Martin Wolf’s column last week presented a convincing argument for why a Greek debt restructuring in the near term may be desirable. Certainly, markets have come to the conclusion that an eventual restructuring is inevitable, with 85% of respondents to a recent Bloomberg poll anticipating an eventual Greek default and yields on Greek government 2Y bonds now around 25%. With the Greek government facing significant financing needs next year (likely in excess of €20bn) even within the current EU/IMF financial assistance package, and with access to capital markets for the government clearly closed, without additional official assistance a restructuring in 2012 would be a near certainty.
Faced with the unpalatable prospect of a euro area country defaulting ahead of 2013, and with fears of the potential contagion effects both on other peripheral countries and the euro area banking system, EU leaders look set over the next few weeks to cobble together a further package to avoid a restructuring in 2012. But with the Greek government missing its fiscal targets as the economic downturn leaves the government chasing its own tail, the country’s debt stock heading towards 160% of GDP and little or no prospect of Greece being able to tap capital markets for many years to come, the huge costs of carrying such a large debt burden are likely eventually to make the arguments in favour of a restructuring irresistible.
But speculation of an eventual default has itself triggered growing expectations that any default would be accompanied by a Greek exit from the euro area. And the possibility of such an outcome is gaining currency among both analysts and investors. So, would euro exit make sense for Greece?
Putting aside the issue of whether a country can legally leave the euro, the possible benefits for Greece are two-fold. First, having lost price competitiveness over the period of euro membership (see chart), Greece faces several years of wage growth below the euro area average to regain that lost competitiveness. Leaving the euro, on the other hand, would allow the price adjustment to happen instantaneously via a new lower exchange rate. Second, at a time when the ECB is tightening policy, the introduction of a new drachma should allow the Greeks to conduct their own monetary policy more suited to its economic circumstances.
Euro area unit labour costs
And, listening to some pundits, it would be that simple - restructure, leave the euro and all Greece’s problems are solved. But that is to ignore the enormous logistical, legal and economic challenges that leaving the euro would present, including:
While Greece may be able to stay within the EU if it left the euro, it is less clear that access to EU financial assistance would remain in place post euro departure. That would leave Greece, even after a significant debt restructuring, faced with a stock of euro-denominated debt to fund that it would most likely have to default on one way or another.
The corporate sector would also find itself saddled with a mismatch between the new currency and its euro-denominated liabilities. While contracts within Greece could conceivably be changed via a forced conversion, this would not be the case for contracts outside Greece. The household sector would find itself in a similar situation.
The logistics of introducing a new currency are gargantuan. The changeover from national currencies to the euro required years of preparation. In the meantime it is difficult to see how a run on Greek banks (which in any case would require huge recapitalisation in the case of a Greek debt restructuring) by depositors could be avoided as depositors scrambled to prevent their savings being frozen and forcibly converted into the new currency. And leaving the euro would deprive Greek banks of access to ECB funding, their only reliable source of liquidity at present. So euro exit would destroy whatever remains of the banking sector after any debt restructuring.
And even the mooted benefits of an exchange rate devaluation and an independent monetary policy are not as clear cut as those advocating Greek withdrawal would have you believe. The new currency would be highly volatile, at least initially, as markets try and judge what its appropriate value is. Preventing too precipitous a fall in the currency, which would obviously have dire effects on inflation, would require the Greek central bank to raise quickly rates well above those of the ECB, thus negating the benefits. And with the Greek central bank unlikely to have much anti-inflation credibility, particularly if it finds itself under pressure from the government to finance deficits in the likely absence of sufficient private sector demand for its debt, real interest rates are likely to be pushed very high indeed.
The Greek government is already shut out from capital markets, and a return looks some way off whether or not it eventually restructures its debt. But the date at which it could once again tap international capital markets would be much further off if it were to leave the euro.
So, while a Greek default would provide lasting and real damage to the credibility of both Greece and the euro area, that would be nothing as compared with the damage and disruption that would be caused by euro exit. The costs to the economy are impossible to quantify, but it seems difficult to imagine a scenario in which the benefits ultimately outweigh the costs. Rebuilding its economy within the euro area will be a long protracted process. But at least it will have the benefits of financial assistance from the rest of the EU and a credible currency, things that would be lost by going it alone. As a small country on the edge of the EU with a pretty terrible track record of managing its own monetary policy, the Greeks knew that membership offered benefits far in excess of the costs. That balance of costs and benefits seems all the more extreme for a euro exit. In any case, those advocating the merits of a Greek withdrawal ignore the politics. How desperate the Greeks were to get into the euro in the first place was demonstrated by the fact that they were less than totally truthful about their fiscal position to ensure they got in and there is no appetite for reintroducing the drachma among either the political elite or the wider public.
