Greece Defaults On Its Loan: What Happens Next?

If you were nervously hoping that Greece would seal a last minute deal on its debt repayment, you’ll be disappointed. Overnight, Greece officially defaulted on its US$1.5 billion IMF loan. As expected, Tuesday’s deadline passed with no repayment forthcoming.

That’s a big deal. For one, it signals that Greece is prepared to play hard ball with its creditors.

This is the first occasion that an economy as advanced as Greece has default on an IMF loan. Not only that, but it’s also the largest default the IMF has ever faced.

Granted, Greece isn’t out of the Eurozone just yet. The referendum on Sunday will give us a better indication of where the future lies for the nation. That’s when Greek citizens will vote on whether or not to continue with the punishing bailout terms.

A no-vote would spell the end of the current debtor-creditor arrangement they have with EU, ECB and IMF. It would also lead us into the unknown. There’s really no telling what twist this saga would take next.

But the referendum does give the Greek government some breathing space. If, by some miracle, Greeks vote to stay in the Eurozone, then their debt repayments could be restructured. It’s not impossible to see the IMF coming to some kind of agreement should that transpire. They’ll probably give Greece another month in which to repay the loan.

That’s a big assumption to make though. Remember, Greece has another US$6 billion repayment due this month as well, which dwarfs the loan they just defaulted on.

Even though it seems likely, we can’t assume that the Greek people will vote no on Sunday. Which begs the question: what happens next?

The three most likely outcomes for Greece following the referendum

The referendum will tell us a lot more about what the future holds for Greece. There are several outcomes which could emerge depending on whether or not Greece reneges on their loan arrangements.

The first is that Greece remains in the Eurozone. Naturally, that would mean a yes-vote on maintaining the status quo.

In short, this would keep the Greek economy ticking along for the time being. Importantly, Greek banks would still have access to European Central Bank funds. It’s also probable that creditors would grant Greece some kind of debt relief in the short term.

The problem with this outcome is that Greece would have to promise to cut spending. That means wages and pensions would be in the firing line. And that’s not likely to happen.

The reason why Greece defaulted in the first place is because they have no desire to cut spending any further.

Yet, as Markets and Money’s Greg Canavan explains, a no-vote could be used as a negotiating tactic, leaving the government in a stronger position to make demands. He explains:

If Greece votes no in Sunday’s referendum, then they will be in a much stronger position to negotiate a better outcome for staying in the Eurozone, which is clearly the better deal for everyone.

‘But with Tsipras saying that Europe doesn’t have the nerve to throw Greece out, he risks turning this from a rational to an emotional negotiation. Because if Europe then turns around and calls Greece’s bluff, throwing them out of the Eurozone, it’s likely we’ll get a lot more turmoil and volatility in the months ahead’.

Greece clearly feels that there is political will among in Europe to keep them in the Eurozone. But as Greg says, they may be overestimating the extent of this. We’ll have to wait and see.

Is a return to the drachma likely?

The second likeliest outcome is that Greece creates a new currency. A return to the pre-Euro ‘drachma’ is what many Greeks have been calling for. That would give Greece full control over its monetary policy.

Any new drachma is likely to float against the major currencies, and would undergo a sharp devaluation. As a result, there would be a lot of short term pain placed on the Greek people. Not only that, but many Greek banks would likely become insolvent.

However, the prospect of a monetary devaluation would lift Greek exports immediately. At the same time, though the cost of exports would fall, the cost of imports would rise.

That could prompt the Greek government to raise wages and pensions in order to meet rising inflation as imports become more expensive. That poses a problem because it potentially lessens the benefits of a devaluation, which could dampen long term economic growth.

Nonetheless, a new drachma would be the kind of shock trauma that Greece needs. Certainly, the Greek people would find this kind of pain more tolerable. Any measure which places less emphasis on spending cuts is likely to be greeted with enthusiasm.

The middle way: euro stays, Greece leaves

A third outcome following the referendum could be that Greece keeps the euro, but leaves the Eurozone. It may seem counter intuitive, but a Grexit could make this the likeliest outcome. Already, there is a precedent of this with Montenegro.

But there is a caveat. As the Wall Street Journal’s Stephen Fidler explains, Greece would become a poor, non-EU state. He explains:

In some ways, this would be the worst of all worlds because Greece would lose access to the ECB. Countries using a foreign currency as legal tender have no access to a lender of last resort. [That] means that every bank liquidity crises becomes a solvency crisis. They therefore tend to have stunted domestic financial sectors [which is bad for growth] or have a banking system owned by foreigners, which exports the lender of last resort role to other countries’ central banks.

If Greece did exit the Eurozone, it’s possible that the situation could play out in this manner. This option would ease some of the volatility that would otherwise accompany a new drachma. Greece would still default on its debts, but it would retain the euro, which many are still keen to do.

At the same time, the country would also become a permanent basket case. As Fidler says, like Montenegro, Greece would become a ‘relatively poor unilaterally euroized non-EU Balkan economy’. That’s a kind way of putting it.

With years of economic turmoil behind them, the Greeks will be hoping for something better than that. By Monday morning, we’ll know a lot more about what the future holds for Greece.

Mat Spasic,

Contributor, Markets and Money

PS: The situation in Australia is nowhere near as bad as it is in Greece. But our economy has its own set of problems. As one of Australia’s leading investment analysts, Greg has been warning for months that we’re sleepwalking into a recession.

In a free report, ‘Australian Recession 2015: Unavoidable’, Greg reveals why economic growth is going to fall sharply over the next three quarters. Falling mining revenues are already taking their toll on the economy. Government revenues are down, household debt is up, and business spending is falling too. As a result, these factors will continue the drag on the economy over the next six months.

But there is hope for anyone who takes the effort to shield themselves from the recession. Greg will talk you through the steps you need to take to protect your portfolio and wealth. To find out how to download the report right now, click here.

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