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Economic consequences of a Grexit

This is a free translation of the original Greek report.

Executive summary

Executive summaryWhy launch this study now?

Greece continues to implement an unprecedented program of economic adjustment that has seen output fall by more than 25% in real terms since 2008 and unemployment reach more than 27% in recent years. In spite of the deep economic contraction, the adjustment achieved over the past seven years has been significant. In 2014, the economy returned to growth for the first time since 2007, with GDP projected to have grown by 0.8% in real terms.

However, recent political developments, both domestically as a result of early elections and with regard to relations with the country’s European partners and official creditors, along with increasing pressures to meet immediate funding needs, have resulted in worsening macroeconomic forecasts and a resurge of uncertainty over Greece’s economic prospects.

The objective of this study is to provide a balanced and independent analysis of the economic consequences of a potential Grexit from the Eurozone on businesses and investors.

EY’s analysis is not based on the extreme scenario of a disorderly exit with complete debt repudiation. The consequences of such a scenario are impossible to assess, as it would lead to a dramatic fall in GDP, prolonged uncertainty and volatility. It could also lead to an exit from the Schengen Treaty and even the European Union, while the time frame of a return to growth conditions and prosperity cannot be accurately predicted with any degree of certainty.

On the contrary, the paper is based on the scenario of a negotiated exit from the Eurozone, following agreement with the EU and the country’s creditors. Even in this “best-case scenario”, the consequences for the economy and society would be severe. The analysis rests on forecasts performed by Oxford Economics based on this scenario, while themain working assumption is for 2015 as the base year.

EY maintains that no simple and quick way exists to resolve the country’s economic problems. Leaving the Eurozone would incur immeasurable costs to households and businesses, as it would leave Greece politically and economically isolated and vulnerable. It is unlikely that any boost offered by exit, depreciation and default, could be sustained in the long term, as Greece would still be left with huge debt levels which would limit the potential for fiscal expansion. More specifically, even in the ideal scenario, under which debt would be reduced by 50%, Grexit would not mean an end to austerity, as high debt levels would act as a constraint on the government, allowing no space for a relaxation of fiscal policy.

Unless Greece builds its export sector from the ground up, through difficult and targeted structural reforms, any quick fix on competitiveness via currency devaluation would not be sustainable. As such, even in the event of an orderly exit which would result from a negotiated agreement, the economy could suffer severe turmoil in the buildup and aftermath of an exit.

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Executive summary (contd)Greece after a Grexit

Exit from the Eurozone does not provide an easy solution to economic problems. Upon the issuance of the new currency and the setting up of its parity against the euro, the exchange rate would depreciate steeply, by at least 50%.

This would be largely led by initial panic and uncertainty regarding the restoration of a current account balance. The size and reversal of overshooting will depend heavily on the policy response.

In the best-case scenario, where political, social and economic stability will be restored in a short time, and assuming optimal management from the side of the government, including a tight fiscal and monetary policy, the exchange rate could eventually reverse its overshoot, stabilizing to about 30%.

In a less-optimistic but equally realistic scenario, according to which the Government would respond to the initial panic by loosening monetary policy leading to inflationary pressures, the initial devaluation will be considerably higher, in the order of at least 60%, and balance would not be restored for several years.

With regard to Government debt, EY maintains that a simple, unilateral debt repudiation is highly implausible. The majority of public debt is governed by international law and it is unlikely that Greece would be able to redenominate it into drachma as part of the exit process. Moreover, it is doubtful that highly indebted Eurozone governments, such as Italy and Portugal, would be prepared to allow for a reduction in Greece’s debt to GDP ratio far below than their own ratios of about 130% of GDP. Thus, the central assumption of this exercise is that creditors could agree to a restructuring that would reduce Greek Government debt to 130% of GDP post exit.

A deep economic contraction …

In order to fully comprehend the dramatic size of the initial decline in real GDP, it is worth noting that, over the last six years, the Greek economy has already shrunk by 25%, which means that the cumulative contraction in economic activity will have reached 50%, compared to pre-crisis levels, before the economy starts growing again.

This is according to the best scenario and under the assumption that a tight fiscal and monetary policy will be adopted after Grexit. If the Government reacts to the initial panic by easing monetary and fiscal policy, devaluation will be even sharper and the impact on GDP more serious and prolonged.