All of this isn’t to say that Greek euro exit couldn’t eventually happen. Events in the euro area over the past year have taught everyone to expect the unthinkable and the politics may well coalesce to lead to such an outcome. But it would almost certainly be an economic disaster for Greece. As such, we continue to believe that both the Greeks and the rest of the euro area will work hard to prevent such an outcome.
This article is published with permission from Daiwa Capital Markets Europe Limited.
The World Trade Organisation (WTO) is an international organisation based in Geneva, Switzerland. It consists of 153 member states representing 97% of total world trade, and has two main roles:
Firstly, the WTO acts as a forum to negotiate trade agreements between countries, similar to a law-making institution like Parliament. The aim is to dismantle tariffs, quotas and other non-tariff barriers in order to promote free trade on the basis of comparative advantage. Negotiations are conducted in ‘rounds’ of trade talks. The most recent of these is the Doha Round, which was launched in 2001 to promote a fairer participation of the developing countries in world trade, agriculture, services and intellectual property rights.
Secondly, the WTO has a dispute settlement role, similar to a court, where it resolves trade disputes between countries and enforces the trade agreements. It does this through the Dispute Settlement Panel and, in case of any appeals, the Appellate Body. The WTO has various ways of enforcing its decisions, such as when it authorises retaliation and cross-retaliation (see below). There have been some well-known cases brought to the WTO, including the EU-US steel tariffs case, the US/Ecuador-EU banana protectionism case, the China-EU shoe tariffs case and, more recently, the China-US tyre tariffs case.
When negotiating trade agreements and resolving disputes between its member states, the WTO follows certain general principles. The three most important of these are:
- Most Favoured Nation (MFN) Rule – this principle states that a tariff reduction granted to one country (i.e. the ‘most favoured nation’) should be extended to all other members of the WTO. So if country X reduces wine tariffs on country Y to only 5%, it should not impose wine tariffs of 10% on country Z. In such a case, country Z’s wine should also be subject to a tariff of 5%.
- National Treatment Rule – according to this principle, once foreign goods have entered the domestic economy they must be treated on a par with domestically produced goods. So countries cannot have a higher rate of VAT on imported wine and a lower rate for domestic wine. Likewise, countries should not insist that foreign cars be subject to an MOT every six months, while domestically produced cars only go for an MOT once a year.
- Tariff reductions should be mutual. So in the example given above, both countries Y and Z benefit from a reduction on wine tariffs to only 5%. In return, they should both lower their own tariffs on country X’s wine to 5%.
- Protectionism is allowed when it can be objectively justified. For example, tariffs to offset illegal subsidies or to protect infant industries; quotas to correct a balance of payments crisis, etc.
There is a large number of trade agreements currently enforced by the WTO. Six of the most common ones are:
General Agreement on Tariffs and Trade (GATT) – prevents any further tariffs and quotas on goods only.
General Agreement on Trade in Services (GATS) – widens access to foreign markets for services like banking, insurance and telecoms.
Trade-Related Aspects of Intellectual Property Rights (TRIPS) – member states have an obligation to create a system of intellectual property rights to protect the copyrights, trademarks and patents of foreign firms.
Subsidies and Countervailing Measures (SCM) Agreement – outlaws trade-distorting subsidies and lays down the circumstances in which a countervailing tariff (also known as an ‘anti-dumping duty’) may be imposed.
Technical Barriers to Trade (TBT) Agreement – this also regulates the use of non-tariff barriers – in particular, technical standards and quality inspections on imports of manufactured goods. The essence of the TBT agreement is that these should be objectively justified and should not create unnecessary obstacles to trade.
It is important to note that the WTO follows a system of international law. In a domestic system like English law, anyone who ignores court rulings will be found in ‘contempt of court’. This is a criminal offence, which can lead to fines and even jail sentences.
However, the same situation cannot hold true in international law. It would be impractical to impose criminal sanctions against sovereign governments who fail to comply with WTO rulings. Hence the WTO has other, more practical ways of enforcing its decisions when recalcitrant member states ignore them.
