By Andrew Smith, Chief Economist
Just a few years ago a eurozone breakup seemed inconceivable but ‘no bailout, no default, no exit’ no longer applies. After two bailouts and a debt restructuring, policymakers are openly discussing a Greek exit from the euro and financial markets are attempting to price it in. The UK may not be in the euro club, but that rather misses the point: we would not be immune from the fallout. For while the direct economic effects of a default and euro exit by a small country such as Greece would be limited, it is impossible to predict the ramifications of the ensuing financial disruption, which could be extremely severe.
The most obvious direct effects of a Greek exit and adoption of a new currency would be on other countries’ exports and banking systems. A ‘Drachma II’ would depreciate overnight – at the expense of UK exports and those who have lent euros to the Greek public and private sectors. There would be confidence and wealth effects too – in the aftermath of an exit, British business and consumer confidence would sink, and asset prices drop, acting as a further brake on investment and household spending. The good news – if any – is that these direct impacts are likely to be relatively minor. Trade with Greece represents less than 1% of total UK exports and banking exposures to the Greek economy are fairly small.
The bad news is that this is not the end of the story. The real problem is the threat of financial contagion to other European economies. Once the Rubicon of exit was crossed by one country, there would inevitably be speculation about who is next. Without sufficient firewalls, there would be an increased risk of bank runs and accelerating outflows of assets from the periphery. Any resulting credit crunch and recession in Europe could not be avoided by the UK. And while British banks have been reducing their exposure to European economies generally, the figures remain significant. Amidst such market disruption, political willpower to hold the single currency together would be sorely tested.
Can companies mitigate the risk? Many have already drawn up contingency plans and are attempting to diversify exports whilst reducing exposure to the euro. And the authorities are taking measures to improve financial system resilience. Such steps are useful, but no-one knows how severe the crisis would turn out to be in the event.
Whether the consequences of a Greek default and exit would be worse than the collapse of Lehmans is the subject of much debate. For what it’s worth – given the massive uncertainty – the UK Office for Budget responsibility estimates that around 3% could be knocked off UK output this year and next in the event of a disorderly default. The IMF goes further, warning that a break-up could “aggravate economic stress to levels well above those after the Lehman collapse”. It should be remembered that Europe produces a quarter of world output – it’s therefore hard to envisage a benign outcome in the UK if bits start falling off the eurozone.