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Optimistic Grexitscenario

Executive summary (contd)… with severe losses in purchasing power …

The real economic contraction is more starkly illustrated by looking at the potential impact on the level of GDP in euro terms.

Indeed, under an exit scenario, real GDP in euro terms is likely to remain below the baseline forecast, the latter depicting the possible trajectory of the Greek economy if exit did not happen. Thus, in euro terms, exit, default and the depreciation of the currency, would result in a permanent loss in national income.

Based on Eurostat projections, in 2014, real GDP per capita in Greece stood at approximately 17,000 EUR, down from its peak of 22,500 EURlevels in 2007. A first approximation would indicate that due to economic contraction and devaluation in the first year after exit, GDP per capita, in euro terms, could plunge to about 11,000 EUR within the first 18 months after exit.

... and no real way out from austerity

Owing to the devaluation, the inability for debt redenomination and the steep decline in GDP, the ratio of debt to GDP would still be more than130%.

This would leave very little room for manoeuvre to Greek authorities, ruling out any possibility for fiscal loosening. The high debt would by itself become the basic external constraint to fiscal policy.

With tax revenues being weaker due to post-exit recession, for the Government to be able to balance its books in the absence of external financing, it would have either to increase taxes or further reduce spending.

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Optimistic Grexit scenario(Euros)

Executive summary (contd)Prices and unemployment would rise severely, impacting fixed income households

Exit and devaluation would feed directly into inflation, as the price of imported and tradable goods will rise sharply. Estimates suggest that this could reach 10%, before gradually easing back. While this would encourage the economy to rebalance toward the exporting sector, the fall in the exchange rate could lead to a sustained period of even higher inflation, if a vicious circle emerges where the currency fall prompts large second-round effects on prices. It is worth noting that, according to a 2012 IMF study, the GDP deflator (as a proxy of inflation) was estimated to reach 35% during the first year after exit.

As prices of goods and services would rise, the real value of wages, fixed in the new local currency, would decline drastically. This would result in an excessive squeeze on real disposable income, especially for fixed- and low-income households, that is, for wage earners and pensioners. Experience from Argentina and elsewhere suggests that it is the middle- and low-income households that are hit harder by a loss in real wages, with consequent impact on poverty and rise in inequality. It is indicative that in Argentina, the already high poverty rates soared during the first years after default, with evidence suggesting that one in two Argentinians was pushed under the poverty line.

A Grexit could push unemployment up in the short term to above 30%, while it has been projected gradually to decline over the next few years if Greece were to remain in the euro.

Imports would collapse, leading to severe supply shortages

Imports of goods and services would collapse as a result of the dramatic increase in their cost following devaluation and the consequent loss in purchasing power by consumers and business. The cumulative contraction in imports would reach more than 30% in the first three years after exit.

While in macroeconomic terms this would be inevitable, reflecting income and substitution effects, the impact on everyday life would be far-reaching.

It is almost certain that there would be severe shortages in the supply of goods and commodities for which Greece is import-dependent, such as gasoline and petroleum, natural gas, medicines and other pharmaceuticals, as well as certain food products. For some necessity products, it would not be unreasonable to assume that rationing would need to be introduced.

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Greek CPI inflation (% YoY)


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Greek unemployment (% YoY)


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Imports of goods and services would collapse as a result of the dramatic increase in their cost following devaluation and the consequent loss in purchasing power by consumers and

certain food products. For some necessity products, it would

Executive summary (contd)Investment decline, uncertainty and credit crunch

Preservation of capital adequacy would be the priority for banks post exit. This, combined with the uncertainty surrounding the economic environment, would lead to a credit crunch, even if the exit did not threaten the banks’ solvency. In addition, uncertainty surrounding the health of individuals’ and firms’ balance sheets could also result in more informal types of credit drying up too. Transactions could become increasingly “cash on delivery”.

This increased uncertainty and associated credit crunch will result in a steep contraction of private investment. It is expected that investment would fall by more than30% during the first two years and only begin to recover after the third year.

Depending on the exposure of firms’ assets and liabilities to currency mismatches, the impact on their financial position could go either way. Even in the event of neutral balance sheet impacts, the change in the operating currency would imply greater cost pressures, particularly through the increased cost of imported materials and inputs, potential currency risk exposure and higher transaction costs.

