Cross-border debt would either remain in euros or be converted into drachmas, depending on the law they were issued under: About 85% of Greek debt was issued under Greek law and could therefore be converted into drachmas. The rest would remain in euros. However, the recent debt restructuring happened under English law, which presents another complication. Whether cross-border debt is denominated in euros or in drachmas would matter because the drachma would likely depreciate significantly, reducing the value of the debt. A lower drachma would therefore be beneficial for Greece but bad for foreign holders of Greek debt.
Phase 3: Pull euros out of circulation
It would probably take at least a month to print new coins and notes, and the transition phase to replace Greek euros in circulation with drachmas could take between two and six months. In the meantime, old Greek euros would likely be stamped and used as drachmas.
Phase 4: Devaluation of the new drachma
The new drachma would likely, at least initially, be very weak relative to the euro because of the combination of capital flight and Greece's lack of competitiveness when compared to other European countries.
In a free-floating currency market system, a country's currency will adjust for lack of competitiveness. Competitiveness is a country's ability to produce goods and services at a price and quality that makes them reasonably attractive in comparison with those of other countries on the global markets. Due to a variety of factors including higher wage growth, lower productivity and a lack of technical innovation, Greece's exports have not been competitive on the world markets when priced in euros. As a result, the country is running a large deficit with its trading partners in Europe. With a weaker currency, Greece's exports could become more competitive and imports would be very expensive, so the trade gap would most likely narrow. Greece could then grow again, much like many emerging markets after their defaults and devaluations (Mexico 1993-94, Thailand 1997, Russia 1998 and Argentina 2002).
Source: Schwab Center for Financial Research with data from Bloomberg
It's difficult to predict the extent of possible decline in the drachma, as investor panic tends to cause currency markets to overshoot when a country leaves a currency union or abandons its peg to the US dollar. Recent estimates of current-account imbalances based on the work of Rogoff and Obstfeld point to an estimated depreciation of 45%, while Roubini Economics estimates a 50% depreciation could eliminate the current-account deficit. Capital Economics' estimates are 40% for the Greek drachma and the Portuguese escudo, 30% for the Italian lira and the Spanish peso, and 15% for the Irish punt.
However, if history is any guide, a steeper decline is likely, in our view. In the mid-nineties, the Mexican peso depreciated by 115% within three months after the peg to the dollar was abandoned. The Argentine peso lost 286% in 6 months in 2002, and the Thai baht and the Russian ruble depreciated 115% and 330% in 9 months, respectively, in the late nineties (chart above).
Phase 5: Haircut on Greek sovereign debt
The exit from a currency union only makes sense for Greece if it is accompanied by an orderly default on sovereign debt and a large depreciation of the new drachma. The default would allow Greece to reduce the interest payments on its bonds and pay back the principal on its sovereign debt in a cheaper currency. In conjunction with a boost to the export sector from currency depreciation, the country could have the chance to grow out of the crisis.
Domestic banks would need to be recapitalized, as would other European banks with large losses. It is difficult to see Greece getting aid from the ECB for this, so it would have to come from the Greek central bank.
Would a Greek exit lead to the departure of other countries?
A full euro break-up can probably be avoided with action from the troika, but time is not on their side. To date, the lack of coordinated action from the various European institutions has raised the risk of other countries exiting the euro. Contagion can spread through rising sovereign bond yields and through exposure to Greek assets. Italian and Spanish yields have already begun to rise and are approaching levels where it may be difficult for some countries to issue new debt or roll over existing debt.
