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Nothing Concentrates Euro Zone Minds Like a Greek Exit

A Greek exit from the euro would have such dire knock-on effects that the prospect could help produce a solution, in the form of more help from other members.

Deep inside the tsunami of trouble that would be unleashed on the euro zone by a Greek exit from the currency bloc, a small stream of hope flows in a contrary direction, based on a perverse but persuasive logic.

The consequences of even one small nation leaving are so dire that other member states are likely to leave no stone unturned in the search for a solution that will keep Greece in Euroland. The sense that the euro zone is going to fight hard not to lose one of its members is not exactly a cause for celebration, but it offers institutional investors some consolation as the Hellenic Republic’s political crisis continues to worsen.

Euro zone equity markets fell for the third straight day on Wednesday, following the news that political deadlock will, in June, force Greece to hold its second general election in as many months. Political parties failed on Tuesday to form a coalition government dominated by technocrats because of opposition from politicians opposing the strict terms of the international bailout of the Greek government.

The greatest fear is that a Greek departure from the currency union will turn other member states seen by the market as the next dominoes likely to fall down and out of the euro zone, such as Italy, Spain and Portugal, into financial pariahs.

Any country that left the currency union would almost certainly redenominate its debt in a new local legal tender. That currency would plummet in value in the years after euro zone exit because of its outcast status: There would be few buyers for a coinage that owed its very existence to economic crisis. As a result, the existing extreme reluctance to buy the sovereign debt of troubled euro zone economies would grow even more marked if Greece left the bloc, because of the fear that this debt would not remain euro debt for long.

The prospect of a euro zone exit would also choke off the flow of capital in these countries – the lifeblood of any economy – as bank account holders switched their money to deposits in countries deemed certain to stay in the euro zone.

This phenomenon can already be seen in Greece, where depositors have on average withdrawn between €2 billion ($2.6 billion) and €3 billion a month since its sovereign crisis began in 2009. The pace of the panic has recently quickened: On Monday alone they took out €700 million.

Finally, many companies that operate in countries deemed likely to exit the euro zone will minimize their business presence in them, because the companies do not want in the future to receive income in a currency of extremely uncertain value. Partly for this reason, even distressed-debt investors have been reluctant in recent months to buy stakes in cheaply valued Greek companies. Mass pullouts by multinationals would destroy a country’s tax base and send unemployment soaring.

If the weaker euro zone economies became pariahs after a Greek exit, the sovereign debt markets of even the strongest euro zone member states would be damaged. Yields on French government bonds raced upwards late last year — forcing growth-busting cuts — because of concerns that core euro zone countries would be forced to shoulder much of the debt burden of peripheral states.

Given all of the above, the incentive for the euro zone to act to keep Greece in the currency union by making its financial obligations in euros more manageable is extremely strong. What, practically, can member states do in the coming weeks, as extreme solutions currently regarded as politically unpalatable receive serious consideration in response to desperate circumstances?

One possibility is to write down even more Greek debt to make Greece’s heavy burden of interest payments more sustainable. In February private sector creditors reluctantly agreed to an effective default of 75 percent of the value of their debt, in a deal masterminded by euro zone finance ministers. The deal raised the hackles of institutional investors — who were angry that central bank holders of Greek debt did not share this burden. Nevertheless, by making it financially possible for the Hellenic Republic to stay in the euro zone, the deal benefited many investors by keeping markets relatively calm. It is unlikely, however, that private creditors would accept further write-downs unless central banks accepted broadly similar losses.

Another possibility mooted by some analysts is for Greece to fund its primary deficit, while member states pay for the rest. Greece has a projected primary deficit — government revenue minus government spending, before allowing for debt interest payments — of only 1 percent of gross domestic product (GDP) this year, according to the International Monetary Fund (IMF), down from 10.5 percent in 2009. This shows that Greece has responded to crisis by bringing day-to-day spending under control, leaving it with the more specific problem of paying off the debt accumulated by previous profligate governments. This will leave its overall fiscal deficit at a high 7.2 percent of GDP this year, according to the IMF. A solution based on primary deficits could be sold to member states’ electorates as a helping hand to a Greek administration that was acting responsibly to address the mistakes of the past.

A final possibility is to give a fillip to the Greek economy — and hence to tax revenue — by giving Greece a larger share of the billions of euros which the EU institutions already spend on structural improvements to poorer member states. Only hours after taking office on Tuesday, François Hollande, the new socialist French president who espouses more growth-focused policies across the EU, called on Europe “to add measures to help growth and support economic activity, so that there is a return to growth in Greece.”

All of these solutions require financial pain. However, the pain of providing life support to an economy such as Greece, which accounts for less than 2 percent of euro zone GDP, is bearable; the pain of sustaining larger nations such as Italy, which would be imperiled by a Greek euro zone exit, is not. By acting as lifelines for the cash-strapped Greek government, these solutions might just prove enough to persuade Greece’s citizens to be loyal to the currency bloc. In a Monday poll, 54 percent of Greeks said the government should continue to implement reforms agreed with the European Union and IMF in order to stay in Euroland. That adds up to a large reservoir of Greek goodwill. A further flow of financial aid to Greece might prevent this reservoir from drying up.

The Eurofirst 300 index of euro zone stocks declined by 0.5 percent to 992.81 on Wednesday. The yield on Greek 10-year bonds was an eye-popping 29.13 percent, down slightly on the day but up 113 basis points since Friday.

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