Equity prices are likely to fall sharply in the buildup to the exit and over the first two years. Thereafter, they would rebound, inevitably reflecting expectations for medium-term growth, starting from an almost zero base.

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Introduction

Introduction

After six years of recession, in 2014 the Greek economy finally returned to growth. Latest data published by the Greek Statistics Authority suggest that GDP is estimated to have risen by 0.8% in 2014. This represents the first increase since 2007. However, recent political developments, both on the domestic front and with regard to relations with the country’s European partners and official creditors, along with increasing pressures to meet immediate funding needs, have resulted in worsening macroeconomic forecasts and a resurge of uncertainty over Greece’s economic prospects.

The purpose of this study is to inform businesses and potential investors in a substantive and objective manner about the consequences of a potential Grexit from the Eurozone, offering a balanced and independent analysis of such a scenario.

EY’s analysis is based on a scenario which includes an orderly exit following negotiations. In the event of a Grexit, this would be the best-case scenario, according to which an agreement would be reached with the country’s creditors over a substantial debt haircut, combined with short-term concessions. The analysis rests on forecasts conducted by Oxford Economics based on this scenario.

This particular scenario, as opposed to that of a disorderly exit, was intentionally chosen, since the catastrophic consequences of a disorderly Grexit combined with a unilateral repudiation of debt are impossible to assess. Such a scenario would lead to a dramatic contraction of GDP, prolonged and excessive uncertainty and volatility in financial markets, as well as to an exit from the Schengen Treaty and even the European Union, while the time frame of a return to growth and prosperity cannot be predicted with any degree of certainty.

The conclusion of this study is that, even under the best-case scenario of an orderly negotiated exit, the consequences for the Greek economy and society would be extremely painful and serious.

Greece is in such a position where no simple and quick way exists to resolve the country’s economic problems. An exit from the Eurozone and a default on public debt, even under the most ideal of circumstances, would only be a temporary quick fix to the country’s poor competitiveness position.

The report is structured as follows - first, a historical overview of economic developments from Euro adoption to present is provided; this is followed by a discussion on the overall impact of Grexit in terms of aggregate and per capita GDP and consumption; third, the effects on national debt and Government finances are analysed; finally, the consequences for households and business are explored, along with effects on external trade.

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Overview of economic developments

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Inflation, consumer price index - % year-on-year

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From economic growth to crisis buildup

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After joining the Eurozone, and until 2008, the Greek economy experienced a period of continuous economic growth, characterized by rising incomes and moderate unemployment.

Adoption of the European common currency, combined with the favorable international economic conditions of the time, brought the nominal anchoring necessary for the buildup of stability and confidence into the Greek economy. From 2001 onwards, inflation and long-term interest rates subsided to record low levels, reflecting,, the end of a long history of volatility in the country’s monetary outlook.

However, the stability that accompanied the common currency also provided space for successive governments to avoid taking decisive action on persistent structural inefficiencies that characterized the economy. Economic growth was not driven by an efficient allocation of resources but, rather, it was based on booming domestic demand, mostly for imports and non-tradables. At the same time, a lax fiscal policy supported the accumulation of excessive public deficits, while minimal action was taken to reverse the continuous decline in the country’s external position.

With underlying weaknesses remaining, the Greek economy, since 2001, experienced a steady deterioration of its competitiveness, reflected in the continuous worsening of the trade balance and the accumulation of substantial current account deficits. Between 2000 and 2009, unit labor costs in Greece increased by approximately 40% cumulatively, as opposed to an average of 20% growth in the rest of the Eurozone.

Meanwhile, the real effective exchange rate in Greece continuously appreciated by approximately 20% between 2000 and 2009, revealing the steady loss of competitiveness for the Greek economy vis-a-vis its euro partners.

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The structural adjustment and economic contraction experienced in Greece over the last six years cannot be compared to any developed country during peacetime. The fiscal deficit has been reduced from more than15% of GDP in 2009 to about 3.5% in 2014 (EU Commission latest forecast) and the country's external position improved, with the current account projected to register a surplus in 2014 according to IMF forecasts.

