Greek default spectre turns material

Prospects of a Greek default or eurozone exit have suddenly become very real, and even with its now reduced debt-servicing burden either option would mean a painful future.

The weekend Greek revolt against the austerity measures imposed on its economy in return for eurozone funding has elevated the prospect of a Greek default on its debts or a chaotic exit from the eurozone.

The collapse in support for the mainstream parties that had reluctantly accepted the austerity program and the vehement opposition to the measures by the radical left party that finished the runner up in the weekend’s elections has made it almost impossible for a coalition to be formed that would persevere with the program.

It is likely new elections will have to be held next month but given the degree to which Greeks have protested against the harsh eurozone prescriptions – and the 20 per cent shrinkage in GDP and 20 per cent-plus unemployment that has accompanied them – it is improbable that Greece will continue with the reforms it agreed in return for the next $300 billion tranche of eurozone funding.

If it does walk away from that commitment there will be chaos in Greece and, to a lesser extent, elsewhere. Greece would inevitably default on its debts and could be forced to quit the eurozone.

While the notion of a return to the drachma and regained competitiveness might be appealing, the immediate consequences would be turmoil, both within Greece and beyond, and some very nasty and difficult years, if not decades, ahead. The austerity program might, as the radical left leader Alexis Tsipras has said, be "barbarous," but the alternatives could be just as unpalatable.

The two earlier Greek bailouts and the $130 billion or so of "haircuts" Greece imposed on private holders of its bonds earlier this year have reduced the implications of a Greek default and/or eurozone exit somewhat, although there are European banks still holding large amounts of Greek public and private debt that would be destabilised and would need to be recapitalised.

Abandoning the austerity measures and relinquishing the funding arranged by the EU and IMF would, however, wipe out Greece’s banks, cut off access to international investment and lenders, spark an exodus of foreign companies and send a wave of red ink through the wider eurozone banking system – and generate very big losses for the European Central Bank and IMF on their holdings of Greek paper.

It would also heighten the concerns about the other weak members of the eurozone – Portugal, Spain, Italy and even France, which too changed leadership at the weekend in protest at its fiscal strategies. There is a risk of contagion and a shunning of European borrowers, sovereign and otherwise, by the rest of the world.

Greece is, however, a relative minnow. It represents only about two per cent of the eurozone’s GDP so its exit from the monetary union could be managed to minimise the damage to the rest of the region.

Within Greece it would trigger runs on Greek banks (there has already been a massive capital flight) and, given the inevitability of a dramatic devaluation of the drachma against the euro, create impossible debt-servicing positions for the government, the banks and private borrowers. The banks and private companies with external borrowings would immediately collapse.

The banks would have to be nationalised and recapitalised and capital controls imposed, and private sector debts to foreign lenders either forcibly converted into drachma at parity or reneged on, which would effectively be similar outcomes.

Either way, as occurred when Argentina defaulted more than a decade ago, the Greek economy would be shut off from the global financial system. It would also experience hyperinflation.

Even with its sovereign debt-servicing burden vastly reduced by a devaluation and renomination of its sovereign debts, Greece would still face a very unpleasant future, given that it doesn’t really have much of an economic base and the reason that it's in the strife it's in was that since joining the EU two decades ago it has borrowed to live beyond its means (and fudged the numbers to disguise that).

Whether it accepts the austerity program or heads for the eurozone exit, the bloated public service and the size of the role of government within the economy are unsustainable. Whatever choice the Greeks ultimately make, there is no painless path to stability.

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