Euro Crisis: How currency devaluation and soaring inflation could actually help Greece if it exits the Eurozone

Currency

By on May 21st, 2012.
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Euro Crisis ExplainedIf Greece leaves, the threat of contagion among the other southern Euro states could break the 17-nation bloc.

If Greece exits the Eurozone then it will be forced to revert to a new currency. This new currency will most likely come in the form of the new Drachma and will have an initial exchange rate of 1:1 with the Euro. However this rate will not last long as investors will endeavour to price the new Drachma in line with the terrible Greek economy. Subsequently the new Drachma is expected to experience mass devaluation in a short space of time.

As the Greek Central Bank furiously print out as much money as they can and the currency devalues on the foreign exchange market, import prices are predicted to go through the roof which will cause inflation levels to soar. The price of raw materials and intermediate goods is expected to increase, which will in turn bump up the domestic cost of living for Greek citizens.

However rocketing inflation will actually help the Greek government, by reducing the real value of its mammoth debt pile. As part of the Eurozone currency union, Greece has been subject to a very strong currency – one aligned to the economic powerhouse at the centre of the bloc, namely Germany. The problem is that Greece has never been as competitive as Germany and has suffered tremendously from using an overvalued currency. This has led to Greece building up an unsustainable level of debt in a currency that it cannot devalue.

90% of Greek government debt is held under local law which allows the state to determine its own currency. This means that following a Greek exit the country should be permitted to re-denominate Euro debt contracts into the new Drachma currency. Therefore Greece will be able to pay back its heavy debt pile with new currency printed by its Central Bank – something which is currently impossible whilst Greece is a member of the Eurozone. Under these circumstances the inflationary consequences of printing money are digestible as a means to reduce the real value of Greece’s debts.

The massively devalued new Drachma should make goods exported from Greece extremely favourable to importers due to the comparatively cheap prices. Tourism, which makes up nearly 20% of the country’s GDP, should also experience a significant boost from the new ultra-low exchange rate. Therefore after a period of desperate contraction and severe economic downturn, Greece should be able to claw its way back towards growth as elevated inflation levels reduce the real value of its debt pile and rapid currency devaluations aid competitiveness in the export and tourism sectors.

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