Greece barely managed to repay a loan installment to the International Monetary Fund (IMF) this week, only being able to do so by tapping its own buffer reserves at the IMF. The rather unusual repayment method underscores how severe Athens’ liquidity crunch has become in recent months. Things will get even worse in June and July as the country shoulders even bigger repayments, primarily to the European Central Bank (ECB). Without outside help, Greece will run out of cash soon and could default on part of its debt.

So far, the predominant view among investors has been that, faced with the prospect of default and possibly a disorderly exit from the monetary union, even the Syriza government will look for and find ways to compromise with its creditors (as we wrote just a few weeks ago). This is still the most likely outcome. However, it is worthwhile briefly examining, and perhaps dismissing, an alternative. What if Prime Minister Alexis Tsipras decides to run out of money and triggers a credit event, thereby lifting what many observers in and outside of Greece perceive as an unsustainable debt burden? Would that automatically lead to an exit from the monetary union? Isn’t the decision to honor sovereign debt commitments still exactly that, a sovereign matter that only the government in Athens can decide? Would such an event not be welcomed by many in creditor countries that believe the time has come to stop extending, to stop pretending, and to stop bleeding cash that will never be returned?

From a purely legal point of view, the answer to this cluster of questions is that a sovereign default would not trigger an ejection from the euro zone and the European Union. Only Greece can decide to leave. Thus, de jure, Greece can stay in the monetary union as long as it wishes to do so.

However, for all practical purposes, a default—even a partial one triggered by a missed payment to the ECB—would severely impact Greece. The ECB is keeping Greece’s banking system afloat by allowing the central bank in Athens to inject liquidity into credit institutions via emergency liquidity assistance (ELA). It is hard to imagine that the Frankfurt based institution would still allow that to happen in the case of one or multiple missed loan repayments. Even a fudge, i.e., applying harsher haircuts on assets offered as collateral in exchange of liquidity, would not make things much easier for Athens. At this point, in order to avoid a collapse of the banking system, Athens would be forced to introduce capital controls and start paying bills with IOUs, thus de facto introducing a parallel currency. There could be a scramble by Greece and its creditors to reach an agreement and reverse this outcome. Market reactions would determine who holds the best cards in this new round of negotiations.

Of course, that would very much depend on the willingness of Germany, its euro area partners, and the ECB to inoculate the rest of the more vulnerable parts of the monetary union against contagion. How much is needed depends on who one talks to. I still believe that simply stating the tools available, such as the ECB’s Outright Monetary Transactions (OMT), the current ongoing asset purchase program, and the funds available through the European Stability Mechanism (ESM) won’t be sufficient to placate a suddenly panicky market. Investors tend to swing in big movements. This time would be no different. Current financing conditions across the monetary union (apart from Greece) are favorable because of the very low interest rate environment, not because of the ability of previously stressed countries to successfully reduce their overall debt stock, both sovereign and corporate. Suddenly adding a few hundred basis points to yields for sovereign and corporate bonds could change the euro area picture quite dramatically, and not for the better.

However, the reaction could be very different if the leading European institutions, the European Council and the ECB, announce significant steps toward a more perfect union. That would placate markets. Unfortunately, in the current political environment no one in Europe seems to think that he or she has the necessary political capital to credibly make such announcements, whatever shape they may take.

Some have suggested that allowing Greece to default would not be such a disaster if Greece’s banks can be protected against its sovereign. After all, that was one of the goals of the banking union. Today, the single supervisor of all major Greek banks is the ECB. If one or more credit institutions need to be wound down, the future resolution mechanism could be quickly activated. Alternatively, banks could be directly recapitalized through the ESM. Europe has shown that it can act quickly when needed. Just as Europe created a resolution mechanism for its banks when it needed one, the continent could benefit from having a mechanism to allow for an orderly restructuring of sovereign debt.

But this is where things can get very tricky indeed. In fact, as long as banks and their sovereign cannot be disentangled, a sovereign default will continue to wipe out the domestic banking system. The reality is that the limits of the monetary union’s current architecture do not allow for a sovereign default to take place without shaking the foundations of the whole of the euro area. But perhaps somebody can teach me to revise my excessive risk aversion.

  • K Bledowski

    If debt restructuring is the answer “then” – as the author implies – then it will be way more expensive to euro-taxpapers than restructuring “now”.