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Europe Program

Policy Brief
Vol. 2, No. 5

July 2015
Policy Challenge: With
the announcement of the
referendum in Greece, a Greek
exit from the euro area has
become a possible scenario. A
so-called Grexit would have
a high price for both sides. The
other euro area members should
be ready to take steps that
reestablish the credibility of the
euro area as a monetary union
built to last. If markets perceive
the euro area as just another
system of fixed exchange rates
that countries can leave and
join freely, this can drive the
monetary union apart.
Policy Recommendations: The
moment Grexit becomes likely,
political communication will be
key. An emergency euro area
summit should announce a
number of initiatives to bolster
the euro areas credibility.
Policymakers should commit to
the completion of the Banking
Union, including a pan-European
deposit insurance scheme. They
should nominate a president of
the euro area summit, establish
a regular meeting series, and
create a committee for euro
area affairs in the European
Parliament. Leaders should
also commit to discussing a
fiscal capacity and broader
institutional reforms for the euro
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Managing Grexit Fallout:

How to Maintain the Euros Credibility
by Daniela Schwarzer
Since Greek Prime Minister Alexis
Tsipras announced the Greek referendum on the deal with its lenders for
July 5th, there has been an increasing
danger of a Greek exit from the euro
area. The negotiations with Greece
over recent weeks on the latest rescue
package payment have been taxing
and dramatic. And while the parties
have wrangled over the release of the
last 7.2 billion credit tranche of the
current rescue package, there has been
little time to look at the onerous path
ahead. Even if another solution were
to be found at short notice, Athens
will again need bridging loans to
repay 11 billion in loans and interest
to its lenders by August 2015. After
that, there could be demands for a
third rescue package, while the Greek
government would likely continue to
struggle to implement the conditionality its lenders expect. The handling
of Greeces sovereign debt and the
reform and consolidation process in
the country will even in the best
case scenario remain an ongoing
challenge for the European Union and
may bring the country repeatedly to
the precipice of exit from the monetary union.
Policymakers should indeed continue
to work on resolving Greeces debt,

competitiveness, and governance

issues within the euro area. What was
true in 2010 still holds true today:
Grexit would have tremendously high
economic, political, and geostrategic
costs for both Greece and the EU.
Nonetheless, the EU needs to prepare
for all scenarios, including Grexit.
The Costs of Grexit
For Greece, an exit from the currency
area could have severe economic
consequences. During the course of
introducing another currency, which
would be expected to devalue up to
around 30 percent, most households
and businesses with external debt
denominated in euros would have
to default on their liabilities, as they
would become practically unpayable.
Additionally, dramatic increases in
inflation rates would hurt households,
as most Greek consumer products
are imported. Further complicating
the situation is the fact that Greek
exports have not experienced strong
increases as a result of either the
ongoing devaluation of the euro or the
real devaluation of Greece through
an adjustment of price levels within
the euro area. Therefore, chances are
that Greeces competitiveness will not
be sustainably restored with a new
currency. In order to limit capital

Europe Program

Policy Brief
flight and prevent a collapse of the banking sector, capital
controls have been introduced, which also rescind the free
movement of goods as one of the main promises of the
EUs single market.
For other euro area countries, contagion risks from Grexit
are lower than in 2012, due to a reduction of Greek debt in
balance sheets of European financial institutions and better
bank resolution capacities. Yet a major danger still persists:
in the case of a Greece exit, markets might perceive the
euro area as a fixed exchange rate regime rather than a
true currency union. Grexit would disprove the implicit
assumption that euro area membership is irrevocable. The
core peril with this phenomenon is the return not only of
country risk but also of irrational volatility, which drove up
the interest rate spreads of European peripheral bonds in
spring 2010 and de facto led to a market-driven spillover
of the sovereign debt crisis to other euro area member
states. These contagion effects could easily spread into
the banking sectors of Italy, Spain, and Portugal, where
domestic banks hold large shares of their governments
debt. There again could be an exacerbation of financial
fragmentation, and this time a bail-out might be too big to
handle by the European Stability Mechanism (ESM) and
the International Monetary Fund (IMF). At some point,
the European Central Bank (ECB) would then have to
make good on its Outright Monetary Transaction (OMT)
promise to do whatever it takes and purchase sovereign
bonds in the secondary markets.

