As the Euro crisis flares up again it’s helpful to take a look at some potential outcomes. As I have stated before, this is one of the most dynamic and complex problems the global economy has ever confronted. What we essentially have is a single currency union that was never really finished. What I mean by that is that the Europeans essentially formed a United States of Europe, but neglected to actually unify it with full political and fiscal union in the form of one government and one treasury.
So, what we have instead is a version of what the world looked like under the gold standard – a disjointed multi-government system with one inflexible currency. The results are similar to what we witnessed with the gold standard – current account deficit nations experience inherently high debt levels and ultimately succumb to deflation pressures as there is no floating exchange rate to alleviate the disequilibrium caused by the single currency system.
One by one the current account deficit nations have succumbed to the inevitable need for foreign aid. Under the gold standard nations would just opt out. But that is not an option here (at least not yet). The core nations have made that clear. But what will be the ultimate outcome? Danske Bank published a superb piece of research that covers the potential outcomes:
Scenario 1 : Crisis Contained
We believe a scenario in which the crisis can be contained to be the most likely outcome of the European debt crisis but we should expect continued high market volatility for some time. Ambitious mechanisms have already been put in place to dampen the crisis and with the amount of political prestige that is already invested, we believe political leaders are willing to go even further to ensure a solution can be found.
The current measures are extensive and if they are increased further it is less likely that they will have to be used for e.g. Spain as bolder measures may help to restore calm in the financial markets and thus reduce the cost of sovereign debt financing on market terms for peripheral countries.
According to our estimates the current European Financial Stability Mechanism (EFSM), the European Financial Stability Facility (EFSF) and IMF measures are sufficient to cover almost all of the government financing needs of Ireland, Portugal and Spain over the next three years (Greece has its own EUR110bn package). If the EFSF is to cover Italy it would have to be increased substantially. An increase in the EFSF seems to be the most likely development and is already partly anticipated in the market.
It has also been suggested that the EFSF should be allowed to purchase government bonds in the secondary market in much the same way as the ECB does today with its Securities Market Programme (SMP), but possibly on a larger scale. Alternatively the EFSF could lend money to the countries themselves so that they can buy their own government bonds back at market prices. This manoeuvre has the advantage that it would help to reduce the countries’ nominal debt without being a default event. Finally, a reduction in the interest rate charged to countries in need of help from the EFSF has been considered. Ireland currently pays a spread of almost 300 basis points, which puts additional pressure on fiscal sustainability.
ECB governor, Jean-Claude Trichet, has been calling for an increase in “both quantity and quality”, which can be interpreted as a call from the ECB to have the EFSF increased in size and (at least partly) take over the current role of the ECB’s Securities Markets Programme. We do not believe that the current uncertainty will prevent the ECB from hiking interest rates later this year if needed.
We expect that the Eurogroup will announce a strengthening of the EFSF at their March meeting and that this will include a combination of the above measures with an increase in the total amount available and the use of EFSF funds for purchases in the secondary market as the most prominent measures.
Initially the EFSF was to expire on 30 June 2013, but with the agreement on a permanent crisis mechanism in November 2010 the existence of the facility will continue. What form it will take after this date, however, is less clear.
Continued public consolidation and structural reforms will have to be implemented before the crisis can be beaten for good. This will continue to be a central theme throughout the year.
Scenario 2: E-bonds and quasi fiscal union
Political leaders have called for a common European bond, or what is often referred to as an E-bond. In December 2010 the president of the Eurogroup, Jean-Claude Juncker, proposed the issuance of E-bonds of up to 40% of euro area GDP. The idea is that each member state would be allowed to borrow up to 40% of its GDP at low interest rates through an AAA rated E-bond market. To achieve an AAA rating the best performing countries will have to guarantee for part of the less well performing countries debt. Debt above 40% of GDP would have to be issued by the member states themselves at an expected higher interest rate. This structure should give the member states an incentive to consolidate and ensure sound public finances. Furthermore, the E-bond market depth and wide basis would be similar to that of US public debt, ensuring better access to capital for the minor countries despite their economic difficulties.
