|May 16, 2012|
Previously published on May 2012
The Eurozone financial crisis enjoyed a brief respite from mid-March, following the conclusion of Greece's sovereign debt restructuring and the release of substantial funding as part of the bailout organised by Eurozone governments through the European Financial Stability Facility and the International Monetary Fund. Unfortunately, following this short period of relative calm, recent political developments have provided a new impetus to the crisis.
As is well known, the price of the bailout package was the implementation of stringent austerity measures in the Greek budget. These were passed by the Greek Parliament in February, although the presence of riot police and the use of tear gas outside the building may have tempered any sense of optimism that might otherwise have prevailed.
Nevertheless, Greece achieved a significant success in March when it was announced that it had obtained bond-holder approval to the exchange of over 95% of its outstanding debt. This had the effect of reducing its overall indebtedness by more than 50 per cent.
These developments provided some hope that the Eurozone crisis could be contained, but events over the weekend of 6-7 May have posed significant challenges to this position.
First of all, the French Presidential elections led to a victory for M. Francois Hollande of the Socialist Party. He had campaigned on a platform for growth, thus implying an expansion in government spending that would undermine recent EU measures on that subject. In addition, Greek elections were inconclusive with anti-austerity parties making significant gains. At the time of writing, it appears likely that new elections will have to take place in early June. Spurred on by political developments in France, and an accelerating economic crisis in Spain, it may be that the anti- austerity lobby will gain further ground. As a result, there is renewed speculation that Greece may have to withdraw from the Eurozone.
It is therefore appropriate at this juncture (i) to provide an overview of the current situation, (ii) to outline the consequences of a Greek withdrawal from the Eurozone and (iii) to consider any contingency planning that may be advisable.
With these considerations in mind, the present Advisory will consider the following matters:
(a) the current Greek sovereign debt position;
(b) the bailout arrangements;
(c) the mechanics of a Eurozone withdrawal;
(d) the monetary consequences of a Eurozone withdrawal;
(e) the possibility of risk mitigation;
(f) the position of the Greek banking system;
(g) certain areas of concern for the United Kingdom as a non-Eurozone member; and
(h) what happens next?
Greece and its Sovereign Debt
On 9 March, the Ministry of Finance announced that it had received sufficient acceptances of its bond exchange offer in respect of Greek law bonds to enable it to impose a collective action clause under the terms of the recently-passed Greek Bondholder Act. As noted above, the completion of the exchange offer resulted in a very substantial reduction in Greece's overall indebtedness.
In addition, some €20 billion of foreign law bondholders also accepted the exchange offer. However, the Greek Bondholder Act could not be invoked to amend the terms of the foreign law bonds, and some €6 billion of "hold out" bonds remain in issue. Of these "hold out" bonds, it is understood that an issue of €450 million falls due for repayment on 15 May. Press reports indicate that Greece intends to meet this payment. However, it is clearly unattractive to pay "hold out" creditors and the Government has stated that the immediate decision will not be a precedent for later bond maturities in this category. The Government will therefore be confronted with a similar decision at later dates in relation to the remainder of this debt. If it does refuse to make any payment due under the "hold out" bonds, then this would clearly constitute a default under the bonds concerned, after the expiry of any contractual grace period. However, it appears that this would not amount to a cross-default into the larger body of Greek sovereign debt because the cross-default provisions in the exchange bonds refer only to those newly issued bonds and to securities issued at a later date. The "hold out" bonds would not meet these criteria and, accordingly, a default on the "hold out" bonds would not create a right of acceleration for the holders of the new bonds.
Although the restructuring arrangements have clearly reduced the overall volume of Greece's sovereign debt burden, it should be noted that these obligations are now governed by English law. The significance of this point is noted below.
The Bailout Arrangements
As noted earlier, Greece's continued access to the international bailout arrangements is contingent on its adherence to the agreed austerity plans. If fresh elections result in a government which repudiates those plans, then it is very difficult to envisage an acceptable political basis on which further international funding could be provided.
It has been widely reported that, if bailout funds are withheld, Greece will run out of money in the course of June. It would be unable to pay public sector workers, to pay pensions or to meet other obligations.
It is for this reason that many observers now see a significantly increased risk that Greece will be compelled to seek an exit from the Eurozone, whether on its own initiative or under pressure from other Member States. What would be the implications of such a move?