Yet the domestic economic cost of this adjustment has been significant. Real GDP has declined by more than 25% over the last six years, unemployment reached a peak of more than27% in 2013, while average earnings have fallen by more than16%. Since 2013, the Greek economy has been in a deflationary state, as consumer prices started to decline due to weak domestic demand.

In November 2012, Greece and its lenders agreed on a package of measures aimed at reducing Greece’s debt to 124% of GDP by 2020 and substantially below 110% of GDP in 2022 (Source: IMF). As part of the agreement, Greece carried out a successful public debt buy back in December 2012. Public debt stands at 177% of GDP as of end 2014.

Notwithstanding the significant fiscal and macroeconomic adjustment and the positive signs for a return to growth in 2014, the Greek economy is again today at breaking point, with macroeconomic forecasts deteriorating, renewed uncertainty and the extreme scenario of a Greek exit from the Eurozone dominating public debate once again.

% of GDP 2014 (EU Commission latest forecast)

years, unemployment reached a peak of more than27% %.

Crisis outbreak and deep recession

By 2008, against the backdrop of a rapidly worsening international economic environment, the Greek economy’s persistent structural weaknesses could no longer be ignored. The country entered into prolonged recession and found itself facing exclusion from international financial markets over the last six years. With financial support from its European partnersand the IMF, Greece has undertaken since 2009 an unprecedented fiscal and macroeconomic adjustment program, which has led to notable improvement on many fronts, but also had a significant negative impact on society.

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► Government announces that budget deficit could be higher than initial projections

► Greece credit rating is downgraded► First program of public spending cuts is

announced

► ELSTAT and Eurostat confirm that budget deficit for 2009 is more than15% of GDP

► First bailout program agreed (EUR110 billion)

► Eurozone rescue fund announced

► National Unity Government takes office

► Second bailout program agreed, financed by EFSF (EUR144.7 billion) and IMF (EUR 19.8 billion)

► PSI “debt- swap” between Greece and its private sector lenders

► Greece raises USD 4 billion in 5-year bonds

► Parliament’s failure to elect new president prompts early elections

► Agreement of the 20th of February 2015

► Bailout agreement between Greece and Eurozone expires on 30.06.2015

► Parliament adopts bill for 15,000 civil service job cuts

20152009 2010 2011 2012 2013 2014

Economic consequencesof a Grexit

What would a Grexit look like?

EY’s analysis is based on an orderly, negotiated exit scenario, under which all of the country’s creditors agree to a substantial write-down of official debt, while concessions are also extended in the short term.

Even in this best-case scenario, an exit from the Eurozone would not provide an easy way out. The majority of public debt is governed by international law and it is unlikely that Greece would be able to redenominate it into drachma as part of the exit process. Moreover, it is doubtful that highly indebted Eurozone governments, such as Italy and Portugal, would be prepared to reduce Greece’s debt-to-GDP ratio far below their own ratios of about 130% of GDP.

Given the above, the form and size of a restructuring is highly uncertain. The central assumption of this exercise is that creditors could agree to a restructuring that would reduce Greek Government debt to 130% of GDP post -exit. Therefore, under the assumption that the nominal exchange rate would fall by 30% in the medium term (after overshooting), and given that all official debt would remain in foreign currency and GDP would contract further after exit, Greece would require a debt haircut of about 50%, to reduce the debt to GDP ratio from 177% to 130% of GDP.

Upon issuance of the new currency and the setting of its parity against the euro, the exchange rate would depreciate steeply. Based on experience, the initial depreciation would be in the range of at least 50%, hence overshooting the underlying target depreciation of about 30%. This would be largely led by initial panic and uncertainty to restore the structural current account to balance. The size and reversal of overshooting will depend heavily on the policy response.

In the best case scenario where political, social and economic stability is swiftly restored, and provided optimal management by the government, including tight fiscal and monetary policy, the exchange rate should eventually reverse its overshoot, stabilizing to about 30%. In a less optimistic but equally realistic scenario, under which the Government willrespond to the initial panic by loosening monetary policy, thus leading to inflationary pressures, the initial devaluation would be substantially higher, at least 60%, and balance would be restored several years later.

