Tuesday, 15 May 2012

The Drachma path

Once more the scenarios of a possible Greek exit from the Eurozone are in fashion. We also see scenarios of a Greek exit from the EU. Most media and commentators replicate the mutterings of European or Greek or other investment experts. In this mess the conspiracy theories abound while some of the Greeks prepare for the day after others do not believe that it is possible.
Today’s Situation 
The Greek state has gone bust after years of financial mismanagement, corruption and nepotism that created a state economy of soviet proportions. The European partners rushed to Greece’s help and gave loans albeit with strict conditionality. However, they made these loans to the people and the parties that were responsible for the mess in the first place. It was like West Germany giving money to Eric Honecker in order to disband his Stasi, restructure East Germany and prepare it for unification. As it happens the people objected to this idea. Unfortunately, this objection took the form of refusing the European help and path. In other words many identify Europe and in particular Germany as the culprit.
Populist politicians are not a rare species in Greek politics. In fact they form the overwhelming majority. The lack of rational debate that was promoted by most political parties finally paid off. No-one can easily discern fantasy from reality. Conspiracy theories have displaced common sense. Many voters wanting to punish the politicians responsible for this and possibly their own selves for voting for them all these years cast their vote to the suicidal left and extreme right (including fascists). Europe responded to this with a simple proposition “Either in with our terms or out”.
The bluff hypothesis 
A basic objection that one hears often against the European position is that Europe is bluffing. There is no way that Greece can be kicked out or that Greece would leave the Euro. Let us see if this is true. Those who play games like poker know well the concept of a bluff. The same bluff cannot be performed by more than 1-2 players. Europe and Eurozone is not one player but 17 (in the case of Eurozone). To think that 10 or more of these countries, European commissioners, ministers and other politicians have agreed to bluff is a conspiracy theory. Three years now and the same players have not managed to solve a problem that represents 2% of the European GDP. Did by magic agree to bluff? Reality is somewhat different.
The constant vacillations of Greece have exposed the weaknesses of the economy and the gap between Greece and Europe in the areas of political rationality and discourse, social structure and culture. European policy makers are beginning to discern that the main problem in Greece is not financial in essence. The crisis is Greece was not a result of the world credit crunch or of bad lending practices by the banks. This was not clear to most Europeans when they signed the first bailout and MOU. The degree of total mess the Greek state was in was not known nor the corruption at all levels of the state apparatus. Now however, things are different. Slowly, a consensus opinion is formed that argues that it is time to put a backstop on the losses and instead concentrate in saving Spain. At least Spain conforms with most of the dictates and does not have second thoughts on the European future. It is not coincidental that we frequently hear of good wishes when it comes to Greece. Everyone is wishing for Greece to stay in Europe. It is like the priest giving the last rites to a terminally ill patient. In other words a new dynamic seems to be shaping that wants Greece outside Europe.
But it is not just thebad Europeansthat want this outcome. Many in Greece wish for the same outcome. Some, for ideological reasons, others because they naively believe that they would make money in the process. Many, because they see political gains or the chance to govern and others because of obscure personal reasons. There is no conspiracy. Some are dressing their opinion in nationalist paranoia and others in socialist or communist terms. There are always the ones that simply want to see their debts reduced. The beloved dear uncle is dying and relatives, wives, mistresses and servants rush to the house to get the wall paintings and the silverware while others are trying to influence the will.
The exit cost 
A frequent argument against kicking Greece out is that it is going to cost the other European countries huge amounts of money. Here, we need to clarify few points. The Treaties do not allow for kicking a member out. Article 7 only mentions suspension of parts of the treaty and only if there is a breach of article 2 which basically refers to democracy, human rights, equality etc.
Thus assuming that Greece does not degenerate to this level it can only ask to leave the EE or the Eurozone. How much would this cost. I am sure many policy makers and countries have done this paper exercise. Most calculations would be probably be wrong but need to start somewhere. Let’s give a brief look at some: 
  • The Hellenic Republic has around 65billion of bonds outstanding under English law. The current market price is around 20% or 13billion. Thus if Greece declares a moratorium the maximum loss would not exceed 13billion, assuming that bondholders have marked to market their holdings. 
  • The IMF and EU loans would be around 240billion in nominal terms (including the money allocated for Greek banks). It would be prudent not to annoy the IMF so let us assume that Greece keeps servicing the IMF but imposes a moratorium on interest rate payments to the rest. As these loans carry an average coupon of around 3% the losses would be 7-8billion a year. These loans do not need to be repaid till 2022-2042 anyway. Moreover, all of these loans are under non-Greek law (English), and this means that when and if Greece decides to rejoin the European family these would have to be settled somehow. For example the Greek revolutionary loan of 1825 was finally settled in 1930, a mere 105 years later. The PSI in this respect is a double edged sword. 