The Mechanics of Eurozone Withdrawal
It has frequently been stated that the EU Treaties contain no legal framework for a withdrawal from the Eurozone. This is true and, indeed, the Treaties make it clear that the process of monetary union was intended to be "irreversible" and "irrevocable".
In the face of an accelerating financial crisis, it would be impracticable to amend the Treaties in order to permit a withdrawal; the markets would not await the completion of a lengthy negotiation and ratification process. It follows that a Greek departure from the Eurozone would be unlawful in terms of the Treaties; such a departure would therefore have to rest upon a political compromise, as opposed to a sound legal basis.
It will also be appreciated that a Greek departure would have to be planned and executed with great speed and - so far as current conditions permit - under a cloak of secrecy. Greek banks have lost a significant proportion of their deposits over recent years, and this would clearly accelerate if Greece gave advance notice of its intention to depart from the single currency. It may well be necessary to announce the move over a weekend and to close the banks for a period, so that the new currency could be printed, issued and distributed. Exchange controls would have to be imposed to prevent a flight of capital. A new monetary law would have to be passed by the Greek Parliament which would (i) sanction the creation of the new currency (the "new drachma") and (ii) establish a substitution rate for obligations denominated in Euro.
The difficulty, of course, is that the Euro would continue to exist. As a result, it would be necessary to determine whether particular obligations are validly converted into the new drachma, or whether they will remain payable in Euro.
The Monetary Consequences of a Eurozone Withdrawal
In order to illustrate the legal questions that would arise, it may be helpful to consider the impact of the currency substitution on various categories of obligations.
When the vast majority of Greek sovereign debt was governed by Greek law, it would have been open to Greece to introduce new legislation that would have redenominated its debt into the new drachma. It could also have extended the maturity date and otherwise amended the terms of the bonds, as illustrated by the collective action clauses introduced through the Greek Bondholder law. Since the payment obligations arose under Greek law, that legal system could also revise or modify the terms of those obligations.
As noted above, however, whilst the overall volume of sovereign debt has been significantly reduced, the price of that reduction was the acceptance of English law as the governing law of the bonds, and a corresponding submission to the jurisdiction of the English courts.
The result is that legislation passed by Greece can no longer have the effect of redenominating its sovereign debt. On the assumption that the new drachma would depreciate by a significant percentage as against the Euro, the cost to Greece of servicing its Euro debt would rise by a corresponding amount.
On the face of it, this would appear to be a significant deterrent to a Greek Eurozone exit. But it must be assumed that the sovereign bond markets will remain closed to Greece for an extended period, with the result that a further default on its external debt may now be a factor of reduced importance.
Loans and other financial obligations
Whilst the Eurozone crisis has largely been triggered by excessive levels of sovereign debt, it should be appreciated that the introduction of the new drachma would have much wider implications.
In transactions involving commercial entities and private borrowers or counterparties, it would be necessary to ask whether an obligation expressed in Euro will remain payable in that currency, or will be validly converted into the new drachma at the legally prescribed rate.
The contract concerned will not usually make provision for this scenario. If the expression "Euro" is defined, this will usually refer to the single currency of the EU Member States participating in the single currency and, even in the absence of a definition, that will clearly have been the parties' intention in any event.
So the starting presumption must be that - notwithstanding the introduction of the new drachma - existing obligations contracted in the single currency would remain payable in Euro. Equally, however, the new Greek monetary law must have some effect, and a certain balancing act may therefore be required. It is thought that the following principles should be applied:
(a) where the contract is governed by an external legal system, such as English law, it will be necessary to determine whether the parties intended to contract by reference to (i) European monetary law or (ii) the Greek monetary system. In the first case, the obligation would remain payable in Euro, whilst in the latter case it would be converted into new drachma at the substitution rate prescribed by the new Greek monetary law;
(b) of course, the difficulty with this formulation is that the parties will not have given any consideration to the appropriate system of monetary law. They will have contracted by reference to the Euro as a unified currency. It would therefore be necessary to infer the parties' intentions from the surrounding circumstances;
(c) thus, for example, if a Greek company has borrowed Euro from a bank based in London under an agreement governed by English law, it will be clear that the company has raised Euro through access to the international financial markets, with the consequence that the Euro would remain the currency of obligation;
(d) on the other hand, loans made by Greek banks to assist local borrowers to acquire homes within Greece would clearly be focussed on that country with the result that the parties have contracted by reference to Greek monetary law. The mortgage debt would accordingly be converted into new drachma at the prescribed substitution rate. This will be especially difficult for the lender to the extent that it has funded its operations through borrowings from external institutions, since the depreciation of the new drachma would mean that the face amount of the asset is worth less than the face amount of the corresponding liability;
(e) by the same token, a deposit held with the Athens branch of a bank will generally be governed by Greek law and the parties will have contracted by reference to the monetary law of Greece. Retail bank deposits of this kind would therefore be converted into new drachma at the prescribed substitution rate. It is for this reason that, as noted above, Greek banks have suffered an outflow of Euro deposits to institutions in other Member States; and
(f) in some respects, the answer to the redenomination question may vary according to the forum in which it is asked. In a number of cases the Greek courts may be obliged to give effect to the new drachma substitution regardless of the intention of the parties, because the new Greek monetary law will form a part of the domestic legal system binding on the court. However, this consideration will not apply to courts sitting outside Greece and those tribunals would look solely to the governing law of the contract and the implied intention of the parties. A creditor who finds himself obliged to litigate within Greece itself is thus more likely to have to accept a judgment expressed in new drachma.
