Today the ground is shaking throughout the Eurozone with even greater intensity, and the epicenter is Greece.
And here's the question:
If Greece does trigger a full blown financial earthquake by an abrupt and disorderly exit from the European Monetary Union, will a massive tsunami overwhelm the entire Eurozone and spark a global meltdown?
The European sovereign debt crisis has been rearing its ugly head for over two years now. They’ve tried to tame it with bailouts, fiscal austerity, long-term liquidity operations and sovereign bond purchases. But the patchwork and masking tape used to paper over the problems just doesn’t seem to stick very long.
Now, faced with the real possibility that one of its members may actually leave, it brings a whole new set of variables into the equation that could pose a bona fide systemic threat to the entire European banking system.
The real systemic threat is not the financial shock of Greece defaulting on its debt and parting ways. No, it’s the potential financial tidal wave that their departure could trigger.
If Greece does exit, the Eurozone can absorb the messy divorce and eat a 500 billion euro loss or so. It wouldn’t taste too good, but the $15 trillion economy could pinch their nose and swallow it.
But the ramifications and reverberations will likely be profound, especially along the debt-strapped periphery, including the beleaguered countries of Portugal, Ireland, Spain and Italy.
We’re already starting to get a glimpse of what may yet be to come, and could in fact turn into a full blown financial crisis.
Let me explain...
The actual makeup of Greece’s coalition government has yet to be determined, which is creating a great deal of uncertainty and speculation, not only for global markets, but for the Greek people. Upcoming elections slated for June 17 should hopefully bring clarity as to what type of government will materialize and the likely fate of its EU membership status.
But the Greek people aren’t taking any chances. With the potential threat of an exit and a forced conversion back to a national currency that will significantly devalue overnight, the citizens are withdrawing their Euros from Greek banks in waves.
Just last week, after a failed last ditch effort to form a coalition government, 700 million euros were withdrawn in one day -- a mini bank run, so to speak.
The primary reason why you get a run on the bank is simply because of a lack of confidence... when people simply feel that their money isn't safe and secure.
The effect was also felt last week in Spain as reports indicated that 1 billion euros were withdrawn from Bankia, the troubled Spanish bank that was essentially nationalized earlier this month.
While the amount of withdrawals are still relatively small to the aggregate, the thing about a bank run is that it can escalate very quickly and easily get out of control.
Like I mentioned earlier, the Eurozone and the European Central Bank are continuing to provide the needed liquidity to the Greek banking system, which is suppressing an all out bank run.
But if Greece is allowed or forced to exit and converts back to a national currency, it will set an awful precedent and signal to the other beleaguered members that if this budget austerity thing gets old, we’re going to follow Greek playbook and find the nearest exit.
The mere speculation of this option will only amplify the mini bank run we’ve seen this past week.
This is the scenario that could send the markets reeling and into a Lehman style tailspin. It’s also the challenge that the Eurozone leaders must address -- and soon. Losing the confidence of the people will not so easily be overcome by how much additional liquidity they can throw into the system.
One recent idea floated around was for the European Central Bank to simply guarantee deposits in all Eurozone banks. After all, it worked in the U.S. during the height of the credit crisis by raising deposit insurance guarantees to $250,000 and preventing money market accounts to break below par value ($1.00).
But the major contrast is that the US is one sovereign country, while the Eurozone is comprised of seventeen. While the US is carved into 50 separate states, one cannot pick up and leave and set up another currency. (Though it was attempted back in the 1800’s, but that's another story.)
The Eurozone deposit guarantee would work in a sense if the people knew that an exit was not possible. But if Greece is shown the door, that sense of security loses all credibility.
They could still choose to guarantee the deposits even if a departure was permitted, but Germany would never go for that. In the event of another exit with a Euro deposit guarantee, the newly converted currency would quickly devalue, and the insurance claims would explode. Having to write a massive check to depositors in a country that just left would not sit very well in Frankfurt.
Greece is indeed a small cog in the wheel, with current deposits around 170 billion Euros, a number that poses no real threat in a vacuum. But if contagion and a break down in confidence spread to Italy and Spain, this is where the Lehman style systemic threat truly lies.
Deposits in Spain and Italy total just over 3 trillion euros -- a massive amount, and a sum that must be protected from a bank run at all costs.
What’s the Solution?
I’m no Eurocrat or a European central banker, but to me the solution is quite simple.
The message at this week’s EU summit in Brussels should be pretty clear: The Eurozone is the roach motel -- you can check in, but you can’t check out!
Don’t let Greece leave! Like the Union did not allow the Confederate South to willingly secede.
That is probably the best option and, in my opinion, the way it should play out. It will no doubt come with another program for Greece that should roll back some of the fiscal austerity and appease the newly elected coalition government and its citizens.
Markets should rally if this scenario indeed plays out, especially as global markets are oversold. Most of all, the bank run threat should subside and if they choose to implement a Eurozone-wide deposit guarantee, it would hold a tremendous amount of credibility and work very well.
However, if Greece does have a disorderly exit or is allowed to leave, then you must consider a Eurozone bank run as a potential threat and have a plan to protect your portfolio if the price action continues to deteriorate and breaks very key levels of broad support.
I’m following this story very closely, and besides watching the AP wires on deposit withdrawals throughout the Eurozone, I’m watching the Euro/USD currency pair.
The Euro just touched a fresh July 2010 low, breaking below 1.26 yesterday. If withdrawals happen to escalate and the Euro breaks the 1.19 low made in June 2010, the tremors may very well send a financial wave on shore.
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