Greek Debt Crisis: What Happens If Greece Leaves The Eurozone?

BRUSSELS -- With a summit of European leaders looming Tuesday, Greek Prime Minister Alexis Tsipras will once again attempt to sit across the table from his country’s creditors and strike a bargain. He does so with the backing of Greek voters, most of whom emphatically rejected an extended European bailout package in Sunday’s referendum.

Whatever the meeting’s outcome, the stage is set for Greece’s exit from the 19-state eurozone bloc. But what happens if the heavily indebted and economically challenged nation leaves the currency union? The much-feared Greek exit -- or Grexit -- is an event without precedent, and definitive answers are scarce. Tuesday’s Eurogroup meeting and eurozone summit could decide whether Greece will stay in or leave the currency zone.

Financial markets around the world reacted with anticipation Monday, and stock markets and the euro showed relative composure. Despite Monday’s 1.56 percent decline of the DAX, Germany’s primary blue-chip stock index, and a 2.24 percent drop in Eurostoxx, a stock index of eurozone blue-chip companies, there is no sign of a market collapse. The euro, meanwhile, sustained its position against the U.S. dollar Monday at $1.10, well above this year’s minimum in March.

“Grexit, if it happens, is likely to be undertaken very reluctantly and in stages,” said Douglas J. Elliott, of the Brookings Institution.

In the 1990s, the eurozone was created as a currency union without legal parameters for an exit. As a result, Greece’s departure, Elliot notes, would be an “ad hoc” process.

The European Central Bank’s (ECB) most pressing decision will be whether to increase the cap on Greece’s Emergency Liquidity Assistance (ELA), which provides cash-strapped banks in Greece with euros. If Greece defaults on payments to the ECB on July 20, the bank may not extend assistance funds to Greek banks. The collateral for ELA to Greek banks has been Greek sovereign bonds. If the country defaults on the ECB, the collateral bonds will become virtually worthless.

If Greece has no more euros, the Greek government has no choice but to pay its debts in IOUs. These IOUs will then circulate throughout the country as a kind of de facto currency.

A July 20 default “would put the bank in a very difficult position,” said ING analysts, in a recent Grexit report. “However, the ECB is definitely not willing to pull the trigger without political backing.”

In Greece, the outcome would likely be catastrophic. The circulating IOUs would likely depreciate against the euro, thus ramping up domestic inflation. Prices of basic necessities imported from the eurozone -- which Greece heavily relies on -- would skyrocket.

“Given the weak export sector, any positive export push would probably take time to materialize,” the ING report said. “The likely positive contribution of cheaper net exports would come first on the back of collapsing imports.”

And what would this mean for the rest of Europe? Greece’s debt stands well over 250 billion euros ($276.2 billion). To some degree, private investors are already protected from the immediate fallout of a Greek default on its sovereign debt. A dramatic series of events in 2012 erased all major private holdings of Greek debt and placed nearly 80 percent of the country’s sovereign debt in the hands of the eurozone countries, the International Monetary Fund and the ECB.

If Greece goes bankrupt and cannot fulfill its debt obligations, the eurozone countries will absorb the largest losses. Through the Greek Loan Facility and European Financial Stability Fund, Germany holds a debt exposure of 57.23 billion euros ($63.2 billion) and France's debt exposure stands at 42.98 billion ($47.5 billion). According to estimates from Barclays, Germany and France’s total holdings of Greek debt through the ECB and eurozone rescue programs total to 3.3 percent and 3.4 percent of GDP, respectively.

With Tuesday’s historic meeting, much is left to debate. Will the countries of the eurozone work to keep Greece in the currency union? And if Greece leaves, will it spell doom for the euro and its economies?

“There are immense legal difficulties for a member state to leave the eurozone,” said Jorg Haas of the Jacques Delors Institute. “But certain chains of events could lead to a situation in which Greece would produce a parallel currency alongside the euro. And a de facto Grexit in an orderly fashion looks impossible.”

The European Commission and the Eurogroup have sought to calm anxieties by assuring all parties that the eurozone is well prepared to handle the fallout of a Grexit.

“The stability of the euro area is not in question,” said Valdis Dombrovskis, Commissioner for the Euro, on Monday. “We have everything we need to manage the situation. We have a banking union to ensure the stability of the financial sector. We have [the European Stability Mechanism] to help the most vulnerable economies. The ECB is using its tools to ensure stability.”

So far, the markets agree -- reluctantly.