Continuity of Contracts
At a wider level, it is necessary to consider whether a Greek withdrawal from the Eurozone might have more fundamental consequences and affect the continued validity of contracts?
As a general rule, contracts will remain effective until they have been performed or have otherwise been terminated in accordance with the terms of the agreement.
Whilst contracts may also be terminated by doctrines such as frustration or commercial impossibility, these rules will only apply where a supervening event renders the performance of the contract radically different from that originally contemplated by the parties. The mere fact that performance becomes more expensive as a result of the creation of the new drachma is not a factor that will generally lead to the termination of the contract under this type of doctrine. So, whilst there may be a dispute as to the currency of payment, the contract itself will remain intrinsically valid.
Some contracts may contain a force majeure clause and one of the parties may seek to invoke this provision in order to avoid his obligations on the basis of the Greek exit. Whether or not he can do so will naturally depend upon the precise language employed in the clause. As a general rule, however, such clauses can only operate in the case of a natural disaster, a major infrastructure failure or certain political events (such as war, terrorism or civil disturbance). It is thus unlikely that a Greek withdrawal from the Eurozone will of itself give rise to the activation of this type of clause.
What can be done to mitigate the risk?
In a situation of this kind, financial institutions and other commercial enterprises will naturally be looking to manage the risks that may flow from a Eurozone departure.
In the face of a crisis, options naturally tend to be limited and there are no perfect solutions. But a few points may deserve consideration:
(a) so far as possible, new contracts should be negotiated on the basis that they will be governed by a system of law that is external to the Member States perceived to be at risk of a Eurozone departure and should include an explicit submission to the jurisdiction of the courts concerned. This will minimise the risk that the creditor would have to accept payment in the new drachma or the substitute currency of any other departing Member State;
(b) for the same reasons, contracts should (i) include a definition of "Euro" that clearly embraces the single currency of the continuing Eurozone Member States and (ii) provide for a place of payment outside the "at risk" Member States;
(c) existing funding arrangements should be reviewed to determine whether there are grounds for terminating the commitment and/or making a demand for repayment (e.g., on the basis of a "material adverse change" clause);
(d) to the probably limited extent to which is may be feasible, lenders should seek to match-fund assets in an "at risk" Member State with borrowings in the same country, so that assets and matching liabilities would convert into the new currency on the same basis. Even then, however, the arrangements would have to be carefully documented;
(e) it may be possible to renegotiate contracts with counterparties in the "at risk" Member States to include specific confirmation that their obligations will remain payable in Euro notwithstanding a local currency redenomination; and
(f) financial institutions will also need to consider '"secondary exposures". For example, where they have provided loans to travel companies or others doing business with an "at risk" Member State, they may need to consider the extent to which the borrower is itself exposed to currency redenomination risk in the context of its own commercial arrangements.
The Greek Banking System
The consequences of a Eurozone withdrawal for the Greek banking system would also be extremely serious. As is well known, the European Central Bank has conducted extensive monetary policy operations which have had the effect of providing liquidity support to the Greek banking sector. It is difficult to see any basis on which this could be continued following a Greek exit from the Eurozone, yet the withdrawal of that support would clearly lead to the insolvency of the banking sector.
