Why is ‘GREXIT’ such a terror for financial world?
If Greece returns to the drachma there is a real risk that trade will break down. How will companies be treated? What happens to contracts that Greek companies made? Will they be honored in original form or also be subject to being redenominated? Can Greek companies afford the contracts after introduction of the drachma? This is just basic stuff, but in a world that depends on global trade, it is hard to tell what the consequences of a trade breakdown with Greece would be. We saw from the Japanese earthquake how sensitive and widespread problems from seemingly isolated supply line problems can develop.
That is all based on the hope that the world doesn’t become fixated on a chaotic breakdown of Greek society. The worst case is shortages of fuel and food where prices skyrocket in the immediate aftermath of the redenomination. Industry grinds to a halt from a lack of raw materials. This should be the easiest element of a devaluation to deal with, but it will require planning.
I’m assuming that depositors will be forced to accept drachmas in their bank accounts rather than keeping Euros. If they are allowed to keep Euros, then the situation would be better, except for the fact that the already insolvent banks would become more insolvent if forced to pay out depositors in Euros while have most of their assets turned into drachma.
These problems are unlikely to get out of control, and should be “merely” disruptive but would benefit from planning and preparation, none of which has really occurred yet.
Bank runs in Italy, Spain, and Portugal
This is the most likely result, no matter what happens to the ECB, IMF, and EFSF’s positions.
If you have a deposit in a bank in a country at risk of redenomination, then you would have to seriously consider taking money out to avoid that risk. This isn’t default risk. This is different. You aren’t concerned that your bank is going to default you are concerned that €1,000 will turn into 1,000 lire or pesetas of unknown value. Pan-European deposit insurance will NOT stop that flight of depositor money, unless it also ensures against forced conversion. That is a big risk to insure against, and may not be even remotely in the ECB’s mandate. So this is another difference from any other situation. If Argentina devalues, there is always risk that Brazil would devalue as well. That contagion risk played out in Asia in the late 1990’s. That risk is amplified here, because Greece will be a template for the others. In the back of every depositors mind, will be the fear that their country does it too.
I am scared that the ECB thinks they can address that risk with liquidity measures because they cannot. I am scared that the ECB thinks they can address that with solvency measures because they cannot. Real fear of forced currency conversion and devaluation is a new fear and new problem. You may not be concerned that BBVA is going to default, but you may be afraid that your account will be turned into something worth a lot less.
The only way to stop this is to insure against it (difficult) or to force Greek banks to pay depositors in Euros. But it is unclear how the Greek banks could afford to pay people out in Euros. The banks are already insolvent and the amount of additional money they would need to pay depositors in Euros would just push the problem elsewhere into the system.
I don’t see an easy way to stop a run on the banks in any of the weak countries if Greek depositors are forced into Drachma, and I don’t see any way for the Greek banks to pay depositors in full in Euros.
Anticipating what forced currency devaluation would really do is a new aspect to the crisis. It isn’t a liquidity or a solvency problem, it is its own problem. Politicians and central banks have to focus on this issue. I remain afraid, that like at so many other stages in this crisis, they will fail to understand the real problem, so their “preparations” will fail to stop this run and the crisis will escalate.