Why Greece must default within the eurozoneRobert Jenkins14 Oct...

Why Greece must default within the eurozone
Robert Jenkins
14 Oct 2011
Robert Jenkins, a member of the Bank of England's interim financial policy committee, explains why there is no choice: Greece needs to default within the eurozone – not outside it.


Not long ago, European leaders insisted that Greek default was unthinkable. Many now acknowledge the possibility. The markets are a bit further along. They have discounted it. But note the nuance in the preferred approach – it is to be a default “within the euro.”

What does this mean and why is this crucial? If you know the answer, stop reading here. If not, you will soon wish you had. For the alternative is that Greece exits the single currency.

Here is how default “outside the euro” would play out:

1: The Greek government decides an exit.
2: Rumours begin to circulate.
3: Greek citizens withdraw their euro deposits while they are still euros.
4. Greek and foreign businesses begin shifting their euro balances.
5: Bank transfers wing their way abroad.
6: Supplies of euro bank notes run short.
7: Foreign lenders to Greek businesses pull their credit lines.
8: Greek banks close their doors.
9: The Government convenes an emergency meeting.
10: The new drachma is announced.
11: Capital controls are imposed.
12: Border patrols are dispatched.
13: Public sector debt is redenominated in local currency.
14: The value of the drachma plunges.
15: Private sector debt -- for example, a German bank’s loan to the Greek subsidiary of a BMW -- becomes a source of dispute. Is the obligation still euro or drachma denominated? If it is drachma then the German bank has a problem, for it now has a drachma asset worth a fraction of its euro book value. If on the other hand the obligation remains euro denominated then the Greek borrower and the German bank have a problem, for the Greek entity must service euro debt from drachma income.
16: Portuguese citizens begin to worry that it might happen there; Portuguese companies take precautionary action and transfer funds out.
17: Portuguese depositors begin to withdraw euros.
18. Similar movements in Ireland with echoes elsewhere along the Med.
19. Banks cease all dealings with their “peripheral” counterparts.
20. Confusion as to the magnitude of European bank exposure to the private sector brings interbank activity to a halt.
21: Bank stocks crater.
22. Safe haven assets soar.
23. Switzerland imposes punitive negative interest rates on non-resident deposits.
24: Bank lending ceases.
25: EU economic activity stops.

I could go on but you get the picture. It is not a pretty picture.

Let me just add the fact that European banking exposure to the private sector -- corporations and households -- of the “peripherals” is a multiple of that to the public sector -- government debt -- of the area. These numbers are not secret. They have appeared in the press. The associated risks are what used to be called “cross-border risk” – a term well known to US bankers of a certain age who once recklessly lent dollars and pesos to the Mexican public and private sector - only to discover that sovereign risk involved not only the risk that the sovereign might not pay but also that the private sector might be prevented by law or currency changes from doing so.

Banks in Europe can be forgiven for making this mistake within Europe. The advent of the euro-zone abolished the notion of “cross-border” risk, n’est-ce pas? Was not German bank lending to BMW Athens now akin to New York bank lending to General Motors in San Francisco? That was the idea. Seemed sound, right? It is, provided the eurozone hangs together.
It would appear the German cabinet has grasped the gory details. They must find the courage to explain it to their constituents. For the German public needs to understand that their interests lie not in hounding the Greeks out but in keeping them in. For Greek default within the euro is manageable and will be managed. Greek default outside the euro involves risk to a different order of magnitude.

It is the elephant in the room – visible for all to see should anyone care to look. For a long time no one cared to. No one wanted to. Now you know why.

Robert Jenkins is Adjunct Professor, Finance at the London Business School and an external member of the interim Financial Policy Committee. He writes in a private capacity.