Based on estimates, the initial fall in GDP would be substantial. EYconsider that a cumulative 15% drop in real national income in the first one and half year after exit is possible, which, based on other available estimates, could even reach 20%. To put this figure into perspective, it is worth contrasting it with the 25% contraction in GDP that the economy has witnessed over the past six years. Thus, taking also into account estimates by international organizations for 2015, the economy could cumulatively have lost nearly half of its precrisis levels GDP, before it could start growing again.

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EY considers that it is unlikely that Greece could simply refuse to pay its official public debt. Such extreme actions have, in the past, often coincided with violent events. In such an instance, Greece would face a prolonged and severe period of uncertainty and be left economically and politically isolated. EU membership and participation in the Single Market would most likely be lost, with trade sanctions and additional losses in financial transfers from the EU budget adding to the negative impact of the exit and default.

Could Greece unilaterally repudiate its debt?

Impact on per capita GDP and consumption

The contractionary shock to the economy is perhaps more starkly illustrated by looking at the potential impact on the level of GDP. In euro terms, real GDP under an exit scenario is likely to remain below the baseline forecast, the latter depicting the possible trajectory of the Greek economy if exit did not happen. Indeed, in euro terms, the economy would be unlikely to recover the initial losses in GDP. Exit, default and depreciation of the currency would result in a permanent loss in national income.

Increased uncertainty and falling real incomes will, following exit, prompt households and firms to tread cautiously.

This would result in a sharp fall in private spending, with consequent negative effects on economic activity. It is estimated that over the first year, domestic demand could contract by at least 25%.

Based on Eurostat projections, real GDP per capita in Greece stood at approximately 17,000 EUR in 2014.

A first approximation would indicate that in the first year after exit, GDP per capita, in euro terms, could plunge to about 11,000 EUR. In other words, the combined effect from economic contraction and devaluation would have catastrophic effects on citizens’ wealth and their purchasing power in euro terms.

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Impact on public finances

Will Grexit bring an end to austerity?

Even in the hypothetical scenario of a 50% reduction in the official debt, the ratio of debt to GDP would remain at very high levels. Owing to the devaluation, the inability for debt redenomination and the decline in GDP, the ratio of debt to GDP would still be more than 130%.

This would leave very little room for manoeuvre to Greek authorities, ruling out any possibility of fiscal loosening. High debt levels would become the external constraint on fiscal policy.

Consequently, with tax revenues being weaker due to post-exit recession, for the Government to be able to balance its books in the absence of external financing, it would have either to increase taxes or further reduce spending.

Overall, for each 10% annual decline in Government revenues, in the event of an exit, it is estimated that a fiscal squeeze of 2% of GDP could be required in order for a balanced primary budget to be run during the first years.

Even if an expansionary fiscal policy was adopted, its consequences on other fronts would quickly lead to its reversal.

This is because it would inevitably have to be financed via monetary financing (money printing) or the use of financial repression (e.g., by forcing banks and pension funds to hold a certain percentage of their assets in domestic Government bonds). This could lead to uncontrollable inflationary dynamics and an increased pressure for further devaluation and credit crunch.

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By how much will the new currency devalue?

The potential fall in the real exchange rate that would be required to restore competitiveness and maintain long-term external balance is difficult to estimate. Owing to the internal devaluation since 2010, Greece has regained some of its competitiveness but, on balance, the real exchange rate might need to fall by about 20% for Greece to regain full competitiveness.

The nominal exchange rate depreciation would need to be much larger than the real decline to restore competitiveness, since the lower exchange rate would lead to imported inflation. The initial conversion rate is irrelevant and would most likely stand at one-to-one parity.

Historical experience suggests that the exchange rate would initially overshoot. Even in the event of an orderly exit, the initial overshooting would be steep, possibly exceeding 50%, because of the initial panic and uncertainty regarding the restoration of the structural current account to balance.

The size and reversal of overshooting will depend heavily on the policy response that will be adopted. In the best-case scenario where policy mistakes are avoided and political, social and economic instability is limited, the exchange rate should eventually reverse its overshoot. However, if panic persists and Greek authorities fail to control expectations and herding behavior, it would not be unreasonable to see deeper overshooting. In the long term, exchange rate developments will reflect fundamentals, such as productivity differentials and Greece’s net foreign asset position.

It should be noted that the forecast regarding official devaluation does not take into consideration possible speculative pressures on the new currency or the IOUs, which will be issued during the transitional period.