The proposal has so far been rejected by Germany, indicating that an enlargement of the EFSF is probably more likely. German Chancellor Angela Merkel is concerned about moral hazards and has said that: “We must not make the mistake of thinking that collectivising risk is the answer”. To avoid moral hazard problems an E-bond would have to be supplemented by a more coordinated fiscal policy and further central supervision from EU authorities. The introduction of E-bonds could thus lead to the “quasi” fiscal union that Trichet has been calling for. Japan has said that it would like to purchase 20% of the issued E-bonds and more importantly, it did not say anything about potential purchases of any of the PIIGS sovereign debt.
Scenario 3 : Default or euro break-up
If overall sentiment starts changing and the political will vanishes in either the peripheral countries or the core this could trigger sovereign defaults. The defining event could be if Italy needs help, but it could also simply be a change in power following deterioration in the general support to further belt-tightening in periphery countries and/or an increase in resistance to further financial support in core countries. Another option that has been mentioned is an actual break-up of the EMU where all member states leave the euro.
We see the probability of a euro break-up as very low. However, it may still be worth considering some scenarios of how it could take place. There exist different default and break-up scenarios that vary in terms of how serious an impact they would have on the financial system and economic growth. Common to all of these is that we do not exactly know how they would look as we are entering unchartered waters.
1. The mildest version would be that one, or maybe a few of the periphery countries default on their debt resulting in a debt restructuring. The candidates most in danger of this are Greece, Ireland and Portugal in descending order. It is less clear how this technically would be done. However, this does not automatically mean that they would have to leave the EMU, just as nobody expects Florida to leave the US should it default.
A sovereign debt restructuring within the euro area is not necessarily a “quick fix”. If , for example, Greek sovereign debt is restructured this would result in losses for German and French banks among others, but more importantly it would also result in renewed fears about which other countries could decide to restructure with both Italy and Belgium being likely candidates for speculative attacks. The country that defaults would also have to be prepared for a period with limited access to financial markets and the default option thus appears most attractive for a high-debt country that isn’t far from having a balanced primary budget. A debt restructuring also does not help the country to improve its competitiveness due to the common currency.
Alternatively a periphery country may decide to leave the EMU if it deems it too tough to get the economy out of the doldrums without being able to devalue and regain some competitiveness this way or if internal public opposition becomes too strong. This is likely to initially cause a bank run in the respective country due to fear of losses on deposits relative to banks in the core euro area. A capital flight from assets likely to be redenominated should also be expected. The risk of redenomination of the government debt (from the euro to e.g. the drachma in the hypothetical case of a Greek exit) and expectations of currency depreciation will result in higher sovereign spreads. But if the government decides not to re-denominate, the debt to GDP ratio will increase, which would put further pressure on fiscal sustainability. It is likely that confidence in the new currency would be so low that the country could see “dollarization” with euros to be used in parallel to, or instead of, the reintroduced domestic currency.
A way to go would be to undertake an initial depreciation/devaluation followed by a peg to, for instance, the euro at a much lower level. If the country doesn’t peg the currency but instead allows it to depreciate further, increasing inflation from imported goods could result in a vicious cycle with increasing inflation and inflation expectations. To defend the peg, sound public finances have to be combined with high official interest rates until confidence in the currency is restored. Confidence in a peg may take years to establish as Denmark experienced after it pegged the currency in 1982 and stopped with occasional devaluations in 1986. It was not until 1991 that the 10-year sovereign spread to Germany tightened to below 1%.
The implications for financial markets and the global economy of periphery countries leaving the euro area would depend on the fragility of the financial system at the time. Concerns about which other euro area countries may leave could result in a prolonged period of high volatility and a continuation of the debt crisis.
We believe that this scenario has a very small likelihood of materialising as the economic cost seems to outweigh the economic benefits – at least in the short term. However, in the end the decision really depends on public opinion and political leadership. The scenario can thus not be fully ruled out.
2. Germany leaving the euro. This scenario is very unlikely in our view. But it cannot be completely ruled out if, for example, public opinion against financial support for the periphery countries increases significantly, e.g. if a “tea-party movement” demands that Germany leaves the euro. It could also be triggered by the German constitutional court saying that politicians have gone too far and breached the no bail-out clause. We doubt that the court would do more than issue a warning not to go further though. In any case an objection from the constitutional court does not imply that Germany would have to leave the euro.
