What happens if Greece withdraws from the Eurozone?
The crisis in Greece has received massive international coverage, and has contributed significantly to instability and uncertainty in financial markets over the last few months.
It is legitimate to ask why Greece – a country which accounts for less than two per cent of the entire Eurozone economy – should have managed to create so much chaos both in the markets and at a political level.
A combination of factors may be noted:
- The economies of several Eurozone Member States – Ireland, Portugal and Greece itself – are being sustained through a combination of support from the International Monetary Fund and the European Union. The economies of Italy and Spain are also experiencing difficulties, and there is a fear of "contagion";
- A Greek default on its sovereign debt may deprive other peripheral Member States of access to the capital markets, and may thus trigger other defaults;
- A number of Europe's financial institutions may be forced to write-down the value of their holdings of such debt, thus further damaging their already battered balance sheets. German banks, in particular, have very sizeable exposures to a Greek sovereign default;
- Much of the German political class and a large section of the public are hostile to the prospect of bailouts for fiscally profligate Member States, thus putting the views of the German establishment at odds with the interests of that country's major financial institutions;
- The European Central Bank itself holds a significant portfolio of Greek sovereign debt as collateral for liquidity provided to the banking system as a whole, and a Greek default would thus impair the ECB's own security position; and
- A Greek default would cast serious doubt over the viability of the single currency arrangements, which have been a "flagship" project for the European Union over recent years.
The list of reasons could no doubt be multiplied, but the above points provide a sufficient flavour of the nature and extent of the problems.
Notwithstanding the urgency of the situation, on 20 June Eurozone finance ministers failed to sign off on a crucial €12 billion payout to Greece. It seems to be accepted by all concerned that – absent that disbursement – Greece will almost certainly default on its sovereign obligations during the course of July. Predictably, the failure to conclude this deal and the resultant uncertainty puts the Euro under immediate pressure on the foreign exchange markets, and yields on bonds issued by the Eurozone's peripheral governments widened against German Bunds.
Of course, the creditor nations and international financial institutions face their own political problems. In particular they have to be seen to be imposing firm conditions on Greece in return for the bailout. The 20 June statement by the Eurozone finance ministers notes the need for rigorous implementation of Greece's privatisation and fiscal reform programmes and, on that basis, notes that "…… Ministers decided to define by early July the main parameters of a clear new financing strategy ……." Unfortunately for the Greek government they have to try to implement these programmes against a backdrop of local political instability, public opposition and periodic riots.
Could these events impel Greece to default on its debts, and to withdraw from the Eurozone?
The Logic of Eurozone Withdrawal
Conventional wisdom has it that it would be financial and economic suicide for Greece to seek to withdraw from the Eurozone. There is some truth in this assertion, but societies do not always respond to this type of logic. And, it must be said, the precedents for withdrawal from this type of monetary arrangement would offer some encouragement to those who argue for such a departure. On 16 September 1992 ("Black Wednesday") the United Kingdom was ignominiously forced out of the Exchange Rate Mechanism which required that sterling should "shadow" the value of the German Mark, within narrow bands of permitted variation. In the ensuing years, the United Kingdom was able to operate an independent monetary policy and began to emerge from its deepest recession for a generation. This episode helps to explain Britain's longstanding opposition to single currency membership.
Likewise, for a number of years, Argentina maintained a peg of the peso against the US dollar. The strains of this arrangement became so great that it had to be abandoned, and a sovereign debt default ensued. Yet the collapse of the peg has coincided with significant economic revival in that country. It is true that the Argentine economy continues to suffer from major structural problems and that other factors – such as protectionist policies and price/currency controls – were significant contributors to that country's short term economic recovery. Nevertheless, the perception remains that the abandonment of the currency peg was a positive move from the perspective of Argentina's broader economic interests.
