Short Guide to Hell and Back?

Why A Grexit Would Make Lehman Look Like Childs Play

By Peter Tchir

Maybe I’m wrong, but every time I look at the possibility of a Greek exit right now I see it spiraling out of control and dragging down the entire global economy.  I hear and read the arguments of why it is controllable and they just don’t seem credible.  They either link a Greek devaluation to other devaluations that have little, if anything in common.  They also seem to ignore human nature and how the markets will likely respond.  I think with planning and time, a Greek exit would be manageable but right now it would create chaos, first within Europe and then the globe.

The ECB, EFSF and IMF will take massive losses

The ECB has €50 billion of GGB bonds still on their books.  Those would not get paid at par by Greece if this is an amicable breakup, but this is quickly heading to a pots and pans thrown in the kitchen sort of break-up.  Why would Greece pay the ECB if they feel like the ECB drove them out?  Don’t forget, not for a second, that most of the money Greece now gets goes to pay back the ECB and IMF.  The EFSF is totally out of luck.  The ECB might be able to offer something to a post drachma Greece, but the EFSF offers nothing.  The IMF has more negotiating power, as their direct loans had more protection in the first place and they are likely to provide additional funds post exit, but quite simply Greece won’t be able to pay them in full on existing loans.

With the ECB, EFSF, and IMF all taking big losses, their credibility is hurt.  Worse than that, they have exposure to Portugal, Ireland, Spain and Italy and the markets (if not the politicians) will become very concerned about those exposures.  The IMF may see its alleged firewall crumble before it is ever launched.  The ECB, integral to any plan to protect Europe will have lost credibility and many will question their solvency.  The EFSF will be hung out to dry and immediately the market will attach all their risk to Germany and France, not making people in those countries particularly happy.

Preparation:  The ECB in particular is acting like a profit center.  Does it really need the current coupon it gets on its SMP portfolio?  Does it need to be paid back at original scheduled maturity date?  Paid back at par rather than cost?  The ECB should work proactively with those countries to exchange their bonds for something that doesn’t cause a loss for the ECB but gives the countries a big benefit (maturity extension, rebate of bonds purchased at discount, and much lower coupon).  Whatever message the ECB is trying to send by not doing this seems bizarre to begin with, but insane once you consider the real losses they will take upon a Grexit.  The IMF and EFSF have less flexibility but can cut rates on their loans, as they too don’t need to generate a profit either.  This takes pressure off all of the countries, has no real “cost” to any country, and sets a good tone for proper negotiations of what will happen upon a Grexit down the road.

European Trade Will Decrease Dramatically

Somehow people seem to believe that switching to the Drachma will increase exports for Greece.  That somehow trade will grow.  Just the opposite is likely to occur, and just like bank “runs” this will hit all the periphery countries immediately.

The standard image is of companies just waiting to buy new “cheaper” drachma goods from Greece.  That just doesn’t reflect the reality of modern trade.  Most companies have existing suppliers and contracts, so they may not even be able to switch to Greek suppliers in the short run.  But the key word there is “contracts”.  Companies depend on contracts.  Do you really think companies will be busy trying to sign new deals with Greece, a country that just left a currency union, and only recently retroactively changed its laws for bondholders?  Or do you think lawyers will be figuring out what it means for any existing business, not just with Greece but with all other periphery countries?

It will mean the latter.  Companies will become extremely concerned with doing business with anyone who might leave the Euro.  They will want to know what happens to their business arrangements.  They will not provide any credit in any form to businesses in those countries.  While someone might be some olives because they are now cheap, no company is about to buy components for bigger projects from Greece.  If the earthquake in Japan taught manufacturers anything, it is how critical their supply chain is.  You really think many CEO’s will take the risk of doing business in a country with an uncertain currency, laws that have been “bent” to serve the country?  No, and that is the optimistic view, as it doesn’t include the risk that Greece faces major disruptions due to the high cost of things like, um, oil.  Greek companies themselves will likely be mired in confusion over what the Grexit does for them.

The problem will hit Greece the hardest, but it won’t be isolated to Greece.  If you think there is a real risk that Spain or Italy head down the same path, you will be reluctant to work with them.  You may even be afraid of what exposure they have to Greek suppliers. 

Preparation:  Time.  Contracts need to be reviewed. Changes need to be made that deal with the consequences. Alternative methods of trade finance need to be developed.  Most importantly, Spain and Italy have to be doing well enough that the risk of them leaving is virtually zero.  Getting Spain and Italy on a stable footing is a critical part of any plan to have Greece leave.

Other Devaluing Countries have been Resource Rich

While some countries have devalued successfully, they are typically resource rich.  Not only do the countries typically have a lot of natural resources, with oil at the top of the list, those industries are typically government controlled.  So while the economy adjusts to the devaluation, the governments typically impose restrictions on not just capital but on natural resources.
Being able to subsidize individuals and company with raw materials at below market rates has been part of a typical EM country’s devaluation program.  Greece is no shape to do that.  Greece has to import virtually all of its energy needs.  They are at the mercy of the markets and a devalued drachma is not going to help them.  This is a huge difference that so far has been overlooked. Without its own supply of critical resources, Greece will be forced to spend inordinate amounts of money to keep the economy merely functioning.  That will offset the alleged benefits of increased trade, with I believe in the near term are overstated to begin with.

