Time is running out--yet again--for Greece. The most heavily indebted country in the Eurozone is headed for a showdown with its creditors that may result in a default on its debt, and possibly in its leaving the euro. The cash-strapped country is dealing with a debt that’s 177 percent of its gross domestic product, more than any of the 19 nations using the euro, and has run out of money to pay its obligations. And if it doesn’t reach a deal with creditors at a meeting of European Union finance ministers that begins Thursday in Luxembourg, it faces the very real possibility of a default, which may be followed by its abandoning the euro in an attempt to escape the debt trap.
Greece struck a deal with the EU in February to get 7 billion euros ($8 billion) in extra bailout funds, in exchange for economic reforms. But prime minister Alexis Tsipras’ leftist government, in office since January, has not submitted that reform plan yet -- and hasn’t received the money. Without it, Greece won’t be able to pay interest on its previous debt, including 1.6 billion euros ($1.8 bililon) due to the International Monetary Fund at the end of June. A deal on Thursday may find more time for Greece to pay or submit a reform plan.
If that does not happen, the “Grexit” that could ultimately ensue would be, according to economists, the most painful for Greece itself and other struggling eurozone economies such as Italy and Spain -- but it may also have a severe impact throughout Europe, if not immediately the rest of the world.
In the near term, the crisis reawakens forces that were ripping the euro apart two years ago. That’s when the rift between the fiscally prudent countries of Northern Europe led by Germany, with low ratios of debt to GDP, and the heavily indebted countries in the Union’s South -- Greece, Italy, Portugal and Spain -- was at its widest. Germans lobbied southward accusations of being a financial burden; the reply was that German-imposed austerity was crippling economies already in recession.
“It’s a divisive thing in the eurozone, where the weak are getting weaker, and the strong are getting stronger,” said Gabriel Sterne, head of global macro research at Oxford Economics in London. “A point often underplayed, missing from the narrative, is the extent to which the international bailout has really preordained this day,” he said. “There has never been really any attempt to make Greek debt sustainable,” according to Sterne, by the EU, the Fund and the European Central Bank, commonly referred to as the troika of Greece’s lenders.
Tsipras rose to power on a platform promising a rejection of the austerity cuts imposed by the terms of the bailout, and so far has appeared to stick to his guns, refusing to make more budget cuts. He may, however, end up paying for it if lenders walk away. For Greece, “it will be a brief political victory, but then a lot of hardship to work through,” said Bart van Ark, chief economist and chief strategy officer at the New York-based Conference Board. Those adversities would be “more difficult than the hardship the European Union is asking from them.”
There are two possible worst-case scenarios, according to Jessica Hinds, European economist at Capital Economics in London. First, a continuation of the current situation, in which Greece still has to make a budget surplus and therefore can’t use public spending to stimulate the economy, would be economically damaging to the country. A messy default and separation from the eurozone, however, could be even worse, resulting in hyperinflation and economic depression that could lock Greece out of international capital markets for years.
A Greek exit would also show that membership in the monetary union is not irrevocable, and could drag into trouble other member countries with high public-sector debt, such as Italy, Spain and Portugal. And at some point, if a Greece without the euro began to benefit from reduced debt and more competitive exchange rates, pressure could build for other austerity-depressed countries to follow, according to Hinds. In the short term, euro-member nations would be skeptical about the future value of the euro currency.
“The euro no longer seen as irreversible could be quite damaging,” said Sterne.
But if a “Grexit” does happen soon, it won’t likely be by any formal process. “I don’t think we’ll see a scenario with parliament deciding, ‘We want to leave the eurozone,’” Daniela Schwarzer, director of the Europe Program at the German Marshall Fund of the United States, said. “It’s much rather that there’s no deal, and then there is a Greek default.” After that, there would be a rapid chain reaction of events to get to a departure from the eurozone. “It’s really an unprecedented situation,” she said.
The Greek crisis has already hit the bond market this week, as investors ditched bonds from Italy, Spain and Portugal and snatched German Bunds, the 10-year bonds considered a safety benchmark for government debt. And because bond yields move inversely to price, the mass selloff is making it even more expensive for those indebted countries to borrow money.
The gap on Spain's 10-year bond yield over German Bunds hit its highest since July 2014, while the spreads on Portuguese and Italian bonds were at their widest since November 2014.
If the bond market’s troubles worsen in the aftermath of a Greek exit, interest rates could rise across Europe, making it more difficult for people and companies to borrow. In that kind of environment, Sterne said, fears of capital flight across Europe as people invest their money elsewhere could easily shave a point off European economic growth next year. That would be immensely damaging, as the European Union on average only grew by 1.3 percent last year.
If Greece stops paying its lenders, the European Central Bank could also shut down its emergency liquidity assistance to Greek banks. Because Greece is a member of the euro, it’s the ECB in Frankfurt that controls how much liquidity assistance Greece’s central bank can provide to Greek banks. With no ECB money, the Greek central bank would have to act quickly to keep the banks running. One measure would be imposing limits on bank withdrawals to prevent capital flights. Another possibility is turning to IOUs or some other form of parallel currency to use in the Greek monetary system.
But if it does that, the ECB could then disconnect Greece’s central bank from the European payments system, effectively forcing Greece out of the eurozone.
“It’s a very political thing the ECB would have to do” to trigger this scenario, said Erik Jones, director of European and Eurasian Studies at Johns Hopkins School of Advanced International Studies. “It would have to say to the Bank of Greece, ‘You are no longer allowed to operate as a lender of last resort to your own domestic banks.’”
Going from a liquidity cutoff to effective “Grexit” could happen in a matter of days. But it will take the Greek government much longer to decide on the thorny questions of managing a new currency and the value of assets and debts.
“Since it’s no longer the euro, it’s not quite clear how people are going to relate to this new currency,” Jones said. “The value of this currency would fall relative to the euro, but we don’t know how the liabilities and assets in the Greek economy would be denominated.”
“We’re really in uncharted territory,” said Richard Whitman, director of the Global Europe Centre at the University of Kent. “I don’t think there will be any sort of clear end and clear beginning” to a Greek exit. “It’s going to be much messier than that.”
Another immediate consequence of a default would be political, especially in Spain, said Van Ark, where national elections are imminent. An economic disaster in Greece may embolden the parties that say the euro and austerity have been the cause of the crisis that’s been gripping many Southern European economies since 2008.
A Greek defection would also affect the U.K., where Prime Minister David Cameron has promised a referendum on EU membership by the end of 2017. For euroskeptics, who want Great Britain out of the Union, “it will be so much easier to point a finger at the EU as a bumbling collection of fractious partners and say, ‘Why would we want to be in there?’,” said Jones. A Pew Research Center poll this month found that 55 percent of Britons supported staying in the European Union, while 36 percent supported leaving -- a major shift from two years ago, when Britons were evenly split on the issue.
What we do know now is that Thursday’s Eurogroup meeting could be one of the last chances for Greece to reach a deal before the government must pay 85 million euros ($96 million) in interest to the ECB on Friday, plus that 1.6 billion euro to the IMF on June 30. If a deal doesn’t materialize this week, the issue could be pushed back to a European leaders’ summit on June 25-26. And at that point, Greece and Europe may find themselves with 96 hours to avoid what may become the worst financial crisis in the Union’s history.