Greece,
barring some bold new initiative, is on course to exit the euro area.
How badly might this hurt the economy? How quickly could it hope to
recover?
What Greece Can Expect
By
Carmen M. Reinhart
Exits from currency unions
are not as common as exits from fixed exchange rates. There are a few
instances where highly dollarized economies tried to “de-dollarize” and
return to the home currency.
These episodes may serve as a guide to what Greece can expect.
The salient aspect of the Greek case is the prospect of forcible
conversion of bank deposits to a new domestic currency under conditions
of extreme economic stress. Since 1982, five episodes best illustrate
this combination. The lesson to be drawn from them is that a Greek exit
would involve deep and lasting trauma.
First, though, is forcible conversion of deposits bound to happen if Greece exits the euro?
The
answer is yes. Confidence in the status quo has collapsed, leading to a
sharp escalation in internal arrears, both public and private. The
private sector is defaulting on its debts and about half of the
country's bank loans are non-performing; include credit-card debt and
the proportion is even greater. Taxes aren't being paid and people are
hoarding euros. The government is financing itself by failing to pay its
bills. The Bank of Greece cannot legally “print” euros to meet the
deposit withdrawals.
Under these circumstances, forcible conversion of euro deposits to drachma will be all but unavoidable.
Five
episodes that mirror such characteristics are, in reverse chronological
order: Argentina in 2002, Argentina in 1989, Peru in 1985, Bolivia in
1982 and Mexico in 1982. All were dollar-based economies under stress
that forcibly converted dollar deposits into domestic currency.
What
happened? In broad terms, from the starting point of an economy already
in crisis, forcible conversion was accompanied by capital flight (table
1), lower output (table 2), and severe contraction of domestic
financial intermediation (table 3).
Capital flight in these cases was typically underway before
the conversion, but it continued during and after -- often at a faster
rate, and despite capital controls. The implication is that conversion
failed to establish confidence in the stability of the new currency.
Extremely high parallel-market premiums on the new currencies during and
after conversion underline that point. (The higher this premium, the
greater the expected depreciation.)
Capital controls were
typically kept in place for far longer than the authorities first
indicated. Note that, in all five cases, partly because the controls
leaked, the authorities chose to relax an initial ban on dollar
deposits. At best, in other words, their efforts to "de-dollarize" and
shift to a domestic currency only partly succeeded. In the same way, a
Greek attempt to cleanly "de-euroize" might fail.
Mexico's case in
1982 is especially sobering. De-dollarization was partially
accomplished, but capital flight more than doubled and bank credit to
the private sector fell by almost half in the two years after
conversion. Inflation stayed high and growth was dismal for several
years. In four of the five cases, growth slumped in the year of
conversion and again in the year after that.
Forcible conversion combined with capital flight,
parallel-market premiums and recession makes it unsurprising that
financial intermediation contracted during these crises. Even so, the
severity is striking. Financial intermediation -- measured by bank
deposits as a proportion of gross domestic product -- tends to trend
upward as economies develop. During these crises, financial development
went into reverse, and for extended periods.
The collapse of
financial intermediation in the Argentine 1989 and Mexican 1982 episodes
is arresting. In the year before the conversion, bank deposits were 20
percent to 30 percent of GDP. In the year of the conversion, they fell
sharply and eventually bottomed out at 5 percent to 8 percent of GDP.
A Greek exit from the euro system doesn't have to happen.
A meaningful debt-reduction agreement and the assurance of European
Central Bank support for the banking system could still avoid that
result. But if exit happens, and forcible conversion of deposits
follows, the setback to Greece's economy is likely to be both large and
long-lived.
This column does not
necessarily reflect the opinion of Bloomberg View's editorial board or
Bloomberg LP, its owners and investors.
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