The Greek crisis debate has centered on the implications of a sovereign default and the chances for a “new drachma” to pull the Greek economy out of the recession. Less has been said about the banking sector, a local front that often plays a decisive role in the development of debt and currency crises. What would happen to local banks if, as expected, the combined threat of a default cum euro exit persists? Can the incipient bank run precipitate an involuntary resolution of the crisis before euro zone members agree on a deliberate one?
The analogies between Greece and Argentina and Uruguay in the early 2000s are useful to illustrate how debt, currency, and banking crises often feed into each other. The intuition behind this vicious circle is simple. On the asset side, dollarized banks hold hard currency loans and sovereign debt, both of which tend to collapse in market value as credit and currency risks mount. On the liability side, dollarized savers first convert their claims to hard currency deposits inside the banks but, once the decline of banks’ asset value (and the fact that hard currency deposits are an imperfect substitute for dollar bills) becomes apparent, they convert them into hard currency bills outside the banks (or at least try to), leading to a bank run. As a result, contingent sovereign debt increases with expectations of a bank bailout funded by the government, and exchange rate pressure deepens with the run to hard currencies, further worsening credit and currency risks.
A close up on the 2001-2002 triplet (debt, currency, and bank) crises in Argentina and Uruguay reveals four stylized facts that shed some light on current and future developments in Greece:
- Macroeconomic risk matters more than bank fundamentals. In a context of growing systemic risk, contagion across banks is inevitable. As a result, once the run is underway, selective central bank assistance and restrictions on cash withdrawals (such as the ones imposed in Argentina in November 2001) are ineffective.
- Hard currency deposits are no remedy for currency risk. Dollar (or euro) deposits can contain depreciation expectations for a while, but ultimately the realization that banks face exchange rate-challenged banks (exposed to currency mismatched dollar debtors with impaired capacity to pay) should highlight the difference between dollars in the bank and dollars in the pocket, triggering a run on dollar deposits as well.
- Liquidity spills over borders. For example, the “good contagion” from the flight of Argentine depositors to the “safer” Uruguayan banks quickly turned into “bad contagion” once the “corralito” (a temporary suspension of deposit convertibility) in Argentina in November 2001 forced them to withdraw to their offshore deposits, ultimately leading to a triplet crisis also in Uruguay.
- Depositors run faster than bondholders. Trivially, deposits are on average much shorter than the average bond. As a result, while the run may be rooted in a debt sustainability problem, it is the bank run that often accelerates the proceedings. It was the “corralito” that brought people to the streets in Argentina in November 2001 (and brought the government down shortly thereafter). And the bank run preceded –and, to a large extent, triggered– the currency and debt crisis in Uruguay 2002.
Figure 1 and 2 illustrate this two-step run in Argentina 2001 –and how its benign effect on neighboring Uruguay, one of the places of choice for the offshoring of local dollarized savings under threat, reverted right after the gates were dropped at Argentine banks.
Source: Banco Central de la República Argentina (BCRA) and Banco Central del Uruguay (BCU).
Note: The increase observed in Argentina’s deposits in Jan 2002 is due to the forced conversion of dollar deposits at an exchange rate of 1.40 pesos. Sources: Banco Central de la República Argentina (BCRA) and Banco Central de Uruguay (BCU).
A look at the Greek bank data suggests that the hard currency argument (the fact that introducing a new drachma is considerably more complicated and costly –hence, less likely– than the floating of the Argentine peso in 2002) is weakening rapidly. The logic is simple: in the absence of a regional bailout, even if the euro is not abandoned, the “internal depreciation” needed to restore the external and fiscal balances could render much of the economy insolvent –and its financial obligations (including bank deposits) worthless. If so, the good contagion to the Cyprus´ banking sectors (Figure 3) can be easily reverted if the Greek run deepens and a deposit freeze in Greece becomes inevitable.
Source: Central Bank of Greece and Central Bank of Cyprus.
Trivially, the current debate about how to deal with the currency-growth-debt trap that crippled Greece and is now threatening other indebted euro members cannot ignore how alternative strategies would affect a banking sector that, if distressed, could amplify an already massive problem. A bank run followed by deposit freeze is not the only possible outcome: while it would be almost inevitable after a default or a euro exit, it could be easily avoided by a regional bailout by euro member states –in a move towards a fiscal union that many see as a precondition for the long-run success of the euro.
However, the time dimension should not be understated. A protracted deliberation in Brussels should continue to stress depositors in Athens. And, as depositors flee in anticipation, a generalized bank run and the inescapable freeze on bank deposits may deepen the recession and fuel civil unrest, derailing current adjustment efforts. Ultimately, a unilateral default may end up being the unintended result of procrastination.