No point in retaining Greece: Allow it to exit euro for quicker resolution of mess

Given that now Greece has defaulted it seems logical that the best solution for all would be to let the country leave the euro. (There is however the possibility that there could be a new bailout policy (the third one for €29 billion) for Greece which will be acceptable to the defaulting nation and provide some more space). The justification for letting Greece go is not that we need to set a precedent or teach a lesson to a country which has been bailed out too often and is not grateful for the same. The reason is that by providing any bail out or further tolerance, we are only deferring the issue and not solving it.

The country has been following the austerity programme that it was to follow for being helped out by the troika, but it has not worked. Not only has growth gotten sliced down, but unemployment is high at 25 percent which is quite mind-boggling. With further curbs on spending, the economy may never be able to recover which will affect their debt servicing power as unless they run surpluses on the fiscal and trade accounts will they be in a position to earn euros. Or else they have keep evergreening their obligations.

The referendum will probably tell us whether Greece will stick to the euro or whether it will walk its own path. The latter will be very painful too as it would mean going back to the drachma which will be valued very low given the fragile nature of the economy. While theoretically a weak drachma should help exports and tourism, it would take time to reap the benefits as presently the economy will be looked at with suspicion especially for potential investors or creditors. As of now the shock is limited to nations and institutions as the debt of around €320 billion resides with countries and organizations like ECB and IMF which will actually not be hurt much by this default (another one is likely in July as there is a payment due to the ECB). In fact almost 55 percent is held by Germany, France, Italy and Spain.

The question that Alexis Tspiras’ government will have to ask itself is after exiting the euro whether it can actually go slow on austerity and keep spending more drachmas, where there are no corresponding goods being produced. Deficits in local currency can be endless but that will go with inflation which is not desirable. The episodes of hyperinflation in Latin America and Zimbabwe stand testimony to what such action can lead to. In fact interest rates will have to be increased to the extent that investment will become difficult and the economy will slip into stagflation – a phenomenon characterized by falling growth and high inflation. Therefore, perforce, there will have to be discipline inculcated by the government even after it secedes from the euro.

How will this impact the world at large? Greece is too small to matter as it accounts for less than 2 percent of the euro nations GDP. But it could tempt some other deviants like Spain and Portugal, which hitherto have adhered to the austerity norms laid down, to reconsider options. If countries in the euro fold feel that they could better off moving away, then this could be a beginning of a chain of such secessions. This is what is indicated by the fear of ‘Lehman happening’. Lehman as it may be remembered led the way of a contagion of failed banks before the government and Fed had to intervene to bail them out. This possibility is probably the most serious challenge which will emerge once Greece leaves the euro.

The stock markets always react to any news and would tend to move back to normal once the decision is taken and hence the present volatility that is witnessed in all stock markets should not be taken too seriously as these fickle segments will only wait for some new news to respond differently. What about the euro? The euro could decline a bit with this uncertainty about the future of the union. This could make the ECB reconsider its options on the easing programme that it has been pursuing as well as interest rate changes. But a weaker euro, and by implication stronger dollar, may not be something that the US would prefer given that their economy is driven largely by exports. The Fed may have to reconsider its interest rate policy approach while closely tracking these developments.

The response of these central banks – though the US has taken a stance that it would be less affected by a Grexit, would determine the flow of funds to the emerging markets. Hence countries like India are more likely to be affected by the FII flows which could move to the US as it appears to be an area of stability in relative terms which will become more attractive once the Fed increases the rates in September. Therefore, some pressure on the rupee is likely if there is a slowdown in capital inflows. This will have an impact on companies with forex exposures raising the issue of hedging the currency risk to protect their profit lines.

Otherwise, the Indian economy per se would be largely unaffected. Trade with the euro nations (share of around 20 percent) should not be affected as there would be no decisive change in the prospects of the euro trading partners with Greece being a very small part of the story (just about 0.1 percent i.e. $300 million in a sum of $310 billion). Hence domestic policy decisions like interest rates would be driven by domestic factors with the Greek options not really coming in the way.

It does appear that there are some serious negotiations still going on to ensure that Greece stays in the euro. If it does work out, the funds provided may allow Greece to service its immediate debt commitments. The referendum however will provide some irony then as if they do go ahead with it and the public says no to the euro, will it mean the government has to back track again?