Europe's Currency Crisis: A Look at Possible Scenarios (Michel)


by Tatjana Michel, Director, Currency Analysis, Schwab Center for Financial Research

Key points

  • A Greek exit from the eurozone has gone from "unthinkable" to a distinct possibility. Years of steep economic decline and unsustainable public debt have increased the odds that the country will once again default on its debt and possibly return to the drachma.
  • A Greek default/exit would present risks to the European banking system, could cause a severe downturn in the Greek economy and might trigger contagion that spreads to countries like Spain, Ireland and Portugal.
  • The European Central Bank and other institutions theoretically have tools to lower contagion risk, but may lack the time and political will to use them.
  • Ultimately, the exit of one country from the euro could lead to the exits of other countries and a breakup of the euro as it's currently known.
  • We suggest investors limit exposure to European bond markets and the euro, both of which are likely to experience more downside.

The May 6 elections in Greece ousted the party that had negotiated and agreed to the bailout package offered by the European Central Bank (ECB), International Monetary Fund (IMF) and European Commission (EC). This group, often referred to as the "troika," provided bailout funding to the Greek government so that it could cover its debt payments in exchange for a promise that the country would bring its budget deficit and debt down by reducing spending and raising taxes. Greek voters have effectively rejected the agreement because of the negative impact that spending cuts have on their economy, which is already in deep recession. No party won a majority in parliament in the May elections and a coalition could not be formed. Therefore, new elections are scheduled on June 17.

If the new government insists on renegotiating the terms of the current bailout plan, new talks with the troika will have to take place shortly after the election. If there is no agreement, the troika could decide to deny Greece its next chunk of bail-out money, which would likely lead to a default on Greece's sovereign bonds.

Greece needs to form a new government and reach an agreement with the troika before it runs out of money in July 2012. If they reach an agreement, Greece is likely to stay in the eurozone but would need to stick to the new austerity plan to continue receiving aid.

Greek opinion polls show elections are wide open

According to recent poll results, the June 17 elections are wide open and could very well lead to a government that meets Europe's terms for keeping Greece in the euro. However, it could also put in power a coalition government that's firmly against austerity—positioning Greece for an exit from the euro.

Scenario 1: Coalition around New Democracy keeps Greece in

Although traditionally powerful Greek political parties like the Pan-Hellenic Socialist Movement (PASOK) and New Democracy (ND) have seen their influence wane in recent years, ND has been catching up with the anti-austerity Coalition of the Radical Left (SYRIZA) party since May 6. Should ND be able to get the upper hand in the June 17 elections, it would increase the likelihood of an agreement with the troika.

Source: Greek Ministry of Interior
*PASOK (Pan-Hellenic Socialist Movement), ND (New Democracy), DISY (Democratic Alliance), KKE (Communist Party of Greece), LAOS (Popular Orthodox Rally), SYRIZA (Coalition of the Radical Left), DIMAR (Democratic Left), ANEL (Independent Greeks), XA (Popular Union). ** Projected estimate of vote tally, after disregarding all blank votes and absentees, and after adjusting for the "likely votes" of "undecided voters.

Scenario 2: Coalition around SYRIZA precipitates Greece's exit

SYRIZA, on the other hand, has denounced the current austerity plan. Party leader Alexis Tsipras believes Greece can stay in the euro and continue receiving money while cutting austerity measures—something Germany and other creditors probably aren't going to like. If SYRIZA gains control, it would likely make the negotiations with the troika difficult and increase the risk of a Greek default and exit.

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