The moral hazard with a Greek exit

With Greece looking certain to default or exit, the critical question is whether it is possible to hold the rest together and maintain stability in Eurozone even after a Greek exit? In this context, John Kay and Gillian Tett point to an existential threat to the single currency union from a Greek exit - the unravelling of the Eurozone's financial integration.

As I have blogged earlier, the build up to the single currency agreement saw a rapid convergence of sovereign risk ratings among the Eurozone economies. Interest rates fell dramatically for the peripheral economies and the bond spreads with German bund dropped. In the firm belief that any Eurozone sovereign debt would be ultimately enjoy collective guarantee of all members, capital moved across borders unhindered. John Kay writes,

When countries joined the single currency, a relatively simple piece of domestic legislation converted contracts in drachmas, pesetas, markkas and Deutschmarks into contracts in euros at a prescribed exchange rate. But you cannot simply reverse that process when countries leave the single currency. You have to prescribe which contracts are now to be fulfilled in drachmas and which remain in euros or converted into Deutschmarks. That determination is politically fraught, technically complex and subject to long legal challenges.

Now that a Euroexit for Greece appears a real possibility, the financial integration process has started reversing. The first indicator of this has been the widening sovereign bond spreads of the peripheral economies (with respect to the German bund) and the near freezing of cross-border inter-bank lending. As speculation about an imminent Greek exit mounts, lenders and investors are looking to cover for cross-border risks. Gillian Tett writes,

Banks are increasingly reordering their European exposure along national lines, in terms of asset-liability matching (ALM), just in case the region splits apart. Thus, if a bank has loans to Spanish borrowers, say, it is trying to cover these with funding from Spain, rather than from Germany. Similarly, when it comes to hedging derivatives and foreign exchange deals, or measuring their risk, Italian counterparties are treated differently from Finnish counterparties, say.

As this trend gathers pace, banks and investors will increasingly seek to match lenders and borrowers within national boundaries. This matching will enable them to cover for the exchange rate and interest rate risks that would surface when Euro-era contracts are forced to be discharged in the respective individual currencies.

This would amount to a virtual repudiation of the process of financial integration that is the objective of the monetary union. Since any Greek exit would put an end to the belief that Euroexit is impossible and would also have laid out the blue-print for any exit, the moral hazard caused by the broken belief would be unleashed.

If this moral hazard gains ground, as it is certain to if Greece exits, it will stretch out the banks across Eurozone. Banks from the core economies, who have large exposure in the peripheral economies, will hasten their deleveraging process. This has the potential to force many of the debt-laden peripheral economies out from the credit markets and send their yields soaring. Wholesale defaults are a strong possibility.

Wolfgang Munchau advocates four steps to mitigate this moral hazard. They are a eurozone-wide deposit insurance scheme with an unequivocal guarantee that deposits will be repaid in euros even if the host country leaves the eurozone; a eurozone-funded resolution trust company with the power to force a recapitalisation of the banks – without national veto; a proper eurozone bond to cover a large portion of outstanding and new debt; and a change in the mandate of the European Central Bank to include specific responsibility for financial stability so that it can conduct secondary market operations.

Taken together, they would mean an effective fiscal union. In fact, the issuance of Eurobonds, which would be guaranteed by all the Eurozone members, would be the strongest signal of the commitment of the members to maintain the monetary union. And, given the inevitability of this moral hazard, the only meaningful way to mitigate it would be to backstop losses by a collective guarantee. But this carries its own risks in the sense that it would amount to the ECB playing its last card and its failure will virtually nail the monetary union.