Why the UK shouldn’t fear Greece quitting the euro

Last-ditch talks to create a 'national unity' government in Greece have failed. There will now be an election next month, which is expected to produce a similar deadlock. And that means Greece won't be able to agree the cuts it requires if it is to continue to get bail-out money.

For their part, both Berlin and Brussels seem fed up with Athens. Indeed, Germany's Finance Minister, Wolfgang Schaeube, has said, "If Greece wants to stay in the euro they have to accept the conditions".

A default and exit from the euro (but not the EU) would be a good idea for Greece, as we've argued before. My colleague John Stepek has also argued that a Greek exit could push central banks to print more money, which would be good for shares.

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However, where does this leave the UK? John Cridland, the head of the Confederation of British Industry (CBI), has warned it would be like "an earthquake happening in Europe". George Osborne thinks that the fear of a Greek exit is hurting the British economy, as well as the eurozone. Mervyn King has also talked of a "risk of a storm heading our way from the continent".

The markets seem to agree. The FTSE has fallen nearly 5% since before the Greek election. But just how bad would a Greek exit be?

Avoid the banks, naturally

The direct exposure of British banks to a Greek default is very low. Indeed, Capital Economics estimates that Greek debt accounts of only 0.5% of Tier 1 capital. However, they also have a large indirect exposure to Greece in two main ways.

British banks have loaned large amounts to French banks, which in turn carry large amounts of Greek debt. In other words, there is a high risk of a domino effect, where Greek default leads to French banks going under, hitting UK banks.

There is also the fear that a Greek exit could see bond yields spike in Spain, Portugal, Ireland and Italy as investors fear they could leave as well. Given that these countries are running deficits, a rise in the cost of borrowing could cause things to quickly collapse. Capital Economics believes that when these countries are taken into account, UK exposure rises to $300bn.

Yet while it's clear that a Greek exit is bad news for British banks which would have a knock-on impact on the wider economy - the direct effect on other firms is more mixed. A new drachma will fall in value against the pound, making exports to Greece more expensive. If a Greek exit forces other countries to leave, British exports to those nations could suffer similarly.

However, the countries that remained would find their currency increasing in value. This would make British exports to these nations more competitive. And since Germany, France and the Netherlands are the second, third and fourth largest destinations respectively for British goods and services, British firms might actually be net winners.

Also, the breakup of the euro would leave countries free to pursue more pro-growth policies. This would boost demand for British goods.

What if Greece stays?

It is also worth considering what happens if Greece stays. With growth expected to be sharply negative this year and next, it is clear that even if austerity continues, it will miss its deficit target. This means that another bail-out is only a matter of time.

However, public opinion in northern Europe is moving against continued support as shown by the drubbing that German chancellor AngelaMerkel's party recently received in German local elections. It is very likely that the UK will have to take part in the bail-out either directly (as in 2010) or via the International Monetary Fund (IMF).

The worst-case scenario would be for Britain to increase its contribution, only for Greece to default anyway. This happened with Argentina, where the IMF extended several loans in December 2000, only for Buenos Aires to default a year later.

In short, a Greek exit will hit the UK, especially the banking sector. If other countries follow, firms exporting to the Mediterranean could find that they are much less competitive.

However, the status quo won't work either. With Germany still opposed to European Central Bank intervention to boost the money supply, Europe is either doomed to a prolonged slump, or a wave of defaults. So claims that a Greek exit from the euro would be a disaster for Britain are over the top the fact is that neither option is particularly attractive.