What happens if Greece defaults?

13th February 2012

Indeed some senior Greek politicians are saying this openly. Here is Antonio Samaras the leader of the New Democracy party.

'the measures should be renegotiated after national elections expected in April'

So there you have it; he does not expect the measures to last.

Even worse we had the technocratic Prime Minister of Greece who replaced an elected leader talking of Greek "democracy" when he is involved in no such thing. At least 74 deputies mustered their courage and voted no.

How would a default start?

The opening move in this situation would be for the Greek govenrment to declare that in future its currency would be the New Drachma and that it going forward would be legal tender rather than the Euro. There are difficulties here in terms of having bank notes printed and the pricing structure of the Greek economy which would have to change very quickly and in some cases overnight.

What would be the new exchange-rate?

There are two main factors at play here. The first is that Greece needs to choose a level which makes her much more economically competitive. The second is that it looks credible with financial markets as she wishes to avoid volatility and extra turmoil if she can. These two issues do of course overlap to some extent. If we look at the situation there is bound to be some turmoil and volatility but a well-constructed plan will keep it to a minimum.

No doubt you are wondering how much? The European Central Bank calculates a competitiveness indicator which shows Greece to now be at 106.5 versus an index calculated at 100 when the Euro began. If we look at the successful German economy we see a competitiveness indicator at 82.3 so my suggestion would be for Greece to announce an opening exchange rate for the New Drachma some 25% lower than the previous Euro exchange rate.

If we look at the likely effect of such a move it may well be stronger than many would have you believe. If we look at Greece's latest set of trade figures for December 2011 we see that 59% of her imports and 48% of her exports were with the European Union. So a large proportion of her trade would see an immediate economic benefit as she would be 25% more competitive with her Southern Meditteranean Euro zone peers overnight which should give quite a boost. I do realise that the figures above are for the European Union and not the Euro zone but lets us break that down. The gain for trade with Euro zone countries is clear but my contention is that if the UK pound sterling is any guide then EU currencies will mostly move with the Euro on this.

Looking further afield then we have an interesting concept to face because "uncompetitive" Greece actually exports 52% of its products outside the European Union according to its figures. There is a little ray of light there is there not? A more price competitive Greece could over time perhaps do a fair bit better than this. So there is some hope for an improvement from an area which contradicts somewhat the stereotypes which have circulated.

This is not a panacea

The terms of trade will move against Greece

The initial effect of the move will be to make Greece's position appear even worse. This is because at day one Greece's exports will earn less per unit and her imports will cost more per unit because of the 25% devaluation. Whilst financial markets can adjust virtually instantaneously the real economy will take time. So there will be a period where the numbers look worse as the underlying real economy begins to make adjustments to the new more competitive situation. This is the logic which underlies what is called the J-curve in economics.

Inflation will rise

There will be an inflationary impact from the devaluation as Greece will have to get some products from abroad and their prices will rise in  New Drachma. Obvious candidates are raw materials and oil as well as other imported goods. But it is a sign of the scale of the crisis facing Greece that I feel she needs to take this risk. I am also aware that the risk is bigger than the devaluation as a 25% devaluation means that the prices will be 33% higher in the New Drachma era.

Those holding bank deposits in Greece will lose out

Another casualty of this process is that savings and bank deposits in Greece (those that are left….) will be reduced by 25%. Those who hold physical Euro notes will probably be okay even the ones with the "Greek" stamp on them. I do not know this but I suspect that the trouble of wiping them out would be more than it is worth for the European Central Bank. In my view it is probably bright enough to figure out that if it did not accept Greek euro notes there would be a flight from the Euro notes of other countries in danger such as Portugal and maybe Spain. It does not want that….

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