Greek Default Scenarios

With the break-down of negotiations between the Greek government and its creditors over the weekend, Greece is about to default on a 1.6 billion Euros IMF loan repayment this Tuesday. While this need not automatically trigger a full default, a critical July 5th referendum on whether or not to accept the latest proposal from Greece’s creditors could. Most polls suggest Greeks would vote to avoid default and stay in the Eurozone, but this is far from guaranteed. This post examines what would happen to Greece in case the government defaults on its debt. We examine three scenarios going from the most optimistic to the worst.

Scenario A: Default Inside the Euro

  • In this scenario Greece defaults on its debt to the IMF and other creditors, but it stays inside the Eurozone. The ECB continues to lend to Greek banks through the Emergency Liquidity Assistance (ELA) program. The capital controls imposed this Monday reduce deposit flight from Greece, and a complete collapse of the Greek banking system is avoided. Nevertheless, Greek banks are forced to drastically contract lending.
  • Lower credit availability, a decline in private sector confidence and rising uncertainty hurt domestic demand and tourism. The lack of access to external funds and falling tax revenues require large cuts in public sector working hours and salary payments. The negative effects of this on aggregate demand are only partly countered by the reduction in debt repayments, now amounting to 3% of GDP.
  • Greece enters a recession with GDP contracting by 0.5% to 1.5% in 2015 and a further 1 to 2% in 2016. The economy starts growing again in 2017 though at a slower pace than under the no default scenario.

Scenario B1: Grexit with Export Boom

  • Greece defaults on its debt and the ECB refuses to provide access to further ELA loans. In order to fund its spending, and hoping to gain from an export boom, the government starts printing its own currency and exits the Euro. This leads to a 40-50% depreciation of the new Drachma and inflation of 20-35% year-on-year.
  • Greek banks lose access to ECB funds, but capital controls are partially successful at blocking deposit flight. The switch back to Drachmas causes confusion and complicates payments for businesses and consumers.
  • The ECB’s aggressive bond buying and bank lending through its quantitative easing and long-term refinancing operations stabilise financial markets in the Eurozone, reducing contagion effects to a minimum.
  • The devaluation is followed by a wave of corporate defaults, due to the spike in the burden of Euro denominated debt, rising costs of imported production inputs (raising production costs) and higher interest rates as the central bank tries to stabilise the new Drachma. This amplifies the negative effects on private sector output of the credit crunch and higher uncertainty also present in scenario A.
  • However, the Drachma’s depreciation leads to a strong export boom, with a large increase in tourism. The boost in exports compensates for the negative effects of exiting the Euro. As a result, the scale of the recession would be similar to that in scenario A.

Scenario B2: Grexit Leads to Depression

  • As in scenario B1, Greece exits the Euro and the new Drachma depreciates significantly. Capital controls are insufficient and the Greek banking system collapses.
  • The typical experience from large devaluation episodes such those of the Asian crisis in 1997 is that the rise in exports tend to be gradual due to other non-price factors determining demand for exports, and due to supply factors limiting the growth in exports. Furthermore, the weight of Greek exports in production is low relatively to other small open economies, with an average exports to GDP ratio of around 30% over 2010-2014.
  • Extra uncertainty by tourists about visiting Greece during a crisis, and doubts by foreign buyers about the ability of Greek exporters to deliver merchandise while facing financial difficulties, limit the rise in demand for exports following the depreciation or even cause exports to decline. Stronger than expected financial contagion effects to the rest of Europe hurt Eurozone growth, further dampening demand for Greek exports.
  • On the supply side, key Greek export industries such as oil refining are hit by large cost increases due the increase in the Drachma prices of oil and other key production inputs. Capacity constraints also reduce the potential rise in exports to benefit from the currency depreciation. As a result, export growth is modest or even negative. Even with positive export growth, net exports may fall due to the higher cost of imports.
  • With all the previous negative consequences of a default and change in currencies, but without any offsetting gains from an export boom the Greek economy enters another depression. Greece’s GDP declines by 4 to 6% in 2015 and by 10% to 14% in 2016.

In case of a default, the ECB will probably maintain access to funding for Greek banks in order to reduce the risk of financial contagion to other Eurozone countries to a minimum. In combination with the majority of the Greek public against exiting the Euro, this makes scenario A the most likely outcome conditional on default. If a Grexit occurs, the rise in uncertainty and other complications will probably reduce the potential for export growth following devaluation. This makes the Grexit and Depression scenario B2 more likely than the Grexit and export boom scenario B1. However, it is worth emphasizing the unusual margin of uncertainty surrounding the outcomes of a Greek default.