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Capital controls

In the buildup and aftermath of a Grexit, extreme uncertainty is likely to prompt capital outflows, as households and businesses begin to withdraw their deposits in order to immediately convert them into euros, in anticipation of further value losses in the new local currency.

For a complete breakdown of the banking system to be avoided, and as foreign exchange reserves would be in short supply, capital controls would be the most likely form of direct intervention.

Capital controls are easy to introduce, but much harder to remove. They tend to lead to a severe lack of liquidity, prompting the use of alternative or nonofficial means of payments. Moreover, permanent restrictions on capital flows would make Greece an undesirable investment destination, as there will be limited ability to repatriate profits and extreme difficulty in cross-country transactions.

Argentina introduced the “Corallito”, which enforced upper limits to cash withdrawals and forcibly converted dollar bank deposits and loans into pesos. Time deposits were forcibly prolonged and the dollar reserves of banks were seized, costing them about USD 1.6 billion. Additionally, exchange controls were imposed, bankruptcy proceedings were suspended and penalties for employers who laid off staff doubled. Similar, controls were introduced by Iceland and, more recently, by Cyprus.

competitiveness but, on balance, the real exchange

The costs of overshooting could be substantial, leading to negative wealth effects that adversely affect consumption and economic welfare. By way of illustration, for goods and services that are highly dependent on imports such as pharmaceuticals, crude petroleum, natural gas and chemicals, as well as certain food products, the impact on prices could be especially substantial.

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Impact on households

Impact on householdsThe introduction of the new currency will affect households via impact on real wages, consumer prices, as well as employment prospects.

Exit and devaluation will feed directly into inflation, as the price of imported and tradable goods will rise sharply. While this would encourage the economy to rebalance towardstheexporting sector, the fall in the exchange rate could lead to a sustained period of high inflation, if a vicious circle emerged where devaluation prompted large second-round effects, leading to a further fall in the exchange and so on. Our base case is that inflation would rise sharply above 10%, before gradually easing back. It is worth noting that, according to a 2012 IMF report, the GDP deflator (as a proxy of inflation) could exceed 35% during the first year after a Grexit.

As prices of goods and services will rise following the devaluation, the real value of wages, fixed in the new local currency, will decrease. The key implication of this is an excessive squeeze in real disposable income, especially for fixed income households, and increased labour market uncertainty. Experience from Argentina and elsewhere suggests that it is middle- and low-income households that are hit hardest by losses in real wages, with consequent impact on poverty and rise in inequality.

While unemployment is projected to decline if exit does not materialize, Grexit would push unemployment up in the short term to above 30%. Thereafter, it could decline but it could equally lead to a sustained period of even higher unemployment in the long term.

From the outset, the Greek authorities would be faced with the trade-off between monetary easing and exploding inflation via wage-price spirals. To bring inflation under control and limit the exchange rate overshoot, the Bank of Greece would inevitably raise interest rates.

After the initial exchange rate overshoot, the drachma would appreciate, helping to reduce inflationary pressures. If wage growth does not respond to inflation, interest rates could be reduced after the initial spike upward.

High unemployment could contribute to this, but with wage-price indexation exercised by several Greek firms, it may be the case that wage-price spirals will continue to push inflation up, forcing the Bank of Greece to raise interest rates even further to contain it.

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Evidence from other countries that have experienced similar large contractionary economic shocks, reveals a pattern of rising unemployment rates, along with changes in the sectoral composition of employment. In Indonesia (1998), Malaysia (1998), Thailand (1997), Mexico (1995) and Argentina (2001), rising unemployment was especially pronounced in construction and especially manufacturing, since the latter would be hit by the higher costs of imported materials, difficulties in obtaining credit and the rising burden of foreign currency debt.

Source: “The Argentine crisis and its impact on household welfare”, CEPAL Review 79, April 2003

Asymmetrical impacts on societyThe impact of a Grexit on society iis likely to be highly uneven. The middle- and low- income parts of the population will prove to be the most vulnerable to the shock. Experience from other countries shows that, the deeper the crisis, the stronger the impact on income inequality.

Between 2001 and 2002, Argentina saw a huge increase in unemployment and poverty, mirroring the dramatic fall in real incomes and the deterioration of labor market conditions. According to the World Bank, by 2002, one in two Argentinians lived below the official poverty line.