So, despite the conventional economic wisdom, a departure from the Eurozone might not be such a bad thing for Greece itself. That conventional wisdom perhaps has its source in other Eurozone capitals, impelled by the significant exposure of the financial system to Greek sovereign debt. But as the Wall Street Journal aptly put the matter on 17 June, "What if the Greeks Decide They don't Want to be Rescued?" Tired of austerity programmes and protests, the public may just decide that a default and Euro withdrawal are the preferable options – even though they would result in the loss of aid from the European Union and the International Monetary Fund. It should be said that not all commentators share this pessimistic outlook. A piece published in the UK's Financial Times on 19 June ("Against the odds, the Euro will scrape through") adopts the contrary position.
A purely legal analysis cannot make much of these competing arguments. If, however precariously, the Eurozone survives in its present form, then few issues of an essentially legal character will arise from the preservation of the status quo. But a splintering of the Eurozone would involve new and uncharted legal territory. Despite their novelty these issues are by no means theoretical and may have direct and massive consequences for creditors holding Greek sovereign or corporate obligations.
Accordingly, the purpose of this briefing is to consider some of the legal implications of a Greek departure from the Eurozone.
Method and Consequences of Withdrawal
The legal framework for the single currency is created by a treaty among the Member States of the European Union. Article 50 of the Treaty on European Union ("TEU") states that "… Any Member State may decide to withdraw from the Union in accordance with its own constitutional requirements…."
It will be noted that this provision contemplates withdrawal from the EU as a whole. There is no provision in the treaties which allows a Member State to withdraw from the single currency and yet remain a member of the EU itself. Even in the case of a complete withdrawal, there are various procedural formalities and details would remain to be negotiated. Beset by crisis and the spectre of default, it is likely that a Greek departure would be precipitous and untidy, with the treaty niceties being substantially disregarded. That this would involve a positive breach of Greece's treaty obligations is also a matter which is likely to receive limited immediate attention in the context of a major crisis.
A Greek withdrawal is thus likely to be unlawful but, as noted earlier in this briefing, it might happen anyway.
In that situation, the Greek Government would have to introduce a replacement currency – referred to for convenience as the "new drachma". The currency will have to be created by a new Greek law, which would have to provide a substitution rate for the conversion of Euro obligations to the new drachma. The application of this law creates difficulties of a particularly acute kind, and these are considered under "The Currency of Payment", below.
It may be noted in passing that a Greek departure from the EU may have many other consequences, especially in the context of the "four freedoms" created by the treaties (including free movement of capital, workers, goods and services). These are huge subjects on their own, and the present briefing is accordingly confined to the consequences for monetary or financial obligations.
Validity of Contracts and Obligations
As a threshold question, it is necessary to consider whether contractual obligations expressed in Euro would remain legally valid and binding, notwithstanding a splintering of the Eurozone.
This may, to an extent, depend on the law that governs the contract in question but, so far as English law is concerned, a contract would only be terminated by the splintering of the Eurozone if this had the effect of radically changing the nature of the contract and the underlying obligations. This will generally not be the case, because obligations of payment remain valid notwithstanding a change in the currency of denomination.
International financial contracts expressed in Euro will therefore remain valid and effective, notwithstanding a Greek withdrawal from the single currency zone.
The Currency of Payment
The fact that contracts remain legally binding is, of course, important. But it is only part of the picture.
It will still be necessary to decide -- in which currency is payment required to be made? Formerly, there was just the Euro, and thus no scope for argument. But now there is the Euro and the new drachma. Must the debtor continue to pay in Euro, or can he discharge his obligation in new drachma at the rate prescribed by the Greek currency law? Given that – following its creation – the new drachma would almost certainly fall in value as against the Euro; this question has an obvious importance for debtors and creditors alike.
There are a few points that may be regarded as obvious:
- Where a contract has been made between non-Greek parties outside Greece and is governed by (say) English law, the agreement will have no nexus with either Greece itself or its currency law creating the new drachma. In such a case, the contract will clearly remain denominated in Euro; and
- On the other hand, where a contract has been made between Greek parties and is to be performed entirely within Greece, the contract will be of an essentially domestic character and will have a close link to the new currency law. In such a case, the Euro obligations would be converted into new drachma at the legally prescribed conversion rates, and payment could be made accordingly.