If Germany were to leave the euro zone, the D-mark is likely to be in high demand from day one and would be expected to appreciate. There would not be any bank runs or capital flight in Germany. However, bank runs could occur in the peripherals as the euro is likely to depreciate relative to the D-mark. Germany would, however, lose competitiveness. The flipside of the coin is that the euro zone would benefit from a much needed increase in competiveness as the euro depreciates. If Germany decides not to denominate its debt it would benefit from a decline in the debt-to-GDP ratio. On the other hand German banks and other investors could face substantial losses on their holdings in the rest of the euro area.
Another uncertainty in this scenario is whether other countries would follow Germany. This uncertainly could prevail for quite some time resulting in higher sovereign spreads and volatility in FX markets. In this scenario there are good arguments for Finland and the Netherlands to consider leaving too. But then we could see a monetary union continuation, with France taking the lead role. We believe that this scenario has a small likelihood of occurring. The costs for Germany of solving the current problems within the EMU are probably smaller than the costs of leaving and the political will invested in the project clearly weighs against this scenario. But if Italy needs help this could be a game
3. The worst-case scenario is a total breakup of the EMU. This could happen by mutual agreement or as a resulting domino effect if Germany decides to leave. It is likely that some of the core countries would peg their currency to the D-mark. German banks could experience severe losses due to currency depreciation on its holdings as well as potential defaults. A period of wide sovereign spreads and high volatility in the foreign exchange market would be expected. Devaluations and expectation of further depreciation could also result in a period of high inflation in a number of countries. The national central banks would have to set policy rates high to gain credibility.
A break-up of the euro would affect the global economy, which is one of the reasons we see both China and Japan as willing to invest in funding for the most indebted countries. The turmoil and uncertainty could lead to severe losses in the financial sector that would impact the real economy, as we experienced it during the financial crisis. In contrast a scenario with a debt restructuring in Greece and maybe even Ireland would only have minor impact on the global economy as long as other member states can maintain their credibility. Since we believe a break-up is very unlikely we are not particularly worried about the impact of the debt crisis on the outlook for the global economy.
In any of the default/break-up scenarios, risk premia could be expected go up for some time. This would result in increases in swap spreads and an overall increase in credit spreads, as the current collateralisation and expectations to future collateralisation disappear.
Like Danske, I see the break-up scenario as unlikely, however, the environment is so fluid and unpredictable that it can’t be entirely discounted. For now it appears as though we are heading towards a larger bailout mechanism and as the crisis continues to flare up the need for fiscal unity will become increasing;y necessary. At this point I think the Europeans are too invested in the Euro to risk its collapse and that means they must move in the direction of unity. As I said earlier there is only one direction going forward and the key investment takeaway remains clear:
But the longer this plays out the longer we risk sinking back into recession. Austerity has already proven a failure for these nations. And an already disgruntled citizenry is unlikely to accept imposed depression for long. The risk in this environment is that Europe does not move quickly towards greater unification. The hope is that Europe can muddle through and eventually piece together some semblance of a working monetary system. But the risks remain enormous.
Revolts would be the likely worst case scenario in the region. While I see the odds of a full blown revolt in one of these nations as relatively low we cannot entirely discount it. But one thing is certain by this point – there is no middle ground. Europe must either move towards a more unified region (US of E) or they must allow some form of debt restructuring and defection from the Euro. I still think the prospects of a Lehman 2.0 will drive the region closer to a United States of Europe as opposed to a complete collapse, but the muddling along is only adding to the uncertainty and increasing likelihood of unrest.
Personally, I don’t know if I have ever been more uncertain as to a particular outcome. Part of me is certain that the core will move towards greater unity (and avoid any banking system trauma), but the other part of me says that the periphery nations will wake up to the injustice that is being imposed on them. For now, the periphery appears to be willing to go along with the core’s playbook. Is that sustainable? I don’t think anyone can predict the outcome here. And while I think we’re likely to see some form of a United States of Europe (with a common tax and common bonds) in the coming decades I think it’s unwise to entirely discount the potential of a defection and the fallout that would ensue.
While there is much uncertainty regarding the potential outcome I believe the biggest takeaway from all of this is crystal clear – there are better regions of the world in which to invest your money.
Source: Danske Bank