Social unrest and rioting is likely, along with substantial indirect consequences on the economy. In Iceland, the Reykjavik anti government protests during the peak of the 2008 crisis ended in rioting. In Argentina, participation of individuals in social protests also rose from 7.6% to 16.2% in late 2002. Violence, such as rioting and looting, was common in the streets of Buenos Aires.

Barter trading is also likely to emerge. The inability of the Russian Federal Government to enforce fiscal discipline, and its failure to pay suppliers, contributed massively to the growth of barter post 1998. The state was forced to accept tax payments in kind, which in turn weakened fiscal credibility.

In Argentina, a vast network of exchange clubs, the Red Global de Clubes de Trueque (RGTs), sprung around the country before the devaluation and continued for several years thereafter. These clubs provided informal fora for barter exchange of goods and services. Soon, the RGTs issued their own parallel informal currency, the “Crédito”, which, however, suffered from both hyperinflation and counterfeiting.

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Source: World Bank Analysis (2003)

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the CPI

Major impacts

Risingunemployment

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currency (Euro)

Falling houseprices that

eroded assets

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loss of skills

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Effects of Iceland's banking

crisis (2008)

Households coping strategies to economic hardship has been very similar in Argentina and elsewhere, including the countries hit by the Asian crisis of the 1990s. These included reliance on social networks (informal assistance from friends and family members), as well as the changes in consumption patterns, working longer hours, drawing down savings and selling assets, while lower-income households resorted to more drastic measures, such as taking their children out of school.

Sources: "The Argentine crisis and its impact on household welfare," CEPAL Review 79, April 2003; "Argentina: Household Risk, Self-Insurance and Coping Strategies in Urban Argentina," Sector Report No. 22426-AR (Washington, D.C.), World Bank, 2001.

Collapse of imports and shortagesImports of goods and services would collapse as a result of the dramatic increase in their cost following devaluation and the consequent loss in purchasing power by consumers and business. The cumulative contraction in imports could reach more than 30% in the first three years after exit.

While in macroeconomic terms this would be inevitable, reflecting both income and substitution effects, the impact on everyday life would be severe.

Goods and commodities whose supply is highly dependent on imports, such as pharmaceuticals, crude petroleum, natural gas, chemicals, but also automotives and auto spare parts, high technology products and clothing, would be in very short supply. In fact, in the case of the pharmaceutical sector, to which total government debt since December 2014 has climbed to EUR1.2 billion, supply shortages are more than certain.

For consumers and households, the impacts from shortages would be significant. For certain essential goods and commodities, such as gasoline and petroleum, natural gas, medicines and other pharmaceuticals, and also certain food products, it would not be unreasonable to assume that rationing would be introduced.

The extent and length of such extreme actions is difficult to predict, but it is quite certain that, in addition to the impoverishment of society, it would also result in a rise of black market economy and counterfeiting.

Although, as a whole ,the food and beverages sector exhibits a low share of import to total supply, for certain products such as milk and flour-based goods, meat and several vegetables, imports have a high share in production and final supply.It is indicative that for milk and related products, the ratio of exports to import is under 40% while for flour based products the same ratio is about 20%.

Source: Greek Foundation for Economic & Industrial Research Annual Report on Food Products

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Impact on business

Impact on business

The contractionary shock to the economy will affect the private sector through several different channels.

In terms of liquidity post-exit, preservation of capital adequacy would be the priority for banks. This, combined with the uncertainty surrounding the economic environment, would lead to a credit crunch, even if the exit did not threaten the banks’ solvency. In addition, uncertainty surrounding the health of individuals’ and firms’ balance sheets could also result in more informal types of credit drying up too. Transactions could become increasingly “cash on delivery”.

This increased uncertainty and associated credit crunch will result in a steep contraction of private investment in the aftermath of an exit. Investment is expected to fall by more than 30% during the first two years and only to begin rising after the third year.

Impact on firms’ financial position would depend on the exposure of their assets and liabilities to currency mismatch. Even in the event of a neutral balance sheet impact, change in operating currency would imply greater cost pressures, particularly through increased cost of imported materials and inputs, potential currency risk exposure and higher transaction costs.

Equity prices are likely to fall sharply in the buildup to the exit and over the first two years. Thereafter they would rebound, inevitably reflecting expectations for medium-term growth, starting from a zero base.

