European Commission, the European Central Bank, and the International Monetary Fund--the so-called troika--returned to Athens today (AP) to determine whether Greece has made sufficient budgetary cuts to receive the next €8 billion installment. The Greek parliament passed a new property tax (NYT) on September 27 that is expected to reduce the budget deficit by €2 billion this year.

Yet despite such efforts, the situation in Greece is unsustainable, analysts say. The country has €353 billion of public debt, approximately 150 percent of its GDP. Moreover, the IMF forecasts (Bloomberg) that the Greek economy is expected to shrink by 5 percent in 2011 and 2 percent in 2012, making it significantly harder for the government to meet its fiscal targets.

Economists say it is no longer a question of if Greece will default, but when--and how. Whether a Greek default is orderly or disorderly will determine the level of contagion to the rest of the eurozone. The debt crisis has generated as much as €300 billion in credit risk for European banks, with French and German institutions the most exposed. "The issue is not so much default--for some form of it will happen--as how burdens are shared," Iain Begg, a professorial research fellow at the London School of Economics' European Institute, told CFR.

An orderly default would involve private bondholders of Greek debt taking a "haircut" of at least 50 percent, Benedicta Marzinotto, a research fellow with Brussels-based think tank Bruegel, told CFR. But even an orderly default, she adds, would necessitate the recapitalization of Greek, French, and German banks. Such a restructuring, though, is not likely to happen until the EFSF expansion has been endorsed by national parliaments, expected no sooner than mid-October. "The most likely scenario remains that Greece gets their next disbursement [of last year's bailout], but restructures when the reformed EFSF has been ratified," Barry Eichengreen, a professor of economics and political science at the University of California, Berkeley, recently told Institutional Investor magazine.

The EFSF plan would double the holdings of the fund to €780 billion, while giving it the flexibility to buy bonds on both the primary and secondary markets. This would allow the fund to ease public-sector debt in weak countries like Italy that have not received an EU-IMF bailout, or help to refinance European banks that have been overly exposed to sovereign debt. EU leaders and IMF officials are even considering leveraging the emergency fund (Reuters) with a credit line from the ECB, which could generate €3 trillion in financing to create a "firewall" against debt contagion.

Still, economists are divided over whether Greece would leave the eurozone in the event of a default.  Nouriel Roubini, the chairman of Roubini  Global Economics and a professor at New York University's Stern School of Business, argues that Greece's debt will remain unsustainably high (FT) if it does not begin to grow again. Since Greece will be unable to do so under the weight of the strict austerity measures being mandated by the EU and IMF, Roubini writes, its only option is to leave the eurozone. He explains, "A return to national currency and a sharp depreciation would quickly restore competitiveness and growth." Similarly, Stergios Skaperdas, a professor of economics at the University of California, Irvine, notes in a piece for the Guardian, "Employment will pick up within a few months after the introduction of the new drachma. By contrast, unemployment and deprivation with no end in sight are the predictable results of following the troika's policies."

However, Bruegel's Marzinotto thinks Greece will not choose to leave the eurozone because doing so would mean it would have to leave the EU. Such a move, Marzinotto told CFR, would have a massive impact on, among other things, Greece's ability to trade with the rest of Europe and on the mobility of its people throughout the continent. "No country that is currently a member of the eurozone can afford to leave," Berkeley's Eichengreen said to II. While LSE's Begg told CFR, "I do not think they will be obliged to leave the eurozone . . . exiting the currency is not the simple change that many commentators seem to suppose."

Background Materials:

"Europe Thinks the Unthinkable," Financial Times

"Greece on the Edge," Bloomberg

"Time Running Out for EU," Reuters

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