What is Really at Stake in Greece

Posted by Adolfo Laurenti on July 13, 2012

I’ve received a number of questions lately about what is going on in Greece and the euro zone. There are some common misconceptions, so I’ve written the following to explain in detail.

Despite the “orderly restructuring” (read: ‘managed default”) of the Greek debt last March and the results of recent elections in Athens that brought back to power a pro-euro coalition, we continue to receive requests about “what ifs” in the case Greece decided to abandon the European single currency. Recently, concerns have been raised in the media about how damaging this scenario could be for the European Central Bank (ECB). We want to take this opportunity to restore some sanity on the issue.

First of all, last March Greece defaulted on a very large portion of outstanding debt, about 65% of the total, mostly owned by Greek banks, Greek non-bank entities and global investors. Greece did NOT default on the remaining 35% of debt officially owned by the ECB as well as the International Monetary Fund (IMF) and European sovereign governments (in the form of bilateral loans.) So, if Greece had to default again, the ECB would take some losses – but not all of them, because the IMF and the international community would share part of the burden.

Secondly, how big would this potential loss be for the ECB? Before the bailout in March, the ECB owned 16% of Greek debt, other European countries owned 14%, the IMF, 5%.  But the ECB’s 16% share amounted to 55 billion (billion) euros. Considering that the ECB has a balance sheet of about 3 trillion (that is trillion with a “T”) euros, I really don’t see why a Greek default would be so problematic for the ECB balance sheet. Admittedly, ECB exposure to Greece would include other important items, such as repo agreements with Greek banks and emergency loans extended to the Greek banking system. The highest credible figure we have seen for total ECB exposure to Greece is roughly 160 billion euros, which is about 0.5% of the ECB’s balance sheet, give or take a few billion. This undermines the assumption that a loss would entirely wipe out the ECB balance sheet (and, in any case, it is more realistic to assume a recovery rate greater than zero).

Bottom Line: People tend to forget that, for all the drama it has caused, Greece is a very small country (accounting for only 2% of the euro area’s GDP) and unlikely to directly undermine the ECB’s balance sheet. Finally, we continue to hear and read a fundamental misunderstanding, in which a Greek default (if Greece stopped servicing its debt or repaid only cents on the euro) and a Greek exit from the euro zone are confused. The two are not the same!  “Default” and “exit from the single currency area” should not be used interchangeably. Greece could default on its debt but continue to use the euro as a currency (think of Orange County in California, which went into bankruptcy but did not leave the dollar currency area). If it helps, you may want to consider the opposite (highly unlikely) scenario: Greece could reintroduce its old currency, the drachma, and continue honoring its debt denominated in euros. The point is: defaulting on sovereign debt and leaving the common currency are not the same thing! While leaving the euro would very likely result in sovereign default, Greece could opt to default on its debt without leaving the euro area. To some extent, Greece already did this; it defaulted but stayed in the euro area – a fact that doomsayers conveniently omit from their narratives.

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