Of course, these two examples are at extreme and opposite ends of the spectrum, and thus lend themselves to simple solutions. But cases that fall into dispute will inevitably be more marginal. Often, such cases may involve Greek debtors but have some significant international element – e.g., the contract is governed by English law, or payment is to be made outside Greece. In addition the "currency of payment" question may be influenced by the forum in which the question arises for decision. In particular:
- The law creating the new drachma will be directly binding on the Greek courts and will thus have to be applied by those courts in a significant number of cases. It is therefore likely that Greek courts would redenominate contracts into the new currency unit, thus favouring the position of debtors and obligors; and
- In contrast, courts sitting in other countries will not be directly bound by the new Greek currency law, and will only have to give effect to the new drachma conversion if the parties intended to contract by reference to internal Greek monetary rules.
In most cases of this kind that might fall for determination by an English court, it is suggested that the court would usually come to the conclusion that the contract remained outstanding in Euro and thus had to be performed in that currency. The English courts would thus tend to favour the position of the creditor. There are two possible reasons for this approach:
- First of all, an English court would only become concerned with obligations of a Greek obligor if there were some significant international angle to the dispute – e.g. a loan agreement governed by English law and syndicated amount a group of London banks. In such a case, the court is likely to hold that there is no clear choice of the internal laws of Greece to determine monetary questions and, on that basis, the agreement remains dominated in Euro;
- Secondly, and as a matter of wider principle, the English court may disregard the new Greek monetary laws – and the new drachma – altogether. As noted above, the new monetary unit is likely to be created in contravention of the single currency rules in the EU treaties.
Given that the United Kingdom is itself a party to those treaties, it may have to disregard the new Greek currency as a matter of public policy.
The net effect of this analysis is that international, Euro-dominated obligations of Greek debtors which are (i) payable outside Greece and (ii) governed by a foreign system of law, are likely to remain denominated in Euro, notwithstanding Greece's withdrawal from the Eurozone and its unilateral creation of a new monetary unit. Thus, obligations contracted by the Greek government or a Greek counterparty would remain outstanding in Euro if:
- The obligations were represented by bonds issued on the international markets and governed by English law;
- the obligations arose under loans contracted with banks in the London market where Euro repayments are to be made outside Greece; and
- the obligations arise under swaps/derivative contracts contracted with a London bank and governed by English law.
Although the above views are expressed by reference to English law, it is likely that the same analysis would apply to international obligations governed by New York law or, indeed, any other external system of law.
Other Consequences of a Eurozone Withdrawal
It may be helpful to highlight a few other, financial market issues which might arise in consequence of a Greek withdrawal from the Eurozone:
- generally speaking, the currency changeover will not of itself amount to an event of default under borrowing or other debt documentation. However, an event of default would arise if the debtor sought to make payment in the new drachma when – under the principles described above- payment ought to have been made in Euro;
- under debt documentation applicable to corporate obligors established in Greece, a "material adverse change" default may arise as a consequence of the currency substitution, because this will render it more difficult for the obligors to service their international borrowings; and
- although creditors may suffer significant losses as a result of the currency substitution, it is unlikely that private claimants would have any recourse in national courts to recover such losses from the Greek Government. Apart from other obstacles, such a claim would be barred by the doctrine of State immunity.
Given the issues at stake, it must be likely that the current impasse in the negotiations between the Eurozone finance ministers will be resolved in the near future.
But there is no certainty that this will be the case, and domestic instability within Greece may threaten its continued Eurozone membership. In addition, the prospect of a Greek sovereign default has massive implications for European financial institutions, the European Central Bank and many others. Markets and government officials will be anxious to see a rapid resolution of the Greek funding crisis.