Is An Orderly Default by Greece Possible?

An orderly default is something quite simple, it is a controlled bankruptcy!In times of acute insolvency crises, it can be advisable for regulators and lenders to preemptively engineer the methodic restructuring of a nation’s public debt- also called “orderly default” or “controlled default”. Experts who favor this approach to solve a national debt crisis typically argue that a delay in organizing an orderly default would wind up hurting lenders and neighboring countries even more.

Without Merkel’s consent, the ECB is unlikely to make any more loans to Greece, and Greece is literally broke. Bank runs are underway as this is written. If the Greek elections go as expected on June 17, Greece could officially default as early as this summer (unless Merkel has a change of heart).

One well-known analyst, Nouriel Roubini, suggested a detailed plan for Greece to default and exit the euro without causing chaos around the world.

Roubini is a professor of economics at New York University and co-founder of RGE Monitor, an economic consulting firm. Roubini is best known for his predictions that the US housing market was going to collapse and spark a severe recession. Those calls led to his nickname, “Dr. Doom.” But not anymore.

Roubini admits that his plan involves lots of risks and would have to be managed very carefully.

QUOTE:

The Greek euro tragedy is reaching its final act: it is clear that either this year or next, Greece is highly likely to default on its debt and leave the euro zone…

Greece is stuck in a vicious cycle of insolvency, lost competitiveness, external deficits, and ever-deepening depression. The only way to stop it is to begin an orderly default and departure, co-ordinate and financed by the European Central Bank, the European Union, and the International Monetary Fund (the troika), that minimizes collateral damage to Greece and the rest of the eurozone.

Greece's recent financing package, overseen by the troika, gave the country much less debt relief than it needed. But, even with significantly more public-debt relief, Greece could not return to growth without rapidly restoring competitiveness. And, without a return to growth, its debt burden will remain unsustainable. But all of the options that might restore competitiveness require real currency depreciation.

The first option, a sharp weakening of the euro, is unlikely, as Germany is strong and the ECB is not aggressively easing monetary policy. A rapid reduction in unit labor costs, through structural reforms that increased productivity growth in excess of wages, is just as unlikely. It took Germany 10 years to restore its competitiveness this way; Greece cannot remain in a depression for a decade. Likewise, a rapid deflation in prices and wages, known as an "internal devaluation", would lead to five years of ever-deepening depression.

If none of those options is feasible, the only path left is to leave the euro zone. A return to a national currency and a sharp depreciation would quickly restore competitiveness and growth.

Of course, the process would be traumatic – and not just for Greece. The most significant problem would be capital losses for core euro zone financial institutions. Overnight, the foreign euro liabilities of Greece's government, banks, and companies would surge. Yet these problems can be overcome. Argentina did so in 2001, when it "pesofied" its dollar debts. The United States did something similar in 1933, when it depreciated the dollar by 69% and abandoned the gold standard. A similar "drachmatisation" of euro debts would be necessary and unavoidable.

Losses that euro zone banks would suffer would be manageable if the banks were properly and aggressively recapitalized. Avoiding a post-exit implosion of the Greek banking system, however, might require temporary measures, such as bank holidays and capital controls, to prevent a disorderly run on deposits.

The European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) should carry out the necessary recapitalisation of the Greek banks via direct capital injections. European taxpayers would in effect take over the Greek banking system, but this would be partial compensation for the losses imposed on creditors by drachmatisation.

Greece would also have to restructure and reduce its public debt again. The troika's claims on Greece need not be reduced in face value, but their maturity would have to be lengthened by another decade, and the interest on it reduced. Further haircuts on private claims would also be needed, starting with a moratorium on interest payments..

Those who claim that contagion from a Greek exit would drag others into the crisis are also in denial. Other peripheral countries already have Greek-style problems of debt sustainability and eroded competitiveness. Portugal, for example, may eventually have to restructure its debt and quit the euro. Illiquid but potentially solvent economies, such as Italy and Spain, will need support from Europe regardless of whether Greece exits; indeed, without such liquidity support, a self-fulfilling run on Italian and Spanish public debt is likely.

The substantial new official resources of the IMF and ESM – and ECB liquidity – could then be used to ring fence these countries, and banks elsewhere in the euro zone’s troubled periphery. Regardless of what Greece does, eurozone banks now need to be rapidly recapitalized, which requires a new EU-wide programmed of direct capital injections.

The experience of Iceland and many emerging markets over the past 20 years shows that nominal depreciation and orderly restructuring and reduction of foreign debts can restore debt sustainability, competitiveness, and growth. As in these cases, the collateral damage to Greece of a euro exit will be significant, but it can be contained.

 

Asad Khan
Financial Analyst  (CFB)
050-8774861
asad@cfb.ae