Tuesday, November 29, 2011

Thoughts about Greek redenomination

Let’s assume that Greece manages to run out of money in the next few months (which is up to the EU/ECB/IMF troika). Assume that the troika says no to the next tranche or the one after that, and Greece can’t pay its bills. (Note that its bills don’t include maturing bonds because it is in the process of repudiating them). Then what?

Greece will have two choices: stay on the euro and default domestically (stop paying government wages), or redenominate into drachma. They will opt for the latter, redenomination.

How would this work? I can't think of any exact precedents, but the closest I can come up with would be Argentina’s 2001 move from the dollar currency board into the New Peso or whatever they called it. Here is my scenario for Greece:

1. By presidential decree, freeze all deposits, debts and financial contracts, foreign and domestic.
2. Impose currency and capital controls prohibiting any movement of financial assets out of the country.
3. Temporarily close all land, sea and air borders to prevent the smuggling of euro notes.
4. Announce the redenomination of all deposits, debts, contracts, and currency notes into drachma on a one-to-one basis. This would include all foreign debts, claims and contracts with the possible exception of the ECB.
5. Require that all euronotes be exchanged for drachma.
5. Allow the drachma’s external value to float (since the Bank of Greece will have no international reserves and no international credit, assuming that the ECB does not make credit available).
6. Sell drachma bonds to the Bank of Greece in order to pay the state’s bills.
7. Nationalize and recapitalize the banking system with government bonds.
8. Impose permanent capital and exchange controls to prevent capital flight and speculative attacks on the drachma.

Debts incurred under foreign (i.e., English) law will have to be litigated. There is ample legal precedent for successful repudiation of such debts and contracts (Peru, Ecuador, Argentina, Russia, China, Cuba, etc.).

Once this exercise has been completed, Greece will be effectively debt free, will be able to pay its bills, will have a solvent and liquid banking system, and will have a very competitive currency. However, its international trade lines will be temporarily eliminated, until it is able to accumulate enough foreign currency to finance its imports on a cash basis.

The terms of trade will shift dramatically in favor of Greek exports and against imports. The importation of oil (which requires dollars) will be a particular problem, unless exporters are willing to extend credit. This could prove to be a big problem, although Greece would not be the first country in such a fix. Over time, as Greek exports grow, foreign currency receipts would be able to finance imports. (Currency controls will allow the Bank of Greece to prioritize imports.)

The standard of living in real terms would decline as inflation would exceed nominal wage growth. The real price of domestic tradeable goods will rise with the real cost of imports. The need for fiscal austerity will be a function of the regime’s willingness to tolerate inflation. Given the Greek social model, the government will choose inflation over the alternative, and there will be no external pressure to do otherwise. We have already seen this in Russia, Yugoslavia, Ukraine and elsewhere. While it is true that the middle class’s domestic savings will be wiped out, most Greeks have their savings elsewhere, so the social impact may be muted.

The foregoing is my best estimate of what we are likely to see next year. Because Greece is small, the international impact would be negligible, as would be the case with Portugal. The same would not be true for Spain or Italy.


Bill Wolffe said...

Are these the steps Germany will take upon reintroduction of the D-Mark?
And, is it better for Germany to abandon the Euro first?

Chris Mahoney said...

German redenomination from the euro into the DM would be very unlike a Greek redenomination. Going from the euro to the drachma is going from a hard convertible currency into a soft currency that may not be convertible. Going from the euro to the DM would be very similar to going from the DM to the euro. It can be pre-announced, and it would not cause a flight from Germany (in fact the reverse, since the DM would be expected to appreciate).
While it might make sense for Germany to exit the eurozone, it is politically impossible because it would make Germany a pariah state once again. Despite the fact WW2 ended 67 years ago, Germany must still be the uber-European citizen.

Anonymous said...

That's a good hypothetical return to a national currency, but do you think that Greece will be allowed to Grexit?

It is so cheap to keep it going with a few billion euros every few months. Even if it runs a 10% budget deficit for the next couple of years, you're only talking about €25bn a year to finance it, about €2bn a month divided among the Eurozone.