As German Finance Minister Wolfgang Schaeuble dares Greece to quit the euro, investors and economists are mapping out what he and fellow policy makers need to do to save the single currency if his bluff is called.
Emergency lending and bond buying from the European Central Bank coupled with recapitalizations and deposit insurance for lenders and broader powers for the region’s rescue fund are among the prescriptions for insulating Spain and other cash-strained nations from what Citigroup Inc. calls a “Grexit.”
Pressure for contingency plans is mounting as Greece’s electoral quagmire forces euro-area officials to publicly revive the once forbidden topic of whether a nation can leave the single currency. Schaeuble told today’s Rheinische Post newspaper that the euro area could handle a Greek departure as “the risks of contagion for other countries of the euro zone have been reduced.”
“Any exit would need to be done as part of a package to reduce disruptions,” said Mohamed El-Erian, chief executive officer at Newport Beach, California-based Pacific Investment Management Co., which manages the world’s largest bond fund. “At this stage, it’s very easy to find things wrong with any approach that is proposed.”
The risk is if Greece leaves and the save-the-euro response flops the world economy could face a sovereign-version of Lehman Brothers Holdings Inc.’s collapse. That makes Schaeuble’s confidence sound all too similar to former U.S. Treasury Secretary Henry M. Paulson’s optimism that the U.S. financial system could withstand the 2008 loss of Lehman Brothers, only to witness the deepest global recession since World War II and a 40 percent slide in the Standard & Poor’s 500 Index in six months.
“If there’s no contagion who cares about Greece, but I wouldn’t be so sure and if I were Germany I’d not be willing to risk it either,” Jim O’Neill, chairman of Goldman Sachs Asset Management, said in a May 9 interview. “If a Greek exit had unforeseen consequences for contagion across countries it would have been a huge mistake.”
Decades in the making and 13 years in existence, the euro-area in its present 17-nation form is in jeopardy after Greece’s voters backed parties allergic to the terms of its bailouts, depriving it of a working government and risking access to the aid it needs to pay its bills and meet debt maturities.
A post-election poll of 1,253 Bloomberg subscribers found 57 percent expect at least one country to leave the currency this year, the most since the survey began in 2010 and up from 11 percent in January 2011.
A splintering of the euro region would leave authorities rushing to avoid capital flight, a default-inducing surge in bond yields and bank runs in the remaining fiscally-stretched nations. While Greece accounts for just about 2 percent of the region’s gross domestic product, its leaving would set a precedent in a currency area that was supposed to have no way out and could prompt investors to raise the threat of default and departure elsewhere.
“A sudden exit of a country from the euro could well lead to financial panic and market selloffs, as well as spikes in volatility and interbank borrowing rates,” said Alan Brown, senior adviser to Schroders Plc in London, which oversees the equivalent of about $323 billion.
Containing those threats would be vital because the cost of a broader break-up would be “very large” given the region’s financial, trade and strategic links, said Willem Buiter, the London-based chief economist at Citigroup, who has raised his estimate on the chances of a Greek departure to 75 percent by the end of 2013 from 50 percent.
Buiter and colleague Ebrahim Rahbari wrote in a report published yesterday that the ECB would use its “potentially infinite” resources to restart its sovereign bond-buying program suspended in April and enact another round of long-term lending akin to the 1.02 trillion euros of three-year low-cost loans issued to banks around the turn of year.
Economists at Bank of America Merrill Lynch see a “high” chance the ECB would also halve its benchmark interest rate from the current 1 percent. The ECB could also follow the example of the Swiss National Bank and announce it is prepared to buy euro-area government debt without limits at a certain yield, say 6 percent, said Brown of Schroders.
“After markets had tested the resolve of the ECB and found it to be firm, I don’t think the ECB would end up owning all the sovereign debt,” Brown said. “Suddenly investors would be very interested in owning Italian debt knowing the ECB stood behind them.”
ECB officials decided earlier this year to deal with any Greek exit on an ad-hoc basis rather than devise a templated set of responses because events would be so unpredictable, said three euro region central bank officials. That may change as the crisis worsens, the officials said. The Frankfurt-based central bank continues to assume Greece will stay within the euro, a spokesperson said on condition of anonymity, in line with ECB policy.
European central bankers have “discussed” the possibility of Greece leaving and how to handle the fallout, Swedish Riksbank Deputy Governor Per Jansson said in an interview in Stockholm today.
“I would be very careful in speculating that it would be a painless process without complications,” Jansson said. “I hope and believe that they will stay in the euro zone.”
Central Bank Action
If the Greeks don’t remain, global central banks may also need to swing into action by opening currency swap lines at cheap borrowing costs to avoid funding problems, the BofA Merrill Lynch economists said. The Bank of Japan already said today it would deploy its foreign exchange assets as part of any international emergency response to market turmoil. Philippine central bank Governor Amando Tetangco said he’s ready to use the necessary tools to fight infection.
For governments and regional rescue funds, an “immediate move” would be to ring-fence banks by guaranteeing deposits and providing fresh capital, said Jacob Kirkegaard, research fellow at the Peterson Institute for International Economics in Washington. Spain alone has deposits totaling 1 trillion euros.
One way to ease such efforts would be to hand a banking license to the 500 billion-euro European Stability Mechanism, the euro-area’s permanent rescue fund scheduled for life from July, according to David Mackie, chief European economist at JPMorgan Chase & Co. That would allow it to boost the aid it can provide by borrowing from the ECB, which has resisted such a move in the past.
Credit lines could also be issued, perhaps in union with the International Monetary Fund, for drawing down by troubled countries if needed, said Holger Schmieding, chief economist at Berenberg Bank in London. Governments would have to tell Spain and Italy they could tap aid without being forced to accept more budget retrenchment in return.
That “would address the market anxiety that Spain or Italy could fall into the Greek trap of ever more austerity in response to ever bigger tax shortfalls caused by recession,” said Schmieding, who added much would depend on the ability of German Chancellor Angela Merkel and incoming French President Francois Hollande to find common ground.
Those leaders would also have to forge ahead with efforts to strengthen political and fiscal ties with the end game being the issuing of joint debt, said Kirkegaard at Peterson. “There will have to be significant deepening of integration to show where the remaining 16 are going,” he said.
Europe may be more resilient now to a fracturing of the single currency. The region will soon have 500 billion euros of added firepower and the IMF is fortifying its own reserves. Greece has also restructured its debt with private investors and EU bank holdings of Greek bonds have fallen by more than half from $68 billion two years ago, according to the Bank for International Settlements.
“We have had some notice to prepare,” said Mark Cliffe, global head of financial markets research at ING Bank NV. “But frankly, most of the mechanisms that transmit the problem beyond Greece remain in place.”