Tuesday 6 December 2016

Greece can't be thrown out of the eurozone

Gary O'Callaghan

Published 23/06/2011 | 05:00

Since the onset of the crisis, there has been a lot of speculation about a break-up of the eurozone as some members could be forced out or quit.

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This week, there were further calls for Greece to be expelled and for the eurozone to proceed without it. But, like an injured limb, the Greek problem cannot be so easily discarded. It is simply not possible to evict Greece from the eurozone.

First of all, there is nothing in the Maastricht Treaty or in the Stability and Growth Pact -- which sets out the fiscal criteria for membership -- to regulate the removal of a member country. Procedures were never established because, quite simply, nobody thought such a crisis could occur.

But now the crisis is upon us and, as often happens, the mechanism for expulsion seems to be at hand in the form of the Greek financing package.

Eurozone finance ministers threatened this week to withhold a crucial instalment unless further austerity measures were approved by July 3 and the ECB has again threatened to withdraw support from Greek banks. If either threat were carried out, Greece would default on its sovereign debt and its banking system would be in danger of collapse.

So what could happen then?

Greece would certainly be out of the good-boys club at that stage, but it would still not be out of the eurozone.

This is largely because it is not possible to go around Greece and vacuum up the €23bn in banknotes and coins that circulate there. Moreover, there is nothing to prevent Greek banks from continuing to accept deposits and give loans in euro. And the government can still operate in euro.

If, as is likely to happen, the Greek response included a temporary freeze on bank foreign liabilities -- to prevent a drain on liquidity -- the financial system might survive.

Foreign loans and central bank credits to Greek banks make up 40pc of their liabilities, while foreign assets are just 25pc of all assets and government bonds are 15pc.

Therefore, if foreign and central bank liabilities were frozen, non-sovereign domestic assets would be sufficient to cover domestic liabilities (at 60pc each of the existing balance sheets). A down-sized banking system could continue to operate for domestic purposes only while the foreign component lay frozen.

Iceland preserved its banking system through the imposition of a similar freeze on foreign deposits in 2008 and, even though it had the advantage of its own currency, this succeeded in preserving an onshore banking system while the offshore system was incubated.

Frugal

Greece would then become like Montenegro and Kosovo, which use the euro as their official currency but do not belong to the euro club.

They are not entitled to credits from the ECB and have to run their affairs in a frugal manner because, if the country runs a balance of payments deficit -- if it spends more than it takes in -- euro notes will begin to leave the country and the money supply will shrink.

When this happens, an automatic austerity programme makes an immediate correction to demand.

In fact, it is a common feature of Balkan economies that they piggyback on other currencies. Due to a legacy of hyperinflation, banking systems often carry extensive deposits in foreign currencies, even if a stable domestic currency exists.

In Croatia, for example, 80pc of bank deposits are linked to foreign currencies. Greece might eventually introduce a new parallel currency that would be used for small purchases, but the euro would continue to be the real money.

The main danger to Greece in these circumstances would be that euro notes could drain out of the country through trade deficits. However, if interest payments abroad were also suspended, a fiscal adjustment such as that sought by the IMF for this year alone (about €7bn) would probably be enough to close the balance of payments deficit and to allow the government to finance itself.

This isolated Greek stance would not be conducive to medium-term growth, but it could constitute a temporary equilibrium while a solution was worked out.

Greece could continue to operate in the eurozone while it imposed a creditor moratorium and went about the business of getting a deal on a debt restructuring. Greece is shut out from international markets anyway and growth prospects are not great.

And this last point is critical. After significant adjustment, Greece is coming to a point where it could enact the scenario outlined above and shut itself off.

Any further belt-tightening and high-interest loans would be destined simply to repay foreign debt and there may be no prospect of market access or renewed growth anyway to make such a sacrifice worthwhile. The financing package is beginning to look very empty.

Meanwhile, a Greek default would cause severe financial distress in the core European countries. So it is increasingly obvious that Europe needs these loans to be accepted more than Greece needs the help. And one day, very soon, Europe's bluff will be called.

Gary O'Callaghan is Professor of Economics at Dubrovnik International University. He was a member of the staff of the IMF and has advised numerous governments on macroeconomic policies.

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