The impact on property prices would be substantial. It is estimated that they would fall sharply around the time of exit, as weaker income will lead to a contraction in demand for the sector. On the other hand, in the medium-term demand for Greek property, not least from foreign investors, is likely to increase. The overall effect could go either way.

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2013 2014 2015 2016 2017 2018 2019

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Greece: Equity prices

Baseline



-35

-25

-15

-5

5

15

25

Greek Investment (% YoY)



Baseline

Will the boost to exports be sustainable?

The boost to the country’s competitiveness and the expansion of exports are the main arguments put forward from those proposing a Grexit from the Eurozone.

Indeed, with the currency initially falling by at least 50% in the context of our basic scenario, exports would grow rapidly in the short term. This adjustment in favor of the tradable sector would drive an improvement on the external front.

Tourism, along with other export-oriented activities, including shipping, processed food and agricultural products, may theoretically be boosted initially from devaluation as their exports would expand.

The expansion of exports against the collapse of imports would allow the buildup of current account surpluses after exit.

However, it is extremely uncertain that this growth would be sustainable in the medium to longterm. The underlying reason relates to the structural weaknesses of the Greek economy, with its fairly shallow exporting base. Exports of goods and services as a share of GDP are surprisingly low in Greece, given the small size of the country. They account for about 30% today, as compared to about 20% in pre-crisis levels.

Moreover, virtually all export activities in Greece rely on imported raw materials, whose costs would surge following devaluation, drastically dampening any benefit caused by the boost to competitiveness.

Finally, it should be noted that, for export activities like tourism, improvements in competitiveness are not simply related to cost reduction, but also to the profile of the tourism product. The deterioration of social conditions, as well as a possible rise in crime rates, would likely affect negatively the prospects of the tourism sector.

Without effective and targeted structural reforms to support and expand the country’s exporting base, currency devaluation could only act as a temporary fix to address competitiveness loss.

Evidence on export performance following past devaluation episodes offers some insight into this. The 1983, 1985 and 1998 devaluations of the drachma indeed boosted exports, but only temporarily, and were followed by sharp declines in export growth within a year or so.

31

-20

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Exports, goods & services, real (% change y/y)

The administrative complexities of a Grexit

Interim lack of currency

► Initially, Greece would not have any drachma notes and coins.► It took six months for De La Rue to produce South Sudan’s currency after the new country was created and this

was considered a rapid turnaround. ► According to the European Central Bank, during peak production ahead of euro’s introduction, 15 printing works

were producing a total of 1 billion notes per month. Thus, 1 printing unit might be able to produce roughly 67 million notes per month. Total circulation in the Eurozone is currently just under 15 billion notes. So, Greece, which accounts for 2.5% of Eurozone GDP, might need 375 million notes, which could take almost 6 months for its only printing factory to produce. (Source: “Leaving the euro: A practical guide”, Capital Economics, 2012).

► Issuing IOUs prior to circulation of the new currency will be inevitable in order for the state to be able to face its obligations including wages, pensions and paying suppliers. These will be issued at parity to the euro, but in the free market they will be traded at a substantial discount, proportional to the expected devaluation of the new currency.

Currency mismatch

► The extent of currency mismatch is likely to be massive, as will be the disruption in currency continuity in paying salaries, pensions and expenses.

► All accounts and bank deposits will be redenominated in the new currency. Foreign exchange deposits will face variable and imposed exchange rate effects.

► Pricing under the new currency will take time to adjust, let alone dealing with rapid inflation. ► Billing and systems will also be affected, depending on capability to deal with the new currency and to capture

data for accounting at the right point in time. Reporting tools and spreadsheet remediation would also need to be adjusted.

Contractual complexities

► Renegotiation of contracts will be extensive. All prices, contracts, assets and liabilities governed by Greek law would be converted, while an extended bank holiday of several weeks would be needed.

► The biggest problem would be sorting out which contracts would be redenominated and which remain in euros. The ability to identify the governing law may be difficult, especially if emergency decrees are passed.

► The Government could redenominate all amounts specified in contracts governed by Greek law from euros to drachmas. But since the euro is not just the Greek currency but the international currency of the EU, the issue of redenomination could become extremely complex.

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