Grexit would disprove the implicit

assumption that euro area
membership is irrevocable.
Furthermore, the ECB and national central banks would
suffer losses equivalent to the amount of balances of the
interbank payment system for cross-border transfers
throughout the European Union, Target 2, connected with
the Greek account deficit. These deficits are significant,
since the euro areas settlement system does not require a
clearing of balances between national central banks on a
regular basis like in the United States, where advances in
current accounts between districts in the Federal Reserve

System are paid back by U.S. states once a year to avoid the
accumulation of large imbalances. The German Bundesbanks exposure via the ECBs Target 2 claims against
Greece at the level of 30 billion would materialize in case
of Grexit, and Germany would have to take a write-down
on these balances.
From a broader EU perspective, Greece leaving the euro
area, despite all efforts since 2010 to help it get over the
sovereign debt crisis, would be perceived as a huge political
failure by the EUs international partners. Within the EU,
further disintegrative tendencies could be unleashed by
this breach of taboo, for instance by strengthening populist
movements that claim that their own country should also
withdraw from the euro area.
Moreover, a destabilized and financially and economically
devastated Greece would not only be an instability risk
on its own, it would also invite external influence, which
would most likely come from Russia and China. While
China has urged Greece to stay in the European Monetary
Union, it would probably embark on the further purchases
of strategic assets. Meanwhile, Russia would likely exert
economic and political influence in Greece and, through it,
in the EU. This also presents a challenge to Greeces neighbors in the Balkans, which could be further destabilized by
financial and political repercussions.
Scenarios for Greece
Greece faces pending insolvency due to the unsuccessful
negotiations over a new financial assistance program
with its creditors and passed deadlines of debt repayment to the International Monetary Fund. Since the ECB
revoked its waiver to accept Greek sovereign bonds from
Greek banks as collateral for fresh capital, Greek banks
were already entirely dependent on Emergency Liquidity
Assistance (ELA) provisions that were passed down from
the ECB through the Greek National Central Bank (NCB),
while Greek banks and the state were only illiquid but
not insolvent. As the Greek state, through the NCB, is
therefore the only means of funding for Greek banks, the
insolvency of one will almost certainly mean the insolvency
of the other. With these funds now also being frozen at
89 billion, capital flight increasing during negotiations,
and public default pending, the Greek government had to
declare a week-long bank holiday to prevent its banking
sector from sure bankruptcy, which would have initiated

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July 2015

Europe Program

Policy Brief
its own default as well. According to the EUs strict rules
on risk contagion, a bankrupt Greek central bank would
have to be excluded from the eurosystem and its crossborder payment system Target 2. As a change of these rules
is as economically prudent as it is politically feasible, four
other scenarios are conceivable in the current situation:
1) Greece remains in the euro area under a conditional
agreement on financial assistance, 2) Greece remains in the
euro area without a new agreement and has to introduce a
parallel currency in order to pay domestic liabilities (fixed
and floating exchange rate option), 3) Greece keeps the
euro but leaves the euro area, and 4) Greece leaves the euro
area permanently and introduces the new drachma.
Scenario 1
In the first scenario, Greece and its creditors come to an
agreement and the country remains in the euro area with
the euro as its currency. However, given that Greece has
already missed payment deadlines that could eventually
trigger a cascade of claims ending in formal default, an
agreement at this point in time will require the commitment from creditors to alter Greeces debt repayment
schedule. In the short-term, the IMF would have to
accept a further delay in the repayment of loans instead
of declaring Greeces default, and the Council of the
European Financial Stability Facility (EFSF) would have
to forgo its right to call in the early repayment of loans
in case of such a statement by the IMF. In addition, a
comprehensive debt restructuring in the medium and long
term could be necessary as well. This outcome would still
minimize the costs for both Greece and its creditors. The
ECBs funding of banks through ELA would be replaced
by the original system of liquidity provision, as the ECB
would again accept Greek sovereign bonds as collateral for
loans. Depending on the degree of capital flight the Greek
banking sector has suffered during the debt negotiations,

A comprehensive debt
restructuring in the medium and
long term could be necessary as