  • The ECB that was exempted from the PSI still owns around 50billion of Greek debt. We do not know the terms of these bonds or where they are marked by the ECB as the swap was done in secret. However we can conservatively assume that 50billion losses are on the cards. The EU however, can use the special account that was created to keep on servicing these bonds directly and simply add the cost to the amount the Greeks owe to Europe.Then there is Target2. The obligations of the Bank of Greece towards the Eurosystem. These are estimated at around 130billion. It is not known how a breakup can be implemented. Could it be that the ECB provides some help to the reborn BoG to settle this and pay in the next 50y? Who knows?
The truth is that on a nominal basis the total loss would be north of 400billion but when one looks at the immediate losses then these are very manageable by the rest of Europe. The question is, how much would Europe save by stopping payments to Greece versus the money to keep Greece in the intensive care. How many more Eurogroup meetings would have to be done and how much political capital would be thrown on the Greek problem. This is a much harder calculation and any guesses are welcome. Would Europe simply postpone the inevitable for Greece at the risk of a much higher bang later? These are some of the enigmas that European policy makers are asked to solve. Greece has many wounds and not all are healed by throwing money. 
The conclusion is that the exit cost is high but not unbearable. In any case, it is not politicians who are going to pay but the taxpayers of the remaining member states. If European taxpayers buy the argument then the probabilities of a Greek exit increase. Recent polls show an increasing trend in this direction. 
The contagion cost 
The third and perhaps more serious objection against a Greek exit is the danger that there may be a contagion, a metastasis of the crisis to other peripheral countries like Spain. Many argue that this is going to be the end of the United Europe. Europe would break up, Germany would lose and finally capitalism would be defeated by the socialist forces. The truth is that if Greece had left 2 years ago the tremors would have been significantly stronger. Now, and after a successful PSI (remains to be seen whose success it is) there is no danger of a financial or banking collapse. Parties have done their war exercises and simulations and we are told that they are prepared for some of the worst contingencies.However, there is always the political and social risk. In reality the market is pricing correctly the financial implications of a Greek exit but has no way of estimating the risk of metastasis in Spain or other European country. Are these two events correlated? In other words, if tomorrow Greece decides to do everything that the Troika demands and stays in the Euro would the Spanish zombie banks come back to life? Would there be a rush to buy Spanish properties? Probably not. Maybe, this is why France and Germany are trying to raise a firewall. Hollande’s victory might speed up this process.
Talk of growth is just political crumps. European states must find ways to reduce their debts and deficits and in many cases do the structural changes (similar to those that are demanded in Greece) before they proceed with money printing. The challenge of the politicians is on how to sell this policy. Here lies the real danger for Greece. If Greece continues the ambivalent policies towards Europe, then Europe might decide to save Spain and do a catharsis with Greece. In other words Greece would be the catalyst that is going to propel Europe to a faster federal union but is not going to take part in it.
It is certainly true that the probabilities of an EU breakup are higher than they were 5y ago but most who opine it are doing it in bad faith rather than rational argument. United Europe took a long time to form and was the dream of many for generations. The union has made many mistakes but it is a living organism that evolves and adapts. In the process some countries may drop out while others may be at a disadvantage, but the main idea would survive. 
Legal exit parameters 
Until the Lisbon treaty there were no provisions for a member’s exit. Article 50 introduced such a possibility. However, article 50 only refers to an exit from the union and not from the monetary union. As it is natural, legal opinion is divided. There are those who believe that an exit can happen only if Greece uses this process to get out of Europe and then tries to re-enter with a special status like Britain. Others are of the opinion of a selective suspension of articles related to the monetary union.
In both cases, it seems the legal and mental jumps are great and Europe would have to structure procedures on the go. Both procedures are also time consuming. For example the first one needs 72% majority (minimum 65% of population) and the consent of the European parliament. In the end any obstacles would be cleared politically rather than legally and details would be filled on the fly. History does not offer many examples. The traditional empires or federations (if we can call Europe as such) do not easily allow members to flee. Many times the centrifugal or secessionist forces are crushed with force. We do not think that this is realistic in our case. The example of the Soviet Union is not similar as there was a massive breakup.
The selective suspension of articles has also some interesting complications but at least spares Greece the negotiations for re-entry (article 48). A danger in this case is that the right to selectively suspend some articles may be extended to other chapters and other countries.
The choice of a unilateral exit by Greece would be the most problematic and dangerous as Greece would breach the treaties.
However, by far the biggest hurdle is how Europe and Greece would react from the time of the exit announcement to the final exit. This may take few weeks or more likely months. 
New Greek Drachma 
There are many technical problems that make the reappearance of the New Greek Drachma (or whatever the new name is going to be) problematic. Most of the problems though are Greek and not European.
