What Greece Can Expect

9/7/2015

By Carmen M. Reinhart

Greece, barring some bold new initiative, is on course to exit the euro area. How badly might this hurt the economy? How quickly could it hope to recover?

Exits from currency unions are not as common as exits from fixed exchange rates. There are a few instances where highly dollarized economies tried to “de-dollarize” and return to the home currency.

These episodes may serve as a guide to what Greece can expect. The salient aspect of the Greek case is the prospect of forcible conversion of bank deposits to a new domestic currency under conditions of extreme economic stress. Since 1982, five episodes best illustrate this combination. The lesson to be drawn from them is that a Greek exit would involve deep and lasting trauma.

First, though, is forcible conversion of deposits bound to happen if Greece exits the euro?

The answer is yes. Confidence in the status quo has collapsed, leading to a sharp escalation in internal arrears, both public and private. The private sector is defaulting on its debts and about half of the country's bank loans are non-performing; include credit-card debt and the proportion is even greater. Taxes aren't being paid and people are hoarding euros. The government is financing itself by failing to pay its bills. The Bank of Greece cannot legally “print” euros to meet the deposit withdrawals.

Under these circumstances, forcible conversion of euro deposits to drachma will be all but unavoidable.

Five episodes that mirror such characteristics are, in reverse chronological order: Argentina in 2002, Argentina in 1989, Peru in 1985, Bolivia in 1982 and Mexico in 1982. All were dollar-based economies under stress that forcibly converted dollar deposits into domestic currency.

What happened? In broad terms, from the starting point of an economy already in crisis, forcible conversion was accompanied by capital flight (table 1), lower output (table 2), and severe contraction of domestic financial intermediation (table 3).

Capital flight in these cases was typically underway before the conversion, but it continued during and after -- often at a faster rate, and despite capital controls. The implication is that conversion failed to establish confidence in the stability of the new currency. Extremely high parallel-market premiums on the new currencies during and after conversion underline that point.  (The higher this premium, the greater the expected depreciation.) 

Capital controls were typically kept in place for far longer than the authorities first indicated. Note that, in all five cases, partly because the controls leaked, the authorities chose to relax an initial ban on dollar deposits. At best, in other words, their efforts to "de-dollarize" and shift to a domestic currency only partly succeeded. In the same way, a Greek attempt to cleanly "de-euroize" might fail.

Mexico's case in 1982 is especially sobering. De-dollarization was partially accomplished, but capital flight more than doubled and bank credit to the private sector fell by almost half in the two years after conversion. Inflation stayed high and growth was dismal for several years. In four of the five cases, growth slumped in the year of conversion and again in the year after that.

Forcible conversion combined with capital flight, parallel-market premiums and recession makes it unsurprising that financial intermediation contracted during these crises. Even so, the severity is striking. Financial intermediation -- measured by bank deposits as a proportion of gross domestic product -- tends to trend upward as economies develop. During these crises, financial development went into reverse, and for extended periods.

The collapse of financial intermediation in the Argentine 1989 and Mexican 1982 episodes is arresting. In the year before the conversion, bank deposits were 20 percent to 30 percent of GDP. In the year of the conversion, they fell sharply and eventually bottomed out at 5 percent to 8 percent of GDP.

A Greek exit from the euro system doesn't have to happen. A meaningful debt-reduction agreement and the assurance of European Central Bank support for the banking system could still avoid that result. But if exit happens, and forcible conversion of deposits follows, the setback to Greece's economy is likely to be both large and long-lived. 

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