Monday, 4 July 2011

Hypothetically speaking - what would happen if Greece were to drop out of the Euro?

By Neil McCulloch

In my last blog I called for a large reduction in Greece’s debt – this may seem like impossibility. But if Greece were to drop out of the Euro, it could completely change the incentives for debt reduction.

Initially Greece would need to announce that it will pay back its foreign denominated debts at a discount.  The discount depends on the speed with which private creditors provide new financing.  It does this by taking the entire private foreign denominated debt and dividing it into, say, 200 pieces.  It then invites daily bids for new funding of X Euro (where X = total private Forex debt/200). 

The winner of the bid will be the bank that provides the best terms (i.e. lowest interest rate/longest term). The twist in the tail is that the bank that wins the bid on day one is guaranteed to be repaid their existing debt at 100 per cent of face value; the winner on the second day will be repaid their existing debt at 99.5 per cent of face value; on the third day the winner gets 99 per cent and so on.  In other words, the longer private banks take to provide new funding, the bigger the discount on their debt.

Now the incentives for private banks are completely the opposite of the current incentives.  It is in their interest to provide new funding immediately if they wish to get anything back on their existing loans.  Wise banks will quickly realise their losses and lend to Greece.  This will both reduce the face value of the debt and provide new finance for the government.

There is, of course, a major snag with this scheme.  Other European countries will be outraged at Greece forcing their banks to accept losses. They might encourage their banks to take legal action against Greece for the full amount, rather than participate in the bids.  However, there are a few things that Greece could do to mitigate this risk. 
  1. It could announce publically that it will honour all sovereign debt in full i.e. all loans from other European countries and the IMF will be honoured in full; only private creditors will be asked to take a hit. 
  2. It can ensure that the daily bids are confidential.  This will make banks anxious that their competitors are secretly bidding and getting ahead of them in the queue, which, in turn, makes them more likely to bid. 
  3. And finally, they could try to bolster the credibility of their threat to discount and default their debts by accessing other major sources of financing, e.g. sovereign wealth funds from the Middle East or China.  Private creditors are more likely to accept losses if their threat to withdraw future funding has less bite. 
All of this is hugely undesirable. An orderly write down by European countries and their banks would be far preferable, although even more unlikely. 


Anonymous said...

Without change, Greece will always be spending more on its government workers and will never have enough. To bailout today, will mean to bailout tomorrow and the next day, forever. When does it reach us americans or has it already?

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