Exit risks

Is a Greek exit from the euro zone inevitable?

Greece's economy is again hitting the headlines. A solution to the country's external debt crisis appeared to have been worked out in an arrangement with the "troika" comprising the International Monetary Fund, the European Union and the European Central Bank. In typical fashion, this required the Greek government to undertake massive structural reforms in exchange for restructuring external debt. Also typically, the short-term impact of those measures were rather adverse for Greeks, with only the promise of a return to solvency sometime in the future to keep them appeased. After four successive years of declining gross domestic product (GDP), massive unemployment and retrenchment in public services, the government that negotiated that deal did not pass its first electoral test and was replaced by a regime that campaigned on a platform of defiance against the oppressiveness of the plan. The new government is fighting to stave off an impending default, brought about by the fact that the troika is unwilling to provide further funds until reforms that were promised are implemented. This, of course, puts the government in an extremely tight spot. Should it give in to the troika, thus reneging on its electoral platform? Or, should it default on obligations to its citizens in order to maintain external solvency? And is the consequence of the default an inevitable exit from the euro arrangement?

Those in favour of Greece conceding ground to keep the arrangement alive highlight the possibility that the transition out of the euro could be extremely painful and unpredictable. On the other side, proponents of exit point out that the immediate correction in the country's real exchange rate vis-à-vis the euro would stimulate a recovery in growth and employment; it is the sole path to salvation, even if the transition is difficult. Of course, the euro zone itself is a major stakeholder in this process; the exit of one fragile economy increases the likelihood of others following suit and, particularly, raises questions about the willingness and resolve of the euro zone institutions to constructively address the problems faced by a member country. Of course, if exit is inevitable, the one significant difference that the first programme seems to have made is that it reduced the exposure of the European banking system to Greece's debt, by shifting it to public sector balance sheets. Consequently, European banks will not be as seriously impacted by an exit. Greek banks, however, are an entirely different story, as citizens will quickly shift their euro balances out of the country in anticipation of capital controls being imposed.

Clearly, this is a situation in which all proximate stakeholders are damned if they do and damned if they don't. If it is to be viewed from the perspective of global financial stability, however, the balance of risks suggests that continuity order is preferred to the disruption of an unplanned or sudden exit. The destabilising effects of such a disruption could spread far beyond Europe and particularly to emerging market economies, which simply cannot afford another upheaval.