Anatomy of a Grexit: What would happen if Greece left the euro

With eurozone leaders struggling to reach a workable solution to Greece’s debt problems, the chances of a Greek exit from the currency union have risen substantially. A Grexit could be good for both Greece and the rest of the eurozone Here, Jonathan Loynes and Jennifer McKeown, economists at Capital Economics, look at the key issues and challenges of a Grexit, and explain how it might be best managed. There is no real plan The first thing to note is that there is no formal, pre-planned process for a country to leave the euro-zone – so there would be a large element of improvisation, and much would depend on the precise causes and circumstances of a Greek exit. For example, does Greece unilaterally decide to leave, or is it forced out because the European Central Bank (ECB) cuts off funding to its banks? Or is a Greek departure mutually agreed and planned? But there are some common concepts and processes which would apply in all circumstances. The need for secrecy The first and perhaps most obvious point is that as much of the process as possible should be planned and conducted in secret. This, of course would be much easier with an agreed exit than a unilateral or forced one. But as soon as it got out that Greece was likely to leave, market disruption and huge capital outflows from Greece would threaten to make an exit very messy. With that in mind, an important initial step would almost certainly be the imposition of capital controls, while Greek banks would be closed for a period. The imposition of such measures in Cyprus in 2013 provides something of a blueprint here. (Note that capital controls may be needed to stem deposit flows even if Greece stays in the eurozone.) A new Greek currency A central part of the process would clearly be the physical production of a new currency, perhaps called the drachma. Previous estimates have suggested that it would probably take at least six months to produce the requisite amount of notes and perhaps longer to produce coins. But this could be shortened in the case of an agreed exit, if other countries’ printing presses and mints could be utilised. In the interim, euros could continue to be used for small purchases and the development of cashless payment systems over recent years would help. Electronic and card payments would be used as usual and domestic deposits would be re-denominated into drachma. The new currency would probably be introduced initially at parity with the euro and all deposits, wage agreements, prices and contracts would be valued on that basis. But before long the drachma would be allowed to float freely and would presumably drop sharply against the euro. In the Wolfson Report, we estimated that the drachma would need to drop by as much as 40% in order to restore Greece’s competitiveness against the rest of the euro-zone. Since then, sharp falls in Greece’s relative wage costs suggest that the required depreciation has diminished. But we still believe that Greece requires a substantially weaker currency in order to return to a path of sustained economic expansion and avoid deep deflation. A drop of at least 20% would seem likely and substantial overshoot due to initial uncertainty is possible. Timetable for a Grexit
Step 1	A few days before exit	Close banks (including ATMs) and announce intention to exit
Step 2	Immediately after decision	Start printing new currency and prepare capital controls for use on re-opening
Step 3	The week before exit	Enforce and assist in re-denomination of all domestic bank accounts, wages and prices
Step 4	The week before exit	Announce intention to default on at least half of public debt and start negotiations with the Troika
Step 5	The week before exit	Redenominate private international debts into drachmas where possible
Step 6	Exit day	Announce reinstatement of drachma at parity with euro, reopen banks and impose capital controls
Step 7	Exit day	Announce inflation targeting and strict fiscal rules for the future
Step 8	A few days after exit	Recapitalise banks and large firms with euro-denominated debts, using QE if necessary
Step 9	Up to six months after exit	Electronic transactions in drachmas, small amount of euros available for necessary cash transactions
Step 10	About six months after exit	All euros replaced with new drachmas, conversion complete

Default on public sector debt
A Greek exit would almost certainly prompt, or perhaps be triggered by, some form of default on Greek public sector debt. One development since 2012 is that the bulk of that debt is now held by the official sector in the form of bail-out loans, from other countries, the European Financial Stability Fund (EFSF) and the IMF, as well as government bonds held by the ECB.
This, of course, would make the negotiation and aftermath of a default difficult, but perhaps no more than would be the case if Greece remained inside the eurozone. What’s more, if Greece avoids defaulting on privately-held debt, that may well facilitate an earlier and easier return to market financing.
The danger of runaway inflation
With monetary and fiscal sovereignty restored, Greece would have to develop its domestic policymaking frameworks and processes. The vast amount of spare capacity in the economy would probably limit the inflationary consequences of the currency devaluation. But the Bank of Greece would need to adopt an inflation-targeting regime in order to keep inflation expectations under control and public sector wages and pension payments would also be tightly controlled.
At the same time, a set of fiscal rules would need to be drawn up in order to replace the Stability and Growth Pact and reassure markets. The fact that Greece is running a primary budget surplus would help its financing prospects, although the likelihood is that it would fall at least temporarily back into deficit as a result of the adverse initial economic effects of the exit. The central bank would probably launch quantitative easing in order to try to keep government borrowing costs down and raise funds in order to support and perhaps recapitalise banks and corporates with large euro-denominated debts.
The eurozone will need to be strengthened substantially
As for the rest of the eurozone, the first priority would be to tackle contagion effects and limit speculation over other possible exits. The ECB would have to reassert its commitment to keeping the eurozone together by conducting outright monetary transactions for any economy experiencing a surge in bond yields (the possibility has so far been limited to countries in programmes).
Ideally, the European Commission would announce firm plans for stronger fiscal and banking union to ensure that the situation did not arise again. But a commitment to more risk sharing may be difficult to extract once it had become clear that most bailout loans to Greece would not be repaid.
The direct effect on banks outside Greece might be minimal given that they now have little exposure. But governments might need to recapitalise banks that experienced deposit flight linked to speculation about further exits and/or defaults. The ECB should offer more unconditional LTROs (‘long-term refinancing operations’), as opposed to the existing targeted LTROs  to avoid renewed liquidity constraints amid financial market turmoil.
The ECB holds around €30bn in Greek bonds and collateral in the form of Greek public and private sector debt for nearly €60bn in lending operations. While some of the latter exposure is being reduced, a Greek default would leave a large hole in the ECB’s balance sheet. Eurozone governments would need to recapitalise the ECB to avoid a loss of its credibility and ability to control inflation.
Grexit could be a good thing in the long term
Overall, a Greek exit from the euro-zone would clearly throw up some huge challenges, no doubt including many that we have not anticipated here. But that does not mean that it won’t happen or that the best ways to meet those challenges should not be discussed and planned. Indeed, doing so will increase the chances that a Grexit, however it occurs, could even end up as a favourable economic development for both Greece and the rest of the eurozone.
Source:MoneyWeek
• This article was originally published as part of a European Economics Update from Capital Economics. Republished here with permission.