some capital controls might have to be implemented in the

short term to further secure financial stability in Greece.
Scenario 2
In a second scenario, Greece remains part of the eurosystem but has to introduce a parallel currency to avoid
default on outstanding liabilities, both domestic and
foreign. This can be achieved by the Greek governments
decision to use alternate means of payment, so-called
IOUs. These would essentially be debt claims against
the Greek government denominated in euros, which it
would repay at some point in the future and with which
it could settle domestic bills immediately. Meanwhile,
and under the implementation of capital controls, the
Greek government could collect euros via the tax system
to repay its external creditors. As the new currency would
manifest as a domestic currency and be traded against the
euro, an exchange rate between the two would develop
over time. Eventually, the governments budget discipline will determine how strong the devaluation of the
new currency against the euro would be in the medium
term. The exchange rate will depend on how much new
money the government needs to issue to settle its primary
balance. A primary deficit would require the issuance of
more domestic currency and lower the exchange rate.
Vice versa, a continuous surplus could reduce the initially
steep discount against the euro and could technically
enable Greece to rejoin the euro if the two currencies are
exchanged at par. This option crucially depends on the willingness of Greeks to accept a parallel currency for domestic
Scenario 3
The exit of Greece from the currency area with the euro
remaining its currency is a third, although counterintuitive, option. Given that many advocates of a rules-based
approach from Northern European countries would
oppose any changes of the rules of the European System
of Central Banks (ESCB) to supply quasi-insolvent banks
and countries with liquidity either directly or through ELA
provisions, the pending insolvency of Greeces national
bank and its banking sector makes a Grexit very possible.
As the political and economic costs of introducing another
currency would be massive in the short term, an alternative would be to keep the euro as a legal tender but exit
the currency area. Various disadvantages come with this
monetary set-up. While the euro would remain Greeces

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July 2015

Europe Program

Policy Brief
currency, it would not have access to the ECBs system to
attain fresh money. As the ECBs role as lender of last resort
disappears for Greece, every liquidity crisis in the Greek
banking sector automatically becomes a solvency crisis.
The only way to secure further funding would be if banks
were owned by foreign stakeholders, who would then
transfer the lender of last resort responsibility to their own
countries central banks.
Scenario 4
As a worst case scenario, the fourth option would be a full
blown Grexit with the introduction of a new drachma.
Without a bail-out agreement, Greeces central bank would
not be able to remain part of the ESCB system, and cross
border transactions could not be cleared via Target 2. Due
to massive capital flight risk, severe capital controls would
need to be introduced for the medium term. This would
by far have the most severe short-term disruptions for
the Greek economy and would also mean the necessity of
a haircut or restructuring on external public debt due to
the heavy devaluation of the new drachma. Furthermore,
external debt of the banking and business sectors would
also become unpayable for the same reason, as all external
debt would remain denominated in euros. Despite some
theoretical long-term benefits, the immediate impact of
redenomination would cause a severe recession and high

A worst case scenario...would

be a full blown Grexit with the
introduction of a new drachma.
Devising a Broad Contingency Plan
It is clear that a Grexit cannot be excluded as a possibility.
So far, euro area governments and institutions have developed emergency plans, mostly focusing on measures of
financial stabilization to ring-fence contagion to other euro
states with high debt levels. But the euro area will have to
do more than that to retain credibility on the markets. If
Greece moves to the brink of leaving the euro area, the
other 18 euro area member states risk a loss of trust of
investors if they are unable to convince the world that they
have plans to strengthen the governance and capacity of the
currency union, beginning with a stronger banking union,

structural reforms, and a fiscal capacity. The crisis of a

Grexit may be what it takes for the EU to press ahead with
the necessary governance reform that has so far been unattainable. In such a situation, the EU will be forced to push
ahead or risk major instability in the eurozone.
Political Obstacles to Euro Area Reform
The euro area could have embarked on a new round of
reviewing its governance set-up at the European Council
meeting on June 25-26, 2015. But this opportunity passed,
just days after the presidents of the European Commission, the ECB, the European Council, the Eurogroup, and
the European Parliament had submitted a Five Presidents
Report,1 which outlines measures to improve the efficiency
and legitimacy of economic governance in the currency
union. The European Council took no position other than
deciding to revisit the question in December 2015.
In December 2012, a similar report2 had been delivered
to the European Council. But the pressure of the sovereign debt and banking crisis had started to lessen due to
the ECBs whatever it takes promise of September 2012
when it announced the Outright Monetary Transactions
The reasons for shelving the proposals to further reform
the governance of the euro were political. First, national
capitals have very different positions on what changes to
the governance set-up are appropriate, and neither the
European institutions nor single strong member governments, such as the German one, took leadership on forging
a compromise once the crisis faded in 2012. Measures that
would entail deeper political integration and stronger joint
risk sharing were hence pushed off the agenda by governments more concerned about protecting their national
Secondly, for those governments that would at least like to
maintain the status quo, the reform wishes of the Conservative government in the United Kingdom seem to limit
the room for manoeuver. A treaty revision is off the table
as many EU governments are apprehensive about U.K.
1 Juncker, J., et. al., Completing Europes Economic and Monetary Union, European
Commission, June 22, 2015,
2 Van Rompuy, H., et al. Towards a Genuine Monetary Union, European Council, December 5, 2012,

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Europe Program

Policy Brief
influence on the mandate of a potential intergovernmental
conference. Opening treaty negotiations could allow
London to push a roll-back on integration, for instance by
questioning the free movement of people, or even the overall objective of an ever closer Union as the treaty states.

narios vulnerable to uncertainty. The evolution of perceptions, too, will affect the economic, political, and geopolitical consequences for the EU and for the broader South East
European region. Coherent and strategic communication is
part of the answer to this challenge.

