A few days ago, this article would have started with the statement that Grexit is closer than ever. Today it seems that Grexit has been postponed for a few months. Yet I fail to understand the underlying strategy of the Greek government since the proposed austerity measures (along with capital controls and low confidence) are destined to push the economy in a deep recession. This recession will make achieving the primary surplus targets even harder and government debt clearly unsustainable (even based on the IMF’s quite optimistic projections). The current program will fail in 2016 and Grexit will come back on the table with a Greek government that enjoys a much more fragile domestic political support and an even weaker economy with a higher output gap.

Probably the biggest problem of returning to the drachma is the fact that there are certain (probable) scenarios where the economy almost collapses and others where we observe the usual path of a large devaluation following an unsustainable currency peg: A short-lived large fall in output followed by a long path of economic growth. Usually people will just choose the scenario that fits their story and ideology and not consider (or even imagine) any other possible paths. The ‘ugly scenario’ basically includes official creditors accelerating Greek debt in the form of EFSF loans and the Greek Loan Facility. That will push Greece in a permanent default state and most probably not make it able to accumulate any foreign reserves (since they would be claimed by creditors). EU structural funds will most likely be lost and Europe will not support the newly created currency exchange rate in any way. Greece will have to function in a ‘semi-pariah’ state with strict and permanent capital controls and an economy that will slowly lose most of its human capital and internationally oriented sectors (such as shipping).

In this blog post I will not analyze the above scenario any further but rather take a closer look at a controlled exit from the Eurozone which will include the help of the other Euro member countries (if not for anything else but to enhance the recovery of their official loans).

First of all let me remind people that currency movements happen mostly because of large gross capital flows and not due to the underlying real trade flows (this paper from BIS Claudio Borio is quite informative). Capital flows, at least in the short-term, will happen for only a few reasons:

  • RoW liquidating domestic claims in order to transform them in foreign currency (think of other Euro banks not rolling over repos with Greek banks or equity investors exiting the Greek stock exchange).
  • Domestic firms and households trying to exchange their liquid assets (mostly deposits) for foreign currency.
  • Institutional players taking large currency positions. This requires being able to borrow large amounts of the currency that will be shorted at favorable terms.

In the Greek case we know that a Grexit will happen under strict capital controls (which are already present), while the terms and price (interest rate) under which the RoW will access the drachma will be determined exclusively by Bank of Greece. Since drachma does not exist in any way, a Eurodollar market is not present and cannot help anyone to circumvent capital controls. Private players outside Greece have already liquidated most of their claims (either equity or interbank loans) while the bulk of Greek liabilities are long-term official loans by other Eurozone member countries. The same is true to a large extent for Greeks themselves who have moved large amounts of liquidity outside Greece. This is the main reason why BoG has more than €120bn in liabilities towards the Eurosystem (Target2 and extra banknotes combined).

As a result, coupled with the presence of capital controls and the fact that Greece already has a strong current account surplus (on a yearly basis) there is actually small scope for strong pressure on the exchange rate of a newly introduced drachma. It is probably one of the few times that capital controls can truly be used as a policy tool and not to trap large funds looking for a way out (as was the case in Iceland). As long as outstanding Greek debt to the ECB (in the form of SMP bonds) and the IMF is rescheduled in the form of a long-term loan by the ESM, the GLF spread over Euribor is lowered to  5bps and interest payments postponed until 2020 (as has already happened with the EFSF loan) Greece will have truly minimal refinancing needs (in terms of foreign currency obligations) for the rest of the decade and be able to slowly accumulate FX reserves through its current account surpluses.

The main subject where a host of different opinions exist is what will happen with ELA financing by BoG and the corresponding liabilities towards the Eurosystem. The story usually goes that BoG will have to default on these liabilities and the Eurosystem having to perform a large capital injection. In my view any such claim is most probably false, at least in the favorable scenario. EU already has an exchange rate mechanism for EU members that do not participate in the Euro area but wish to maintain a controlled exchange rate relationship, called ERM II. This mechanism defines a ‘central exchange rate’ with the Euro, with a fluctuation band of +/- 15%. Intervention at the margins is automatic and unlimited while a short-term financing facility exists with a maturity of 3 months (which can be renewed at least once):

for the currency of each participating non-euro area Member State (hereinafter ‘participating non-euro area currency’) a central rate against the euro is defined;

there is one standard fluctuation band of ± 15 % around the central rates;

intervention at the margins is in principle automatic and unlimited, with very short-term financing available.

For the purpose of intervention in euro and in the participating non-euro area currencies, the ECB and each participating non-euro area NCB shall open for each other very short-term credit facilities. The initial maturity for a very short-term financing operation shall be three months.

The financing operations under these facilities shall take the form of spot sales and purchases of participating currencies giving rise to corresponding claims and liabilities, denominated in the creditor’s currency, between the ECB and the participating non-euro area NCBs. The value date of the financing operations shall be identical to the value date of the intervention in the market. The ECB shall keep a record of all transactions conducted in the context of these facilities.

The very short-term financing facility is in principle automatically available and unlimited in amount for the purpose of financing intervention in participating currencies at the margins.

For the purpose of intramarginal intervention, the very short-term financing facility may, with the agreement of the central bank issuing the intervention currency, be made available subject to the following conditions: (a) the cumulative amount of such financing made available to the debtor central bank shall not exceed the latter’s ceiling as laid down in Annex II; (b) the debtor central bank shall make appropriate use of its foreign reserve holdings prior to drawing on the facility.

Outstanding very short-term financing balances shall be remunerated at the representative domestic three-month money market rate of the creditor’s currency prevailing on the trade date of the initial financing operation or, in the event of a renewal pursuant to Articles 10 and 11 of this Agreement, the three-month money market rate of the creditor’s currency prevailing two business days before the date on which the initial financing operation to be renewed falls due.

My view is that in the case of a Grexit current BoG liabilities towards the Eurosystem will be transformed into a long-term financing facility, capped somewhere close to their current level. BoG will have to pay interest to the Eurosystem, either the 3-month rate applicable to ERM II financing facility or the MRO (as it happens today for Target2 liabilities) with the clear agreement that BoG will use its FX reserves in order to slowly pay back the facility (through annual current account surpluses). This will obviously mean that BoG financing towards Greek banks will remain significant, absent a domestic QE program. Short-term financing by the Eurosystem will be provided in order to facilitate temporary FX needs (the Greek current account is actually in deficit during the first months of a year) and to allow the smooth payment of government liabilities denominated in Euros. Obviously this financing facility will be capped for intramarginal interventions.

As long as the central rate is reasonable and both sides are determined to defend it through monetary policy (interest rates), capital controls and automatic interventions, confidence on the drachma will quickly be strengthened and domestic players will have little reason to try to convert their assets into foreign currency.

Obviously one important problem is the fact that creating the actual physical currency will take time. Electronic payments as well as the over €50bn in Euro banknotes circulating in Greece right now (for a GDP of less than €179bn) will help minimize the short-term impact.

Although I hope the above will remain only a scenario exercise, it is my view that, given the political climate inside Europe and the short-term economic reality, Grexit will emerge again during 2016, especially if the current package is not accompanied by serious debt restructuring.