Preparation:  Stockpiling.  Greece needs to build supplies of essential raw materials.  It will eat up additional money, but better to buy in Euros than Drachma.  Also, if the conversion can be done smoothly, maybe you only see a 10%-25% devaluation, making the risk lower and far better than some estimates of an immediate 50%-75% drop in value. 

Other Devaluing Countries weren’t part of a Fragile Currency Union

It ultimately keeps coming back to Spain and Italy.  If every other member of the EU was doing fine, the impact of a Grexit would be much lower.  The impact on the ECB, EFSF, and IMF would be bad, but tolerable if they weren’t immediately going to take losses on Portugal and Ireland, and have to face potential consequences from Spain and Italy.

Trade with Greece would drop, but other companies wouldn’t be that concerned about continuing to do business with Spain and Italy on standard terms.  While they are weak, prudent businesses will treat them more like Greece than might be warranted, but companies will be careful.  What executive would want to lose money on a Spanish business venture when everyone will say in hindsight it should have been obvious they were also going to fail.

The horrible state of Portugal and Ireland, the weakened state of Spain and Italy, the ignored but dubious state of Cyprus, Slovakia and other small members make the ramifications of one country leaving that much more difficult to deal with.  If Greece was truly an isolated case, then fine, but it isn’t.   The countries are all too similar, all too tied to the ECB and EFSF, and ultimately those connections are what making a Grexit a far bigger deal than it would be otherwise.

Preparation:  Determining which countries need to leave will be key.  If Portugal really needs to leave as well, it should be done in conjunction with leaving. Spain and Italy have to be made to appear to be “rock solid” members of the EU.  The contagion risk of doing anything while Spain and Italy are so weak is just too big.  If they ultimately have to leave, then I think the planning and preparation is that much harder.

Currency Runs

This is already hitting.  It isn’t just bank runs, it is the willingness of companies to do business with these countries.  It is showing up in the bond markets.  The activity has been frantic with huge amounts of money flowing out of countries that aren’t just weak, but out of those with perceived currency risk.

I don’t think anyone truly believes Belgium is a great credit.  The Belgium 5 year bonds traded at 5.6% in November of last year.  They are currently at 1.8%.  This is Belgium, the home of Dexia, the land without a government, and yet they are trading much better than other members of the November 5% club.  That is at least in part because people believe they will stay in the “good” currency union. 

This currency risk is visibly playing havoc with the bond markets, and I suspect it is playing almost as much havoc in corporate board rooms we just don’t get to witness it on a daily and immediate basis.

This currency run is more than just a run on bank deposits. It is a run on doing business within countries. It’s an inability to get trade credit which is necessary to be competitive.  It’s deals that aren’t getting closed because whether admitted to or not, the companies are nervous about the future.

The problem with “runs” is that they become emotional and self-fulfilling.  It is relatively easy to take a stab at the solvency of a bank.  The data isn’t great, but at some level you can convince yourself BBVA is safe.  They have enough capital, enough support, etc., that their solvency risk is manageable.  Spanish branches of Deutsche Bank are even easier to get comfortable with from a solvency perspective. Bankia, right now appears to be teetering on insolvency, but with recapitalization, the depositors can get comfortable again.  Addressing solvency is painful because it will involve the governments taking stakes in banks, but it is relatively solvable.  Dealing with conversion risk is much harder.  If my money sits in a deposit account at BBVA, Bankia, or Spanish branch of DB, the currency conversion risk is the same.  The only way to protect myself is to take the money out.  It isn’t quite the same for companies doing business, but it isn’t that dissimilar.

Preparation:  Getting the bank recapitalizations done would be helpful.  Eliminating the immediate solvency risk would help.  One of the many EU institutions (EBRD? EIB?) needs to come up with some new form of trade credit support.  Not just for Greece, but for all of the at risk countries.  Ultimately, getting Spain and Italy back from the brink is key, but finalizing the much talked about, little done, bank recapitalizations and ensuring the availability of trade credit would start to calm the tension.

Decoupling is a Myth

As we saw after Lehman and then to a lesser extent after the earthquake in Japan global trade is very fragile.  A Grexit would immediately affect the entire periphery.  It would disrupt supply chains (like Japan) and impact credit (like Lehman).  From there it quickly spreads to the rest of Europe and the U.S. and China. Some of the contagion will be over concerns about the banks in those countries and their exposures, which won’t be calmed as easily by an ECB and IMF with huge volumes of bad loans on their books.  It will also occur because their customers won’t be buying their goods.

A butterfly flapping its wings may or may not cause a rainstorm in New York, but a Grexit will make people look at the post Lehman collapse as the good old days.

A Grexit is So Bad That it Won’t Happen

Again, I fail to see the optimistic case of a Grexit.  Every time I try and play through scenarios where the IMF and ECB come to the rescue, it seems like it will be far too little and far too late.  Maybe the powers that be are smarter and have figured out a plan, but given their track record, that is hard to believe.  The more they look at the situation, the more I am convinced they will see not only how potentially awful the situation becomes, but that the cost to avoiding it right now are relatively small, and with proper preparation a Grexit can be managed down the road.

I still think we should have had more Lehman moments.  In fact, not letting the AIG moment occur was probably a bigger mistake, but most politicians have taken the lesson never to let a “Lehman” happen again, so once they see that Greece is Lehman on steroids, they will back down and figure out enough to give Europe and the markets a solid kick.