Why a Selective Default Does Not Mean Grexit

Confusion reigned supreme in the euro area over the weekend. The decision of the Greek government to call for a referendum over the terms of the programme, needed to unlock money for the IMF debt repayment due on Tuesday, plunged the euro finance ministers into despair, while they fought a deal was very close. It is now nearly impossible to reopen negotiations, at least until the Greeks will cast their votes on July 5th. If the Greeks will reject the conditions of the bailout plan, the Eurogroup may already decide to put an end to the Greek membership of the euro. The Germans are already acting to defend a euro area without Greece, but a political agreement will be the first obstacle to overcome for the fear that Grexit could have knock-on effects in the periphery of the euro financial system. The implementation of this decision will be also difficult because there is no actual procedure for exiting the currency union. Greece may also try all available legal tricks to keep the euro currency. The Eurogroup is in effect an informal body, which cannot take decisions that can modify in any way the EU Treaty or other EU legislation. It will need to find a way to suspend or to limit the circulation of the euro in Greece. In this case, any intervention shall also preserve the freedom of movement of capital and financial services, unless the circulation itself threats financial stability, which is clearly not the case.

Whether or not a political agreement is struck or a legal procedure is created for the exit of a country from the euro area, a selective default will not cause Grexit also from a financial standpoint. The Greek banking system lives thanks to a ‘thin’ emergency credit line of the ECB, which is taken up on the balance sheet of the local central bank and allows local banks to offer liquidity and financial services during a crisis to avoid a bank run. This emergency liquidity assistance (ELA) cannot be cut off by the ECB on the basis of a decision that is unrelated to the solvency of local banks. It is questionable whether the default of the Greek government on IMF debt shall trigger the insolvency of Greek banks. The Single Supervisory Mechanism (SSM), nonetheless, may decide that Greek banks are insolvent either on July 5th, if the Greeks decide to refuse the programme, or on July 20th, when the payment of part of the Greek debt held by the ECB will be due. Meanwhile, the default on debt held by the IMF shall not cause a Grexit. Greece has already lost market access some time ago and further rating actions will not affect the financial position of the country further. In addition, Greece is already introducing capital controls, as already happened with the Cypriot crisis in 2013. This should somehow reduce the immediate burden on Greek banks and give time to organise a response. Greek banks may have more than a month of liquidity without further ELA expansion.

Even in the apocalyptic scenario that the Greeks reject the programme and the ECB terminates the ELA, there is no automatic exit from the euro area. With the help of capital controls, the Greek national bank can still try to manage the crisis without a suspension of the euro legal tender issued by the Greek central bank and/or the printing of a new local currency. Greece has approved in recent years a resolution law in line with the European legislation entered into force in 2015. Even though there is no reliable resolution fund when the whole banking system melts down, the national resolution authority can use other tools, like the sale of viable local operations to local branches of international euro area banks. With the support of capital controls, these branches could then gradually restart bank operations and use intra-group liquidity coming from entities in other euro area countries. This is the way the Federal Reserve ensured the continuation of the operations of hundreds of banks that failed during the crisis, including big retail networks like Washington Mutual. As Greece is also a member of the European Union, there should be no impediment to the freedom of movement of capital and financial services vis-à-vis commercial bank operations.  It is in fact in the spirit of the recent banking union to break the link between governments and banks. What a better occasion to show that the fate of a financial system is not linked to the fate of its government in a monetary union?

What we learned in this long and confused weekend is that, beyond the positions of individual governments and newspapers headlines, the default of a member state does not necessarily imply the exit from the euro area. An exit may not necessarily happen without a mutual decision by democratically elected bodies. Grexit is far less certain than it looks, from a political, legal and financial standpoint.