Europe's Currency Crisis: A Look at Possible Scenarios

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. (more)