Thirdly, given the divergent preferences between member

states and the pressure that rising euro-skeptic parties have
put on governments, national capitals fear that both the
negotiation of an eventual treaty change and its ratification
could fail. This concern has been prominent since the negative results of the ratification of the Lisbon Treaty in the
referenda in the Netherlands and France in spring 2005.

A first objective of communication should be to highlight

that Grexit is a special case, which is unlikely to be repeated
in other euro area member states, even those hit hardest by
the recent crisis. The second task is to show that member
states in the euro area have closed ranks on Greece and
the challenge that the Tsipras government has posed to
the euro area. The public polarization between Greece and
Germany in particular and the leadership role that the
German government has taken in handling the case has at
times hidden the fact that there was no North-South divide
in the euro area over the Greek case. Governments from
southern countries like Portugal and Spain, which have
gone through a painful reform and consolidation process,
and to a certain degree also the Italian government, were
concerned that too much leeway for Greece could question the policies they are implementing and strengthen
left-populist parties in their home countries. Consequently,
former crisis countries actually closed ranks with those
governments that are the more traditional proponents of
consolidation and structural reforms, like Germany, the
Netherlands, Austria, and the Baltic countries.

All in all, there is a broad consensus in the EU that a

governance reform entailing treaty change is unlikely
to be launched anytime soon. However, changes in the
governance set-up in the euro area implemented in recent
years under the pressure of multiple crises may serve as an
example how a deepening crisis may unfold in the future. A
threat of a Grexit could be the crisis moment that should
be used to press ahead with further governance reform.

A threat of a Grexit could be the

crisis moment that should be
used to press ahead with further
governance reform.
Framing the Case
Given the risk of contagion, destabilization, and loss of
credibility of the euro area and the EU more broadly, the
utmost should be done to prevent Greece from leaving the
euro area. If it does happen, however, Europe must at least
minimize the costs of this step with a pro-active policy approach that combines substantive political communication
efforts, a number of concrete measures to be implemented
in the very short term, and a detailed roadmap for fartherreaching measures to deepen the euro area. Strategic communication will be key as the conduct of knife-edge negotiations, ongoing blame games, and conflicting perceptions
and interpretations of the crisis together make future sce5

For the future credibility of the euro area, it is important

to show that the countries remaining in the euro area
share a broad consensus on the necessity of reform and
consolidation and the notion that financial solidarity
requires a reliable commitment to jointly agreed rules and
common standards. Against this background, governments should then relate how they plan to further improve
the governance of the euro area, through immediate and
longer-term measures. The objective is to convince market
participants that the remainder of the euro area will remain
as an irrevocable currency union. Eurogroup states will
need to halt speculation that there are ongoing divides
among them, which could suggest that Grexit is only the
beginning of the end of the euro area.
Immediate Measures to Take
As soon as Grexit becomes a likely scenario, a euro area
summit should be convened to announce a number of
initiatives to bolster the credibility of the euro area. As

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an immediate step, they should nominate a president of
the summit. The heads of state and government should
establish a regular meeting series for a euro area summit
to increase the legitimacy of political leadership in the
euro area, and announce the creation of a subcommittee
for euro area affairs in the Economic and Monetary Affairs
(ECON) Committee of the European Parliament. Importantly, these steps can be implemented without a change
in primary law. For the euro area summit, the rules of
procedure have already been agreed upon in March 2013,3
but have been used only twice since then, as this summit
format was only reconvened on October 24, 2014 and June
22, 2015, not at least twice a year as stated in the rules of
In addition to these measures (which serve to ensure
political dialogue and coordination on the highest level),
the eurogroup or the euro area summit should announce
immediate steps to help economic recovery in the hardesthit euro area countries. In order to achieve this objective,
necessary structural reforms, as well as the coordination of
public spending and financial aid, should be brought into a
better balance.

