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A Greek exit from the Eurozone is looking increasingly likely. European leaders are thought to be preparing for this scenario and looking at measures to protect against the risk of contagion to other highly-indebted European nations.

To date, Greece has received two bailouts packages, €110bn in May 2010 and €130bn finalised in February 2012, which included a “voluntary” restructuring of Greek bonds held by the private sector, involving net present value losses of around 70%. It is hoped that the packages will help reduce Greece’s public debt to around 120.5% of GDP by 2020 from 179% in 2011. Ongoing payments under the second package are dependent on Greece implementing austerity measures.

Greek elections on May 6th led to a political crisis with no parties able to form a government. The Greek electorate punished the parties that agreed to the international bailout terms that have forced austerity on the country, blaming them for unemployment reaching a record high of 21%, with under-25s being particularly hard hit with an unemployment rate of 54%. However, at the same time as rejecting austerity, opinion polls indicate that Greeks do not want to leave the single currency—a recent poll found 82% of Greeks wanted to remain in the Euro.

Similarly, Eurozone leaders are insistent that they want Greece to remain in the Euro, but that they also must adhere to their bailout terms. Somewhere, something has to give, but the showdown will have to wait for new Greek elections on June 17th.

Immediately following the May elections, the anti-austerity party, Syriza, was ahead in opinion polls, suggesting that the new elections could lead to rejection of the international bailout and an exit from the Euro. However, five new opinion polls on May 26th put the two main pro-bailout parties back in the lead, suggesting that the electorate’s desire to remain in the Euro may be overcoming its dislike of austerity. Nonetheless, the situation is too close to call, the pro-bailout lead remains slim and they may still fall short of a clear parliamentary majority.

Eurozone leaders will be keen to avoid the risks inherent in a Greek exit from the Eurozone, which could strengthen the Greek hand in bargaining for more lenient austerity measures. The knock-on effects from an exit could put massive strains on the European financial system, risking the viability of banks and sovereigns in heavily-indebted nations, setting off a chain of events with negative consequences for the global economy.

en_graph1THE INCREASING LIKELIHOOD

The scale of risks entailed in a Greek Euro exit has been clearly illustrated by the market reaction to recent events. The Euro has fallen in value against the US dollar by 4.2% since the beginning of May from 1.321 to 1.266, its lowest level since mid-2010. European stock indices have also fallen sharply. The EuroStoxx 50, an index of the Eurozone’s leading 50 blue-chip companies, has fallen 7.5% since the beginning of May and 18.2% from its 2012 peak of 2,608 in mid March. The impact is not restricted to the Eurozone—the MSCI World Index has fallen 8.8% in May.

There are a number of reasons that the current situation in Greece is viewed as dangerous by financial markets. A rejection of austerity by the Greek electorate would break the terms of its bailout package and could force the troika (the ECB, EC and IMF) to cease making bailout payments. This would result in Greece defaulting on its bonds, initiating a damaging chain of events.

The value of Greek bonds would collapse leading to losses for Eurozone and global banks. Greek banks are heavily exposed to their sovereign’s debt—lending of Greek financial institutions to the government was €35bn in March 2012 - making a total collapse of the domestic banking system inevitable, wiping out savings and the ability of the populace to withdraw cash or make payments.

The default would also be likely to upset the functioning of the government while a new form of financing was arranged. The country would lose access to Euros and would most probably need to issue a new currency to enable any form of functioning government and banking system to re-emerge. The disruption to lending from banks and the absence of government support would lead to an economic collapse, higher unemployment and increased social misery. Imports of goods would be interrupted by the lack of currency, leading to shortages of oil, medicine and some foodstuffs.

However, once through the initial shock, Greece would most likely emerge with less debt, more independence and a more competitive exchange rate. Analysts expect that a new Greek currency would immediately depreciate by around 50% and would remain depreciated by 50%-60% for the next five years. The initial shock would lead to a double-digit contraction in GDP but in the longer term, growth would rebound to over 4% as gains in competitiveness from the lower exchange rate would revive exports and tourism. The Greeks will either have to face this kind of shock or adhere to the existing or renegotiated austerity terms of the troika, which are likely to involve years of economic repression.

A Greek default and exit from the Euro would have an impact beyond Greece. Banks across the Eurozone, and beyond, would be impaired by their exposure to Greek sovereign debt. Some of Europe’s largest banks face exposures of over €3.0bn each to Greek debt. The total exposure of European banks to the Greek public sector was €31bn and for non-European banks it was €1.6bn in September 2011, according to the Bank of International Settlements (BIS). The total external debt of the Greek general government was €178bn at the end of September 2011, although this fell to €157bn by the end of the year, mainly owing to support packages.

Lending would be held back and borrowing costs would rise, making it harder for Europe to escape recession. In countries where banking systems are already fragile, banks may require government support to stay afloat. Higher borrowing costs and potential bailouts would make it harder for heavily-indebted nations, such as Portugal, Ireland, Spain and Italy, to meet payments on their sovereign debt, leading to more sovereign bailouts. All these factors would undermine the Eurozone and global economy, making it yet harder for indebted nations to overcome their financial burdens.

  en_graph2THE INCREASING LIKELIHOOD

 number of steps to mitigate the risks of a Greek default have been put forward: shoring up the region’s banks through recapitalisations from European rescue funds; implementing a Eurozone deposit guarantee to try and avoid a potential bank run; and jointly guaranteed Eurobonds. However, at a summit on 23rd May, European leaders put off any decisions. It is therefore likely that uncertainty will continue to repress financial markets until the situation is clarified by the Greek elections on June 17th.


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