History has many examples of currency changes but most if not all deal with the demise of an old currency and the introduction of a new one. In other words the old currency stops being a legal tender and to be accepted as a means of exchange. As such the incentive of currency holders is to give up the old for the new no matter how low the value is. States recognize the sovereign right of a country to issue a currency and determine the exchange rate (Lex Monetae). In the case of the Euro things are different. The Euro would still exist and most probably would be a stronger currency than the NGRD. Also according to protocol 24 (3rd stage of EMU) that sovereign right was taken away and pooled together with the other countries to create the Euro. Putting these details on the side a possible sequence of actions and events could be (The actions are highly speculative and hypothetical)
  • The Hellenic Republic passes a law giving the BoG the right to issue NGD, to conduct monetary policy, to oversee Greek banks and to provide liquidity in the new currency. In addition it freezes banking transactions in order to change the Euros of all Greek citizens into NGRD. The original exchange rate does not matter at all whether it is 1 to 1 or 1 Euro to 100NGRD. It is a nominal exchange. What matter is what you can buy with it. 
  • Another law forces redenomination of all liabilities and contracts made under Greek law to NGRD. 
  • As it is highly unlikely that paper notes would be ready in time, Greece might decide to stamp or otherwise cancel the paper Euro already in the banks with 100Euro Cancel-100NGRD. This may need the consent of the ECB as the notes are liabilities of the ECB. NCB are allowed to print notes according to their quota and the notes are distinguished by the first letter in front of the numbers. For example Greece has Y while Germany has X and Spain V. This however, cannot be used as a criterion since banknotes circulate across Europe. We can assume that electronic transfers would begin faster than the paper money as it only involves changing computer code. 
  • What is going to happen to the Greek banks? Their bonds if issued under Greek law would redenominate while those under English law most probably would not. The same goes for Greek corporates. For other contracts and derivatives it gets more complicated. 
  • Collateral given to the ECB would no longer be valid although in anticipation of such a move Greek banks would have requested funding from the ELA mechanism which is the liability of the Greek state. This would then be converted to the NGRD. Thus an early warning sign could be a massive increase in the ELA (currently at 54billion). 
  • The BoG would no longer be a Eurosystem member and ECB should return the capital plus any reserves (including gold) that the BoG contributed originally. However, the BoG would have a massive liability towards the Eurosystem through the Target2 imbalances. Would the other NCBs accept the loss? Who decides any disputes? 
In conclusion if Greece decides to change the Euro into NGRD it would encounter many problems. Anyone having Euros outside the banking system would hoard them and anyone having Euros inside the banking system would try to take them out causing a bank run. In no way this is a smooth changeover. Black market would thrive and almost certainly there would be controls on the movement of capital and foreign exchange and price controls. For a considerable period absurdity would rule and there is a real danger of a failed state. It is conceivable that enhanced security measure would be introduced to safeguard public and state enterprises, banks and other assets. The biggest losers would be public servants, pensioners and salaried workers that have not hoarded Euros or other hard assets. The example of Argentina where bank safe deposits were opened and the dollars found were converted might be replicated.The abovementioned actions are highly hypothetical and speculative. For the changeover to the NGRD to be successful Greece needs social calmness, planning and organization. These are hardly qualities that characterize the Greek state. In addition, many of the actions described, if they happen, breach fundamental rules and values of the EU. In other words, it is possible that article 7 and 2 (mentioned earlier) might be used to suspend Greece. Again this is a possibility but chances are that Europe would help Greece overcome some of the hurdles in the changeover. 
Greek Economy
If Greece crosses the transitional period successfully then the economic pros and cons would not take long to manifest. Obviously, the devaluation shock would be good for Greek exports and tourism. The abrupt reduction in wage cost if it is accompanied by structural reforms and opening of the economy would most probably be beneficial and the economy would jumpstart very fast. If FDI is encouraged by tax, and labor laws then the possibility of averting hyperinflation is realistic. Greece would need to find hard currency to pay for energy (current account balance is -19billion) and Europe and the IMF would help there.
The bad scenario is if Greece decides to go autistic and closes up in which case the probabilities of a failed state increase. The rapid reduction in the GDP would not be reversed and Greece might degenerate fast. Traditionally, immigration acted as a safety valve (witness the millions of Greek diaspora) and we will probably see this again. 
The possibility of Greece exiting the Euro and introducing NGRD is neither impossible nor highly improbable. Whether this would mean catastrophe depends on how the state and the people are going to handle the changeover, especially after they lost a significant part of their wealth. It is my conviction that Greece should fight to stay in the Euro and try to avoid the adventure of introducing a new currency by force. Exiting the Euro is a very expensive very volatile and very dangerous way of a state reducing its liabilities (salaries, pensions etc) as most of the loans are not under its jurisdiction and cannot be reduced to zero with a simple law (like the PSI). In any case the structural changes in the economy would have to be done, Euro or NGRD.