May 25, 2012 by Shawkat Hammoudeh
Greece has been a hot topic recently, and it needs a detailed plan on how it can orderly exit the eurozone. The plan includes elements that should minimize the risk to Europe and the global and American financial systems if a thoughtful exit is considered.
The plan contains these rules to govern an orderly exiting:
1. If there will be an exit, it must be very secretive and should happen very quickly. Any significant disclosure, leak or lingering will lead to an exodus of enormous euro-denominated funds to another euro territory, which would cause bankruptcies, recession and maybe a depression in the exiting country.
2. Just to account for a possible credible leak or insight information happening before the withdrawal, the exiting country should temporarily stop all money transfers with the rest of the world, particularly with those fellow countries in the eurozone when it is ready to exit. This may require shutting off all electronic communications including fund wires, Internet, fax, etc. with the outside world for a few days.
3. The exiting country should find a quick way to transform the euro currency into the national currency such as the drachma to keep its function as a medium of change working during the exiting period. History tells us of examples where the splitting country in a currency union in the 20th century stamped the common currency into a national currency temporarily before it was replaced by a true national currency. In the successor countries of the Austro-Hungarian Empire, the krone was stamped with a national mark after the empire, which lasted for 51 years and was defeated at the end of World War I. Austria, for example, stamped the krone with “DEUTSCHSTERREICH,” and then a few years later the krone was replaced by a silver coin called schilling at the rate of 10,000 kronen per one silver coin.
4. The hardest task the exiting country must deal with is the denomination and valuation of the national debt that includes retail, commercial and sovereign loans. If the agreement stipulates that the debt must be denominated in the national currency, then the exiting country’s risk exposure is reduced, and the risk exposure is shared with the lender. However, if the debt is stipulated to be in the union currency, whether signed in the exiting country or another country, both the executive and legislative branches must deal with it simultaneously and discretely. The legislative body, in coordination with the executive branch, should have parallel sessions during the euro stoppage period to rectify what the executive branch sealed according to the rules above.
Now, I still believe that Greece should be the first to exit the eurozone before it will be forced to leave in a disorderly fashion that would eventually wreak havoc on the world’s banks and financial system. I also argue that it is in Greece’s best interest to exit orderly and early. Greece will then face the internal devaluation of its currency before other members of the eurozone do likewise. Therefore, a vacation in Greece would be dirt cheap after the important devaluation. The tourism sector will then lead the way to economic recovery in Greece in two or three years, as happened in Argentina and Iceland, which are major exporters of wheat and marine products, after devaluation of the peso and the krona, respectively. It will be difficult for Greece to reap the full benefits of devaluation if other eurozone countries also exit and devalue internally right after Greece does.
Here is some recent information on U.S. banks’ exposure to a possible disorderly exit by Greece: Those banks’ direct total exposure in the eurozone is valued at more than $240 billion. They have about $6 billion in proper Greek debt. Their exposure in Italy is about $65 billion, in Spain $65 billion, in Ireland $50 billion, and Portugal about $7 billion. Estimates of gross total U.S. banks’ exposure in Europe through loans and bonds are equal to $678 billion.
The damage is not confined only to this direct exposure. There is real and material risk to the euro. It’s now about $1.27 per one euro. In the case of a disorderly exit, it should not be surprising if the euro will drop significantly below parity with the dollar.
The eurozone risk also lives within U.S. borders. In recent years many European banks have moved money to U.S. banks to avoid the direct exposure to the crisis and fend off the potential real danger to the Europe. A good portion of this money has been invested in U.S. money market funds. Now, European holdings account for more than 35 percent of those funds. In terms of runs on European banks, the American money market funds will be devastated if panic overruns European banks.
An ensuing severe recession in Europe as a result of the disorderly exit will endure for several years. Such a profound recession will also damage real economic activity in the U.S. and other countries through the trade linkages. It will also cause damage to the banking system. The eurozone market is the third largest market for U.S. exports, accounting for one-third of American economic growth in 2010, the second year of recovery that followed the 2007-2008 recession.
Therefore, what happens in the eurozone does not stay in Europe. It’s not the direct exposure to Greece’s debt woes that matters; it’s the contagion that spreads the risk that matters the most. Based on that, the damage to the U.S. economy can still be material. Risk aversion is also still the way to go in these days and for several years to come.
Shawkat Hammoudeh is a professor of economics and can be reached at email@example.com.