Firstly, the WTO may authorise retaliation. This is where the country which has been hit by illegal tariffs / quotas is allowed to impose its own protectionist measures against the offending country. The aim is to encourage the government of the offending country to abolish its illegal measures and to continue trading on the basis of comparative advantage.
Two important points need to be made here, both linked to the principle of reciprocity. Firstly, retaliatory measures can only be imposed up to the value of the original protectionist measure. So if country X’s illegal tariffs have reduced export demand in country Y by $10 million, then country Y’s retaliatory tariffs can only reduce X’s export demand by no more than $10 million.
Secondly, retaliation must be kept within the same WTO agreement. For example, if country X’s illegal tariffs are on manufactured goods (i.e. breaking the GATT agreement), then country Y’s retaliatory tariffs must also be on manufactured goods. Y cannot impose tariffs on services, as this is covered by the GATS agreement. By insisting on these two conditions, the WTO ensures that retaliation remains ‘fair and proportional’, and is therefore seen by the international community as a legitimate response to protectionism.
A good example of retaliation can be seen in the steel tariffs case. Here, the US government failed to remove its illegal tariffs on imports of steel from the European Union, despite losing its case at the WTO. The WTO then authorised the EU to impose $2.2 billion worth of retaliatory tariffs against a range of goods imported from the US. Consequently, the US government agreed to abolish its steel tariffs.
In this case, retaliation was seen as a powerful enforcement mechanism. Indeed if there was no risk of retaliation, the US may have felt confident enough to impose even more illegal tariffs, to see what it could get away with.
However, there is a major downside. If the original country decides to retaliate even further by stepping up its illegal tariffs, this may spark a trade war and mass protectionism. Admittedly, the likelihood of this happening is quite rare, so long as retaliatory measures remain ‘fair and proportional’, as above. However, if it does happen comparative advantage will no longer form the basis for trade, thus resources will be used inefficiently. And the consequence will be a fall in total world output, which undermines global living standards.
When the two countries involved in a trade dispute are of equal bargaining power (e.g. the US and the EU), retaliation can be very effective. However, when retaliatory measures are taken by economically weak countries against stronger ones, they can often be ineffective and therefore ignored.
In such a case, the WTO may authorise cross-retaliation. This is where a small country, which has been hit by illegal tariffs / quotas from a large country, is allowed to impose protectionist measures and to suspend its obligations under more than one WTO agreement. The aim is to threaten to inflict enough economic damage on the offending country that it will have an incentive to remove its illegal measures, despite the unequal bargaining power.
A good example of cross-retaliation can be seen in the US/Ecuador-EU banana case. Here, the European Union imposed tariffs and quotas on banana imports from Ecuador, to allow more bananas to be imported from its former colonies in Africa and the Caribbean. The WTO ruled that these tariffs and quotas against Latin American bananas were illegal, yet the EU failed to remove them.
For Ecuador to impose retaliatory tariffs on European goods would be pointless, as it is a very small and insignificant export destination for EU goods. Hence the WTO allowed Ecuador to cross-retaliate and to suspend its obligations under the TRIPS Agreement too. In other words, Ecuador was no longer required to protect the copyrights, trademarks or patents of EU firms.
The impact could have been catastrophic, with counterfeit goods produced legally in Ecuador, finding their way into other world markets, particularly the highly lucrative US market. Not surprisingly, the EU agreed to bring its illegal banana tariffs and quotas to an end, hence no suspension of the TRIPS Agreement was necessary.
However, despite such legal wrangling in these very few instances, it must be noted that in the vast majority of cases member states do voluntarily comply with WTO rulings. Indeed losing parties realise that their failure to recognise the organisation’s legitimacy may result in a weakened system that is unable to effectively regulate trade – much to their own and everyone else’s detriment.
One good, though by no means unique example of voluntary compliance can be seen in the Costa Rica-US underwear quotas case. Here, the world’s most powerful economy willingly complied with a WTO ruling to remove import restrictions on underwear from one of its small neighbours, despite the huge disparity in economic power between the two countries. As with the majority of trade disputes, there was no question of the US ignoring the WTO decision. Accordingly, we see voluntary compliance as the norm and cases of retaliation / cross-retaliation as the rare exception, though of course it remains vital for the continued viability of the world trading system that such exceptional measures stay on the list of possible remedies, and that the WTO is willing and able to use them when needed.
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