The eurogroup or the euro

area summit should announce
immediate steps to help economic
recovery in the hardest-hit euro
area countries.
Engage Legislative Procedures to Complete
the Banking Union
Meanwhile, within a one- to two-year time horizon, policymakers should complete the Banking Union. The Banking
Union was an appropriate response to the governance
3 European Council, Rules for the Organisation of the Proceedings of the Euro Summits, General Secretariat of the Council, March 14, 2013, http://www.consilium.

weaknesses of the euro area revealed by the sovereign debt

and banking crisis starting in 2010, and it is now declared
completed. However, it will need to be improved to disconnect banks soundness from their sovereigns debt situation
and to increase financial stability.
Appropriate measures include augmenting the bank resolution fund and the introduction of a euro area-wide deposit
insurance scheme. The lack of a pan-European deposit
insurance scheme is one of the reasons why contagion
to other EU member states through bank runs is a likely
development if Greece were to leave the euro area. Thus,
to avoid such contagion, a cross-border deposit insurance
mechanism should be created. Its announcement may help
to reduce capital flight from Italy, Portugal, and Spain in
case a Grexit becomes imminent. The completion of the
Banking Union should be conceived in conjunction with
the implementation of the Capital Markets Union that
Commission President Jean-Claude Juncker has set out
as an objective, but which has not yet been spelled-out
Engaging a Debate on the Longer-Term Perspective
Finally, heads of state and government should credibly
commit to a process of discussing substantive questions
of further integration, notably in the realm of fiscal policy.
This will be a highly contentious issue but needs to be
addressed regardless, possibly as part of a package deal
involving stronger control mechanisms for national fiscal
and economic policies.
A Banking Union completed as described above would
make the euro area more resilient, but still would require
further steps of integration to be fully functional. As the
crisis with Greece illustrates, the link between the solidity
of banks and of public budgets (i.e., the bank-sovereign
nexus) remains strong as long as no coherent fiscal
framework exists at the European level. A pan-European
treasury, which does not currently exist, is a prerequisite
for a coherent framework that would eventually enable a
breakup of the bank-sovereign nexus in the euro area.
With Greece on the brink of leaving, the leaders of the
other euro area countries need to send a strong signal with
regards to their commitment to the euro. As part of this
messaging, they should acknowledge the need to assess
the benefits and costs of various elements of a fiscal union
to underpin the single currency. This issue had already

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been outlined in the Four Presidents report in 2012 and
has reappeared in the Five Presidents report of June 2015.
Yet national leaders have so far not engaged in a serious
debate on the euro areas long-term perspective, mainly
for political reasons. The risks and benefits of introducing
a treasury and a fiscal capacity to the euro area should be
assessed in the broadest possible manner and should be
discussed publicly. The multiple crises in the euro area
since 2007-08 in fact provide ample input into a discussion of tools and policies that could have prevented the
underlying causes of the financial, sovereign debt, banking,
and economic crises, and which steps, beyond the Banking
Union, are necessary to increase the euro areas resilience.
Finally, euro area governments should announce that they
will assess the institutional set-up of the euro area with
the objective of improving transparency, efficiency, and
legitimacy of decision-making. So far, this political debate
has mainly concentrated on procedural improvements for
the European semester, which is the framework for the
coordination of economic and budgetary policy in the EU.
If, however, more elements of mutual insurance and risk
sharing are introduced as part of a completed Banking
Union, through a treasury and elements of a euro area
budget, stronger parliamentary control on the EU needs to

The views expressed in GMF publications and commentary are the

views of the author alone.

About the Author

Daniela Schwarzer is GMFs senior director for research and director
of the Europe Program and the Berlin office.

About the Europe Program

The Europe Program at GMF aims to enhance understanding of the
challenges facing the European Union and the potential implications
for the transatlantic relationship. It contributes to the European and
transatlantic policy debate through policy-oriented research, analysis,
and convening to help improve the political, economic, financial, and
social stability of the EU and its member states. The Europe Program
focuses on the following key areas: integration and disintegration in
the EU; Germanys role in Europe and the world; challenges in the
EUs neighborhood; reconnecting Southern European member states;
migration; the rise of populism; and EU energy security.

About GMF
The German Marshall Fund of the United States (GMF) strengthens
transatlantic cooperation on regional, national, and global challenges
and opportunities in the spirit of the Marshall Plan. GMF does this by
supporting individuals and institutions working in the transatlantic
sphere, by convening leaders and members of the policy and business
communities, by contributing research and analysis on transatlantic
topics, and by providing exchange opportunities to foster renewed
commitment to the transatlantic relationship. In addition, GMF supports a number of initiatives to strengthen democracies. Founded in
1972 as a non-partisan, non-profit organization through a gift from
Germany as a permanent memorial to Marshall Plan assistance, GMF
maintains a strong presence on both sides of the Atlantic. In addition
to its headquarters in Washington, DC, GMF has offices in Berlin,
Paris, Brussels, Belgrade, Ankara, Bucharest, and Warsaw. GMF also
has smaller representations in Bratislava, Turin, and Stockholm.

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