Euro-Zone Exit Scenarios: Germany Plans for Possible Greek Default

Herman Van Rompuy is an influential man in Europe. He is already president of the European Council, the assembly of the European Union's heads of state and government. Soon he will also serve as the chief representative of the euro zone, if all goes according to plan.

Van Rompuy's new role as "Mr. Euro" is a highly prestigious position. German Chancellor Angela Merkel thinks highly of the unassuming Belgian politician, who conceals a propensity for toughness and efficiency behind his seemingly humble appearance.

One of Merkel's European counterparts felt the brunt of Van Rompuy's unconventional charm last Monday, when he took Greek Prime Minister Georgios Papandreou to task in a telephone conversation. The representatives of the European Commission, the European Central Bank (ECB) and the International Monetary Fund (IMF), known as the troika, had left the crisis-ridden country in protest a few days earlier, because the Greek government had, once again, circumvented agreements it had made.

We have a problem, Van Rompuy said at the beginning of the conversation. Unless Greece delivers, he told Papandreou, the next tranche of aid would not be paid. Papandreou understood immediately: Van Rompuy was telling him the Europeans were on the verge of cutting off funding to his country.

A lot of people in Europe are displeased with Greece at the moment. "We cannot be satisfied with the latest reports from Greece," an irritated Chancellor Merkel said last week. "The troika mission must be continued and brought to a positive conclusion," said German Minister Wolfgang Schäuble. Even Euro Group President Jean-Claude Juncker, normally not one to engage in fearmongering, took Greece's prime minister to task on the phone. "Things are not moving at the right pace in Greece," he said after the conversation. "There are no results."

Losing Patience

The tougher talk is much more than show. The rest of Europe is losing patience with Athens. And after 18 months of crisis in the country, there is still no improvement in sight. Key economic figures are worsening, and there are growing doubts over whether the Greek government truly understands how serious the situation is.

In European capitals and at the European Commission, some are beginning to wonder whether the efforts of the last year-and-a-half were in vain. The partner countries have already provided Greece with €110 billion ($152 billion), and a second bailout has already been agreed upon. But Europeans are now beginning to realize that they have spent a lot of money for nothing.

The disappointment runs particularly deep in Berlin, where the government's crisis-management policy has clearly been going around in circles. In the beginning, the chancellor said that the Greeks ought to help themselves out of their own crisis. Then came the first and subsequently the second aid package. The new approach, the government said, was to rescue Greece so that the other debtor nations would be spared.

Now the Germans have come full circle, and the prevailing emotion is fear of a never-ending debacle in Athens. "Enough is enough," says one senior government official, adding that Berlin has lost patience with the Greeks. With a mixture of resignation and fatalism, Merkel and Schäuble are facing up to the inevitable and thinking the previously unthinkable: Greece is going bankrupt, and not even its withdrawal from the monetary union can be ruled out anymore.

Between Desperate and Hopeless

The planning for the day of reckoning is already underway, in departments at the Finance Ministry in Berlin as well as in task forces at the EU in Brussels. German Finance Ministry officials hope that a Greek bankruptcy would be manageable, as long as European politicians keep their cool and the bailout funds are increased as planned.

The motivation here is to send a signal, not only to Berlin's European partners, but also to skeptical politicians in Germany's coalition government. The message is that Europe also has an alternative to helping: If necessary, it can also withdraw its help.

The subject was discussed at a dinner last Tuesday at the German Finance Ministry, to which Finance Minister Schäuble had invited his counterparts Finnish Finance Minister Jutta Urpilainen and Dutch Finance Minister Jan Kees de Jager.

Officially, the ministers were there to discuss the collateral the Finns want to receive from the Greeks in return for further aid. But the real issue was the escalating crisis in Athens. The attendees were all aware that the situation in Greece is now fluctuating between desperate and hopeless, and that bankruptcy is probably unavoidable. The only differences of opinion were over the consequences.

Schäuble argued that the Greeks should remain in the monetary union, even after a so-called haircut. De Jager, however, was not opposed to their leaving the euro zone. The attendees did agree that the ultimate consequences are up to the Greeks themselves: The other members of the euro zone do not have the option of ejecting them from the monetary union.

Calculating the Consequences

Schäuble is convinced that things cannot continue as they are. He shared his concerns and conclusions in several conversations with close associates last week. Each time, his message was that he no longer believes that the Greeks will be able to fulfill the stipulated conditions, and that they are likely to run out of money as early as October.

Finance Ministry officials have already calculated the consequences. Last week, an envoy from Berlin presented the results to Germany's partners in Brussels.

There are basically two possibilities for a Greek bankruptcy, the German official said: Either the country remains in the monetary union, or it withdraws.

Either option would involve a haircut, meaning that Greece would only service a certain share of its debt, such as 50 percent. This would translate into significant losses for Athens' creditors, like the European Central Bank (ECB), other European Union countries and banks, insurance companies and financial institutions throughout Europe. Schäuble's envoy presented his Brussels audience with the results of the German Finance Ministry's simulations, and said that the goal should be to contain the damage caused by these losses.

The European Financial Stability Facility (EFSF) plays a key role in their considerations. The Finance Ministry wants the Luxembourg-based facility, headed by German economist Klaus Regling, to be provided as quickly as possible with the new competencies that were agreed upon at the crisis summit in late July. Once that happens, there will be a good chance of protecting the rest of the euro zone from the disruptions emanating from a Greek default.

Preventive Credit

The German plans focus on two instruments. First, Schäuble's officials advocate the use of preventive credit lines, which would involve the EFSF issuing bridge loans to financially weak countries. Second, they want to provide financial injections for banks to stop them getting into difficulties.

Entire countries and their banking sectors could be protected with the two instruments, Schäuble's man in Brussels argued. The loans would help Italy and Spain, but also small countries like Cyprus, who could find themselves unable to borrow money from fearful investors following a Greek bankruptcy.

Banks in many euro-zone countries could eventually find themselves dependent on the billions from Luxembourg, because they would have to write down their holdings of Greek government bonds. Greek banks would suffer the most from the consequences of a national bankruptcy. For this reason, German officials argue, it is quite conceivable that Greek banks could still receive aid even after the Greek government itself had been cut off from EFSF assistance. As the financial crisis showed, banks are deeply interconnected across national borders. If one major bank fails, others can easily be dragged down with it.

Such consequences are to be expected regardless of whether Greece keeps the euro or withdraws from the euro zone. In reality, Athens would have no choice: The government could only hope to boost its languishing economy if Greece reintroduced its own currency and sharply devalued the new currency against the euro.