All in for plan B?

The chances of Greece leaving the euro are growing stronger by the day. So why don’t we know what the next stage is for the eurozone yet, asks Hugo Dixon

Unless one side blinks, Greece will be out of the single currency and any deposits left in their banks will be converted from euro into cut-price drachmas

WHEN eurozone policymakers are asked if there is a plan B to cope with a Greek exit from the single currency, their typical answer goes something like this: “There’s no such plan. If there were, it would leak, investors would panic, and the exit scenario would gather unstoppable momentum.”

Maybe there really is no plan. Or maybe policymakers are just doing a good job of keeping their mouths shut. Hopefully, it is the latter because, since Greece’s election, the chances of Athens quitting the euro have shot up. And unless the rest of the eurozone is well prepared, the knock-on effect will be devastating.

The Greeks have lost their stomach for austerity and the rest of the eurozone has lost its patience with Athens’ broken promises. But unless one side blinks, Greece will be out of the single currency and any deposits left in their banks will be converted from euro into cut-price drachmas.

People outside Greece may think this is simply a Greek problem. Would it really be much worse than Athens’ debt restructuring earlier this year which passed off with barely a murmur? But the process of bringing back the drachma is likely to involve temporarily shutting banks and imposing capital controls. That would set a frightening precedent.

Politicians and central bankers would, of course, argue that Greece was not a precedent but a one-off. But why trust them? When Greece was first bailed out in 2010, policymakers said it was a special case. Then Ireland and Portugal required official bailouts while both Spain and Italy have had to be helped by the ECB. If savers in Greece get hammered, depositors and investors in these other weak euro members would want to move their money to somewhere safer. Fears would rise of a complete break-up of the eurozone.

Indeed, there has already been significant capital flight from peripheral economies. The best way of seeing this is by looking at so-called Target 2 imbalances — the amount of money national central banks in the eurozone owe to the ECB or are owed by it. These imbalances are a rough proxy for capital flight.

Four eurozone central banks — in Germany, the Netherlands, Luxembourg, and Finland — have positive balances. At the end of April, the Bundesbank was owed €644bn, according to data from Germany’s Ifo Institute. The sum has been rising by an average of €33bn a month since the crisis took a turn for the worse at the end of July last year. Meanwhile, all the peripheral countries have big liabilities. Italy and Spain have the largest with €279bn (as of April) and €276bn (as of March), respectively.

A Greek exit from the euro would, at least temporarily, accelerate capital flight. Measures would need to be taken to counteract it — to protect both depositors and governments in vulnerable countries.

Fortunately, it’s not too difficult to construct a contingency plan. To protect depositors, the ECB would have to make clear that a limitless supply of liquidity with very few strings attached was available for banks across the eurozone. This would avoid the possibility that savers would find they couldn’t get money out of their accounts. After a while, calm might return.

To protect governments, the ECB would also need to wade into action. Although it cannot lend to states directly, it can buy their bonds on the secondary market. Indeed, it has already done so. It would, though, need to be prepared to buy bonds in limitless quantities. Otherwise, investors might run anyway and take the ECB’s money while it lasted.

Although the ECB would have to play the main role in preventing a panic, the eurozone’s so-called firewall should play a subsidiary role. The region will soon have two main bailout funds — the existing European Financial Stability Facility and the European Stability Mechanism. These could be deployed in two ways.

First, they could provide a backstop to national deposit guarantee funds. Thus, an Italian saver would know that if Rome’s own guarantee scheme ran out of money, there were funds in another kitty to fill the hole. Second, the bailout funds could lend cash directly to governments no longer able to issue bonds in the markets.

However, the bailout funds are not large enough to stem a panic on their own. They only have €740bn available. Even with help from the IMF, they would not be able to douse the flames.

Although it is fairly easy to think of a plan B, that doesn’t mean it would be easy to get political agreement for it from Germany and other creditor countries. One concern would be that the ECB would be taking huge financial risks by buying government bonds and lending to banks. Another is that such rescues, which would amount to a big step towards fiscal union, would take pressure off the peripheral governments and their banks to reform themselves and improve their solvency.

On the other hand, failure to act as a lender of last resort in a Greek-exit panic could trigger a domino effect of bankruptcies — of banks and governments — throughout the periphery. The euro couldn’t survive that.

Germany may soon need to decide between going all in to save the single currency or witnessing its destruction.


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