The EUR/USD is the most generally traded currency pair, with 27% of trades in the forex market being made on this pair. Accordingly, the problem of many traders at the moment is ‘where is the euro headed?’ and, ‘what will occur when Greece defaults?’

The current situation

Greece’s situation could be worse after strict austerity measures forced by the EU-IMF rescue, its economy shrank by 7.3% in Q2 of 2011, surpassing the most gloomy forecasts of both the EU and the IMF.

Meanwhile, Greek bond yields have risen to record levels, with on three-year-bond, which was trading at Twenty p.c. in June, now trading at 172%. Bonds scheduled to be paid back in March 2012 are being priced at around about half their official value. And prices for Greek credit default swaps, which offer investors a defense against default, have more than doubled since the start of August, rising above Four thousand basis points.

Adding to the problem is the chance that Greece will not be given the following EUR8bn tranche of aid, as German finance minister Wolfgang Schauble has charged them of not abiding by the terms of the agreement. This puts Greece in the hard position where disproportionate austerity measures mean it cannot stimulate its economy so it may expand out of debt, yet not applying these measures means it does not have prepared money to pay state wages and allowances in October.

Consequently, Greece will default, the only question is when.

What will happen when Greece defaults?

Once Greece defaults, the governing body will nationalize every bank in the country, and then forbid withdrawals from Greek banks. To prevent riots among Greek depositors, the government will then enforce a curfew, and could even declare martial law.

Greece will then leave the EUR and re-denominate its debts into a new currency. This currency will devalue by 30-70% against the EUR, effectively defaulting on over fifty percent of all Greek euro-denominated obligations.

A number of French and German banks will make losses large enough to no longer satisfy capital adequacy requirements, while the ECB will become insolvent due to its high exposure to both Greek administrative and Greek banking sector debt. The French and German governments are then likely to meet to decide whether to recapitalize the ECB or to let it to print money to restore its solvency. They will then recapitalize their own banks and likely declare an end to all bailouts.

And this eventuality doesn’t consider the reaction of the other peripheral nations.

Nonetheless a Greek default might not be all bad. Of the countries that have defaulted since 1999 have not all performed as well since their defaults, the average post-default GDP rate of growth improved by about Three percent.

How will this impact the EUR?

As far as the euro is concerned a default could also be beneficial. As it would permit Greece to have a new, separate, currency that can be devalued, Greece is more likely to improve its competitiveness with favorable exchange rates. And, though there would be an instinctive sell-off of the euro and volatility over several months, the business performance of the eurozone in total would be boosted, especially if it begins to expel the weaker members. This would lead to a potential strong jump in the EUR.

Closing thoughts

Greece will default, or leave the eurozone, at some point. The Greek economy has reached the point at which it cannot recover, and Germany’s patience with the peripheral economies and the ECB is wearing thin. What is still to be seen is whether or not this is to be an ‘orderly’ default, the voluntary debt exchange agreed in July where holders of Greek debt suffer 21% losses on bonds that mature before 2020, or a ‘disorderly’ default, where Greece walks away from its liabilities without consultation.

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