Some clients have been puzzled by my suggestion last week that the Greek government could go bust, and that Greece could still remain in the Eurozone and keep the euro as its currency. Actually, a government bankruptcy is much easier to reconcile with Greece retaining the euro than a banking system bankruptcy.
In this week’s note I look at the consequences of a generalized banking system insolvency for Greece’s position in the Eurozone. I accept that – if Greece’s banks cannot meet their obligations in inter-bank settlement – the temptation to bring back the drachma may be overwhelming. (Professor John Whittaker of Lancaster University Business School has pointed out that – if Greek banks no longer have a positive balance in their cash reserve with the ECB – they cannot cover a deficiency in cash flows arising from customer instructions. Whittaker’s observation is compelling if depositors withdraw cash from Greek banks in ‘a run’. Indeed, I discussed that possibility in a
weekly e-mail of 26th February 2010, with the key passage an appendix at the end of this note.) However, it must be remembered that Greece continues to receive large amounts of money – for farming and regional development – from the European Union. It seems to me that Greece will try to keep the euro even when both its government and banks are ‘bust’. I am not saying it will succeed in keeping the euro. I don’t know and I am pretty sure the key policy- makers are just as uncertain as I am. If Greece does keep the euro, there is a high possibility that Greek banks will be unable to repay deposits in full, perhaps for an extended period.
What happens to Greek banks’ inter-bank settlement position when the Greek government runs out of money?
Some clients have been puzzled by my suggestion (in my weekly e-mail of 26th July, on ‘Will Grexit follow if external creditors do not renogotiate the existing financial arrangements with Greece?’) that the Greek government could go ‘bust’ and yet Greece could still retain the euro as its legal tender. Let me emphasize that I have also said that the Maastricht Treaty nowhere contains a promise that bank deposits – anywhere in the Eurozone – will always be repaid at par. I find it only too plausible that – assuming that the Greek authorities decided to keep the euro (i.e., euro banknotes and coin) as legal tender – Greek government bankruptcy would be accompanied by Greek banks’ ‘closing their doors’, i.e., not repaying drachma deposits in full with legal tender notes after depositors had served notice. The customers of Greek banks might well receive a piece of paper acknowledging the banks’ liability to repay in full with legal tender at a later date, but they would not receive legal tender euro notes. I will explain the macroeconomic implications later in this note. These implications would indeed be drastic. Nevertheless, life could and would go on.
Suppose that the Greek government goes ‘bust’. Its cash balance (i.e., its deposit with the Eurpean Central Bank) drops virtually to zero, while its external creditors say that they will lend it either nothing further at all or only interest accumulating on past debt. (The accumulated interest of course belongs to the external creditors.) Willy-nilly the Greek government has to slash government expenditure until it is line with incoming revenues, which is rough for civil servants, public sector contractors and the rest, but so what? If Greek banks were solvent and fully funded (i.e., their assets – including the relatively illiquid assets – were covered by deposits and other market-sourced liabilities), I submit there is not much more to say. It is conceivable – certainly in principle – that a Greek government bankruptcy could be accompanied by a normally functioning banking system.
However, that is not the real world in mid-2012. The unpleasant truth is that Greek banks are almost certainly insolvent if their loan portfolios are valued properly (i.e., all the actual losses on the loans are taken) and that they cannot fund themselves in the market. They have in fact borrowed about 100 billion euros ‘from the ECB’ in order to fund their assets. (I have put ‘from the ECB’ in quotation marks. In form the loans are from the Greek central bank. But the ECB as such – that is, the ECB in Frankfurt – has to agree and endorse the loans by any member of ‘the Eurosystem’ [i.e., the system of national central banks] to the commercial banks.) Deposits have been withdrawn from Greek banks and market funding (i.e., funding from other banks) has declined. Without the 100b. loans from the ECB, the Greek banks would not a positive balance in their cash reserves with the ECB; and, without positive cash holdings, the Greek banks could not do one of the following,
i. meet their inter-bank settlement obligations (i.e., the obligation to cover a deficit on the balance of payments from their customers to the customers of other banks),
ii. repay cash to depositors over the counter, or
iii. meet inter-bank settlement obligations and repay cash over the counter.
Let us suppose – realistically – that the Greek government’s bankruptcy causes a further run on Greek banks. So customers withdraw deposits, i.e., deposits of cash, and Greek banks’ cash reserves threaten to go negative. Let us also assume that Greek banks no longer have any liquid assets to sell (which would replenish cash) and that pulling in loans is too destructive to contemplate. What happens?
In the first instance the Greek banks ask the Greek central bank (i.e., the ECB really) to increase its loans to them. The ECB says ‘no, sorry, you are already borrowing 100b. euros from us, we are afraid you are bust and you cannot have any more’. (See my weekly e-mail of 26th February, 2010, where I pointed out the likely sequence of events. Also see Appendix below.)
