Let's think the unthinkable about the euro
What are the consequences of a Greek default? Zoe Fiddes from easy-forex delves into the subject .
Almost 20 years ago when an economic and political union was established in Europe, which would later be responsible for the creation of the European Central Bank (ECB) and the adoption of the euro, the dream was to create a stronger nation with sturdy trade flows and a single currency to bring together many countries.
The founders were proudly aiming to create a 'too big to fail' state with safety in numbers. Until recent years it would have been unimaginable that this dream would crumble and a European Union country could default.
Now, as Greece hangs on the edge of the steep cliff of failure, how might a default be played out and what are the possible consequences?
History shows there are one of two routes a country can take when faced with the reality of default; a restructured default or a sudden default. A restructured default usually occurs when there is time for the financial system to prepare for the inevitable consequences of bankruptcy. In this case a haircut in government bonds may not be as extreme and there would be preconditioned support for the banking system.
In contrast, a sudden default is when a country suddenly announces they can no longer pay their debts, including public sector wages. Both types cause huge financial damage to creditors, pension funds, banks and businesses. Furthermore, history shows us the knock-on impact is usually a currency crisis where liquidity is scarce and recession looms for many years.
An analysis of 45 defaults from 1970-2003 by the International Monetary Fund, the Bank of England and top-level academics concluded there are no miracle drugs to resolve this economic ailment. The dark downward spiral of failure begins when a country announces they cannot afford to pay their debts. If this happens it risks a collapse in the financial system triggered by panic and bank runs. If an EU country, such as Greece, fails we expect the ECB to attempt to save the day by injecting more liquidity into the system. If Greece undergoes a restructured default, the creditors may come to an agreement about cuts to bonds and thus the banking system may be more supported and likely to cope with such an event.
Whatever the result, it is certain that if the default bomb explodes EU banks will take a big hit as they hold substantial Greek debt. France and Germany will take the biggest hit if Greece goes down but British banks also face considerable damage; Barclays, HSBC and RBS have a combined total of £2.3bn invested in the first bailout. Furthermore, 50% of British tier one banks are exposed to France and Germany. US banks are also at risk as they hold long- term stakes in EU banks.
Greek failure may also trigger a domino effect that could lead Portugal and Ireland to announce defaults. If Ireland fails, the UK will take an enormous hit as British banks have a £140bn exposure to Ireland. A loss of this scale would be a serious issue to overcome for the UK economy and, to add to this loss, the EU is Britain's largest trading partner so we would no doubt see a drop in our manufacturing and production industries which may directly lead to an increase in unemployment.
The ECB would likely face mounting losses because they possess huge amounts of government bonds from the so-called PIIGS nations - Portugal, Italy, Ireland, Greece and Spain. They may be forced to print more money, injecting cash into the system as a last resort to get banks lending again. There will also likely be a strain on governments. A political crisis may emerge, particularly in Germany, as leaders take the opportunity to blame each other. In the US, consumer confidence could collapse. These problems could then be passed on to Asia with exports suffering and China's growth may stall.
Many corners of the world could be sucked into the blackhole of default and hence the forex markets may become a jungle of wild swings as traders become unsure which currency to invest in. Whether your interests lay in the equity, commodity or currency markets you can look forward to an interesting year ahead with uncertainty continuing for some time to come.