Germany Makes Contingency Plans in Case of Greek Default

Sources:
Guardian: Greece on Verge of Default as Doubt Grows Over €8bn Bailout
NYT: German Leader Faces Key Choices on Rescuing Euro
Spiegel: Germany Plans for Possible Greek Default

This week, German Finance Minister, Wolfgang Schauble, gave Greece a loud and clear message that it needs to be more aggressive in implementing its program of spending cuts and tax increases if it wishes to avoid a default. Schauble stated that unless Greece follows through with the austerity measures, the International Monetary Fund (IMF), European Commission, and European Central Bank (ECB) may refuse to release the sixth €8 billion installment of their joint rescue package. Without the aid, Greece will not be able to make interest payments on its outstanding bonds and will, therefore, default.

In view of a possible Greek default, German officials are preparing plans to limit the resulting damage. If Greece defaults on its debts, the ECB, other European Union countries and banks, insurance companies, and financial institutions throughout Europe that have lent money to Greece will suffer large losses. The primary goal of the German plan is to protect the Eurozone from such a large disruption.

The German plan has two major aspects. First, it calls for the use of “preventive” credit lines, whereby the European Financial Stability Facility (EFSF) would loan funds to financially weak countries, such as Italy or Spain, in the even that private investors stop lending to those countries after a Greek default. Those countries would then use the money to pay their own debts to avoid defaulting themselves. The second aspect is to have someone (the details are not yet finalized as to whom) provide cash injections to banks to help cover any losses they may face. Taken together, the two instruments would protect both countries and their banking sectors from the spillover effects of the default.

Furthermore, the German plan would make it possible for Greek banks to receive aid even after creditors stop giving money to the Greek government. Without special aid, the Greek banking sector would suffer significantly if the government defaults on its debts, because the banks hold a large portion of Greece’s bonds (its debt). This if of major concern because, as the global financial crisis showed, banks are deeply interconnected across national borders. Thus, allowing Greece’s major banks to fail would risk dragging down other banks across the Eurozone, putting additional strain on an already weak region.