Risks Of Eurozone Breakup Increased
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Risks Of Eurozone Breakup Increased
The euro could be about to collapse. Despite what the politicos say, analysts are thinking this could be more likely.
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Daily Themes 9 December 2011 - Financial News -Adam & Company

Daily Themes 9 December 2011

Progress toward fiscal union, but risks of a euro break-up have increased

Euro-zone leaders finally seem ready to move closer to a fiscal union, but it has been delayed so long that the risk of a break-up in the next two years has increased significantly. A recession in the region is now a given and depending on the extent of bank deleveraging it could be severe. Many euro-zone economies are deeply uncompetitive and political risk is also high. Our main scenario remains that the euro-zone will continue to exist with all its current members, but only as long at it continues to make at least some progress towards fiscal union. Even this central scenario will involve considerable volatility for European investors.


Probability of a euro exit up since last year

In an 8 July 2010Daily Theme we highlighted our analysis suggesting that there was then a 10% probability of a euro-zone break up in the next two years. This probability increased to 30% on a 5-year horizon, with a 50% chance that member states would move closer to a fiscal union within that period instead.

Since then the euro-zone leaders have reluctantly taken steps to address the European debt crisis, but have consistently lagged market expectations and failed to reassure investors about their commitment to the continued existence of the single currency. As a result the crisis has escalated and we now see the probability of one of the euro area countries leaving the single currency in the next year or two to have increased to 20%. The longer policy-makers fail to implement fiscal union, the higher this probability will go.


Our base-case scenario for next year is that the eurozone will remain with all its current members and move towards a fiscal union. European Central Bank (ECB) intervention will be paramount to ensure that the financial system remains operational in times of financial stress. Within this broader scenario of moving closer to fiscal union, an orderly default of a euro-zone member, while remaining in the single currency, could occur.

The political cost is another parameter that should be taken into consideration. The economic integration of the European Union is a process that started after World War II and fear of the stigma that would be attached to “the politician who dismantled the euro-zone” will be a substantial deterrent.


However, we see significant threats to this base-case scenario. We expect the euro-zone to be in recession in 2012, causing fiscal plans for next year to be missed and more austerity measures to be announced. Countries whose economies are deeply uncompetitive such as Italy, Spain and many of the smaller periphery countries will be particularly severely affected. On top of that, euro-zone governments may have to change their constitutions to control government spending more tightly. Ratings agency Standard & Poor’s has already put all AAA-rated eurozone countries on negative watch for a possible downgrade. Ratings downgrades would undermine the ability of governments to finance themselves and the EFSF stability fund to raise enough money for the announced bailout packages.


An exit from the single currency that allows currency devaluation to boost exports and fight the recession may look more tempting than it did a year ago. As governments are forced into further belt-tightening, the political cost of staying in the euro will increase as voters become less willing to take on more pain. This was manifested in the Greek prime minister’s decision last month to call for a referendum. While it was subsequently scrapped, just raising the possibility of a euro exit opened up Pandora’s Box. The risk remains high that countries like Greece, which will be entering its fifth year of recession in 2012 and still has a multi-year process of fiscal adjustment ahead, may decide to leave.


European leaders have finally added the idea of fiscal integration to their agenda, but achieving it would require a change of the EU treaty and/or changes in the constitutions of each euro area country. This would probably take two to three years and require ECB intervention in the meantime to alleviate market pressures (e.g. more bond purchases to keep yields from increasing further). Severe hurdles will also have to be overcome to implement the agreed measures (e.g. efficient tax collection in Greece) that may put further political pressure and make it politically impossible to continue within the euro-zone.


Impact of EMU breakup would be substantial

Within our base-case scenario of some progress toward fiscal union the outlook for Europe and the global economy remains muted, although this would improve significantly in the best-case scenario of substantial progress toward fiscal union. But if either a peripheral or a core country decided to leave the euro, the impact on the global economy would be substantial. It would bring extreme stress on the banking sector, a massive fall in trade activity and loss of confidence in the financial system.

The three main conduits through which a crisis from a country leaving the euro could spread to the whole region and the rest of the world are the banking sector, world trade and consumer and business confidence.


Bank runs could spread among the weak European countries but also to all banks with high levels of distressed sovereign debt on their balance sheets. The financial system of the country leaving the euro would be under the threat of collapse, unless government support is provided. But this support would come with high political cost and potential rating downgrades. Central Banks would also need to step in and provide support by printing more money, further undermining weakening faith in the fiat, or paper, currency system. Claims of the country leaving the euro would have to be redenominated to the new currency causing widespread writedowns across creditors around the globe. Bank lending to the real economy would suffer. Seizure of private assets, as seen during the Argentinean default, could also occur.


Emerging markets would also likely be affected by a eurozone breakup. According to the IMF emerging markets send around 18% of their exports to the euro-zone, two percentage points above exports to the US and three times higher than exports to Japan. A euro-zone breakup would probably cause a trade collapse similar or worse than that after Lehman’s collapse in 2008.


The third channel of impact would be through the loss of confidence in the private sector. Households would likely postpone spending and corporations push back their investment plans, subtracting from already fragile global growth.


Our central scenario is still fiscal union

While the risk of a euro-zone breakup has increased, our main forecast is that the euro countries will slowly edge towards a fiscal union, supported by ECB intervention as and when market conditions deteriorate. However, a euro-zone recession now looks inevitable and there is an increased chance of a systemic crisis in Europe.


from Adam & Co financial planning


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