As has always been the case, one of the chief fears about the Greek situation has been the risk of contagion to other Eurozone countries such as Portugal and Spain. At one level, the risk of contagion may be reduced or contained by EU/IMF support arrangements, in the sense that it may be possible to contain a sovereign debt crisis in those countries. But again, difficulties may arise at the retail, rather than the sovereign level. Depositors in banks in the other "at risk" Eurozone countries might elect to move their funds to Germany or other "safe" Member States with a view to avoiding the redenomination of their money into a new national currency. Such a process would only be accelerated as the consequences of a Greek withdrawal became apparent.
Whilst the current crisis thus has its roots in excessive levels of sovereign debt, the danger that individual Member States may depart from the Eurozone thus has the effect of exacerbating the associated difficulties within the banking and financial system.
The United Kingdom
The UK is a Member State of the European Union but is not a member of the Eurozone. Whilst it is obviously and seriously affect by the Eurozone crisis because of its close trade links, the UK has consistently taken the position that the costs of resolving the crisis should be borne by the Eurozone alone.
But there is scope for a dispute between the UK and its EU partners in this area. If Greece leaves the Eurozone but remains a member of the European Union, then - even though the "bailout" funds would cease to be available - it would remain entitled to apply for EU financial assistance at a more general level. For example, Article 122(2) of the Treaty on the Functioning of the European Union provides that "... Where a Member State is in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control, the Council on a proposal from the Commission, may grant, under certain conditions, Union financial assistance to the Member State concerned ...".
This provision was invoked as the basis for the creation of the European Financial Stabilisation Mechanism in 2010 and it is conceivable that it might again be used to assist Greece following its withdrawal from the Eurozone. The British Government would no doubt see this as part of the cost of resolving Eurozone issues and there would be significant resistance to a UK contribution via its EU membership. Consequently, the Greek crisis has the potential to exacerbate existing tensions between the UK and the Eurozone over the handling of the crisis.
Any discussion of a possible Eurozone exit has, for many years, been taboo. As noted above, it has frequently been stated that the EU Treaties contain no mechanism for a Eurozone departure, and as a consequence, no such exit can occur. This approach to the subject may have an attraction for the legal purist but it is clearly a non-sequitur. Treaties have been broken before, and they will be broken again.
At all events, this particular genie can no longer be kept in its bottle, and the prospect of a Greek departure (or, as it has been dubbed, a "Grexit") is now the subject of open discussion. There is no doubt that Greece faces a sharp dilemma. On the one hand, polls suggest that a significant majority of Greeks support their country's Euro membership and would wish to remain within the single currency zone. On the other hand, the recent election resulted in gains for anti-austerity parties.
Perhaps understandably, this situation has led to exasperation on the part of some EU Member States, whilst others are seeking to manage expectations around a Greek exit. For example, the German Foreign Minister, Guido Westerwelle, was recently quoted as stating that "..... the future of Greece in the Eurozone lies in the hands of Greece. If Greece strays from the agreed reform path, then the payment of further aid tranches will not be possible. Solidarity is not a one-way street...". On the other hand, the Governor of the Central Bank of Ireland has noted that, "... things can happen that are not imagined in the Treaties. Technically, [a Greek departure from the Eurozone] can be managed... It is not necessarily fatal, but it is not attractive ...". Equally, Jens Weidmann, President of the German Bundesbank, has observed that "...the consequences for Greece [of a departure from the Eurozone] would be more serious than for the rest of the Eurozone...".
If Greece is to remain a participant within the single currency, then it will clearly need substantial and continuing support from its partners in order to do so. Yet from a political perspective, it will be very difficult for Germany and other countries to continue to provide that support if the new Greek government repudiates the austerity package.
It is difficult to state any conclusions with real confidence, given the ongoing nature of the Eurozone financial crisis.
Nevertheless, it seems clear that the crisis has entered a new phase, with sharply increased prospects of a Greek withdrawal from the single currency.
If this process occurs and can be managed in a reasonably orderly fashion, then this may ironically have the effect of reinforcing confidence in the remainder of the Eurozone. A Rubicon will have been crossed, but it will have been crossed successfully. The knowledge that an exit can be managed as part of a damage limitation exercise might help to reassure the financial markets.
If on the other hand, the process is seen to be disorderly, then the risk of contagion to the other peripheral Eurozone Member States must be correspondingly increased.
Financial Institutions and commercial undertakings are, of course, unable to influence these events, but they can assess their exposures and seek to manage or mitigate their risks in the manner described above.