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EUROPE’S WORST CASE SCENARIO

I can’t even believe I am re-posting this, but given today’s events with discussions of a two tier Euro and Jurgen Stark’s explicit comments about Germany’s (or the ECB’s) refusal to become the lender of last resort, we have to very seriously consider the Euro break-up option. I posted this piece earlier in the year. Danske Bank provides a nice overview of the worst case scenario (see here for more):

“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
changer.

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.”

Source: Danske Bank

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