I have to confess I am not entirely sure what now happens. The Greek authorities do not want to bring back the drachma, but Greek banks cannot meet inter-bank settlement obligations because they have nothing left in their cash reserves and the ECB will not lend them anything further. Clearly, the Greek banks can make cash payments out only to the extent that cash payments come in. As with the equally embarrassed Greek government, the payments out would have to be on a hand-to-mouth basis. The other central banks in the Eurosystem would strongly deprecate any discrimination in the basis of Greek banks’ payments. It seems to me that an understanding between the Greek central bank and the rest of the Eurosystem would be needed about which creditors the Greek banks would in fact pay.
A possible arrangement might be the Greek banks met only a %age of their obligations in the inter- bank settlement. Obviously, the counterparty banks (from Germany, the Netherlands, Finland etc.) would be furious if their net claims on the Eurosystem were not covered in full. So the ‘loss’ on the Greek banks’ obligations would have to be covered by a newly-created fund of some sort, presumably to be replenished in due course by the ECB’s shareholders. The shareholders here are of course the Eurozone’s governments. These governments would – also of course – chase the Greek central bank/the Greek government for the % deficiency on Greek banks’ payments to other Eurosystem banks. The Greek banks ultimately can over time realize their assets, but – if these assets are not adequate (i.e., the loans are bad) – their losses become part of the Greek government’s external debt. Note that this means that the current published figure for the Greek government’s ratio of public debt to GDP is too low. (Yes, I mean that. If readers find this all rather far-fetched, well, I understand, but we are in new territory. As I also rather boringly keep on saying, I spent quite a bit of the 1990s warning that the single currency area had been set up without sufficient care and attention paid to these plumbing issues.)
How much does the Greek public-debt-to-GDP ratio – as currently published – understate the true figure? It depends on
i. the losses to be incurred, in excess of published capital, by Greek banks over – say – the next five to ten years, which in turn depends on wider macroeconomic trends, including the behaviour of asset prices, particularly the prices of Greek real estate (since real estate is the typical collateral for bank loans), and
ii. the extent to which the Greek authorities can inflict the banks’ losses on Greek residents and citizens, by not paying out the full 100 cents in the euro on their deposits.
Who knows? We have the latest figure for the Greek commercial banks’ borrowing from the ECB, which was in fact 101.6b. euros at the end of May. I would guess that perhaps 50b. – 75b. euros of this will prove difficult to recover in any meaningful sense. (It may be ‘repaid’ in 2045, if no interest has been charged between now and then, but that is not meaningful repayment.)
The ultimate losses to the northern creditor nations in the Eurozone – from the eventual tidying-up of all the debts – will run into several hundreds of billions of euros. It seems to me that Greece alone could ‘renege’, in a practical sense, on 200b. of euros of externally-held debt, i.e., debt in the form of both government securities and inter-bank lines held by foreigners.
What happens in Greece itself?
Clearly, in the situation under consideration Greek banks will not repay depositors at par. Greece can keep the euro, but depositors at Greek banks will lose some fraction of the value of their deposits in Greek banks. (Will German depositors similarly lose some fraction of the value of their deposits if they leave money with a Greek bank? To be determined in the law courts, I suggest.)
However, at (say) the mid-2011 level of Greek prices and incomes, the population of Greece wanted to hold – roughly – the level of money balances at mid-2011. The destruction of money balances under consideration here is very large, with perhaps a quarter of the value of deposits being wiped out. (Incidentally, bank notes are fine. They are legal tender and hence are always worth their stated value.) Either the citizens/residents of Greece have inadequate money balances relative to the normal price level associated with the euro, or Greece has low prices (of assets, including real estate) relative to the rest of Europe, as prices fall in line with the drop in the quantity of money. Whatever the nature of the disequilibrium, Greek citizens/residents can rebuild their money balances only by running a payments surplus with the rest of the world. When they receive more euros from the citizens/residents of the rest of Europe than they pay to these other Europeans, their money balances increase. Hence, for a period – which may last a few years – Greece has to run a payments surplus because that is the one and only way in which the shortage of euros within Greece (i.e., the monetary disequilibrium) can be eliminated. The surplus could be on either or both the current account and the capital account. Thus, one way for the Greeks to rebuild their holdings of euro money would be for them to sell Greek assets – including Greek real estate – to other Europeans (and indeed foreign citizens from all round the world). In other words, if Greece keeps the euro, further large falls in the price of Greek real estate are to be expected. Needless to say, more people will then be tempted to move to Greece for holiday and retirement homes, and that is as it should be. I am not suggesting that these outcomes would be particularly palatable to the Greeks. That is not my point. However, over time the normal institutions of a market economy – including a banking system – would be restored. (Deposits after a certain date would be repayable in par, in the usual way. The losses to depositors would be only those that had the misfortune to leave cash with their banks before that date.)Tags: 2009 Great Britain and Ireland floods, Compact Disc, Deposit account, European Union, Greece, Grexit, Interest rate, Time deposit, United Kingdom, United States