The euro -Act III
September 30th, 2011
Thanos Papasavvas, Investec Asset Management Strategist for Fixed Income & Currency, discusses his central case for the euro crisis, as well as the probability of less likely alternative scenarios for the months and years ahead. Our central case is one where the euro zone remains intact and we see a gradual move towards closer fiscal union over time We think the probability of Greece defaulting/restructuring is very high in the near term, however, we believe it is most likely to be an orderly process For as long as the cost of the break-up scenarios are prohibitively expensive and outweigh the cost of keeping the single currency together, the probability of the euro surviving will be the highest There is a small window of opportunity to address the structural issues of the euro for its third and final stage of development. Policy makers and politicians should not miss it. A quick recap of the action so far: It has been nearly two years since November 2009 when the newly appointed Greek Papandreou government announced to the markets that its economic data had been misrepresented for many years, and its fiscal state of affairs was significantly worse than previous estimates. The first euro-zone financial crisis in May 2010 followed concerns of economic headwinds from fiscal tightening across the euro zone alongside a downturn in economic data. Greece was bailed out and the European Central Bank (ECB) was persuaded to intervene to stabilise markets until finance ministers across the euro zone were able to address the fiscal concerns. After a year of politicians and policy makers „kicking the can down the road‟ and orchestrating bailouts for Ireland and Portugal, the second crisis took place in May 2011 with a further bailout plan for Greece. After two crises, the first proactive move by the euro-zone policy makers and politicians was the 21 July 2011 agreement which improved financing terms and extended the scope of Europe‟s bail-out funds: the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM). These latter measures are being voted on by the national parliaments over the next couple of weeks. Where does the euro project go from here? Will Greece default? If so is it also likely to leave the euro zone and will other countries follow suit? If not are we heading towards closer fiscal union? Let us try to answer all the above questions and come up with a central case outlook as well as alternative plausible scenarios. Will Greece default? We think that the probability of Greece defaulting/restructuring is very high. However, we believe it is most likely to be an orderly process and unlikely to occur before the 17 euro-zone nations have voted through the 21 July agreements which include the new EFSF measures. Assuming that these measures are voted through the national parliaments, we expect policy makers to move ahead with an eventual restructuring for Greece, the recapitalisation of banks and, last but not least, a „ring-fence‟ around the remaining nations. As to how we proceed from here to deal with these short term issues, there are a number of options being considered at the G20 and Finance Ministerial level. These vary from the issuance of eurobonds, which would raise concerns with the Constitutional Court of Germany in Karlsruhe; leveraging the EFSF which may be another issue for German parliamentarians but also threaten its AAA rating, or set up a separate leveraged vehicle which the EFSF can invest through. Furthermore, individual states could unilaterally capitalise their domestic institutions as well as assist in the recapitalisation of the ECB. We think that a credible plan with a big enough „stick‟ similar to the recent intervention tactics of the Swiss National Bank could succeed in containing the crisis in the near term until the longer term plans for the next stage of the euro are drawn up. Last but not least, there is the IMF, which is a willing partner alongside President Obama, whose re-election prospects next year rely very much on a resolution of this euro-zone crisis. So, how likely is the national approval of the 21 July agreements? Today (29 September) saw the Bundestag vote in favour of the 21 July measures as was widely expected. The vote also passed with a “Chancellor‟s majority” therefore not requiring the assistance of the opposition SPD and Green parties. As for concerns on any smaller member states revolting against the agreements, we would expect to see concerted pressure from EU as well as global leaders to ensure that the process is not derailed at this critical stage. Hence, we would expect the 21 July agreements to be passed through the national parliaments over the next month. When could Greece default? Technically there are no payments which would trigger a default until December. So, with no immediate market pressure, the Troika (ECB, European Council and IMF) has been maintaining a tough negotiating stance for the Greek government to pass through further austerity measures before they consider whether to hand over the next tranche of funding. The only time constraint here is not the immediate risk of a default by Greece, but the state running out of cash by late October. Our expectation is for Greece to receive this current tranche from the Troika, buying policy makers and politicians time to put in place the various measures to contain the eventual consequences of an orderly Greek default. As to when this is likely to occur, we place the highest probability for early next year as Greece finds it difficult to meet the criteria for the next bailout instalment in January 2012. Will Greece leave the euro? We do not believe that Greece will leave the euro at this stage of the euro project. However, the probability has increased over the past six months and would become much more likely should Greece go down the route of a disorderly default. An exit of Greece from the euro zone, especially in a disorderly manner, would be negative for both the euro zone and for Greece. For the euro zone it would be negative because it would create a schism by setting a precedent of a country exiting the single currency and hence opening the room for further speculation over who will be the next one to be „pushed over the edge‟. For Greece it would be negative for two key reasons. The first is the well-known downside of a sudden debt restructuring accompanied by significant currency depreciation: loss of access to financial markets for a number of years and a dramatic loss of domestic purchasing power as import prices soar. The second is more crucial, however. If Greece leaves the euro zone it will have no incentive to address all the structural problems which brought it here in the first place: a bloated civil service, an ineffective tax collection system, corruption and political bickering. The passage of time can help deal with the former, but not with the latter. The latest poll in Greece seems to confirm our reasoning. Despite the draconian measures being taken, the latest poll conducted between 14-19 September by Kathimerini (a broadsheet newspaper) shows 63% of Greeks have a „positive‟ opinion of the euro and 66% say that re-adoption of the drachma would be a negative development for the country. These are similar percentages to a survey conducted in April 2011. Considering that these polls were taken amidst a period of crisis for the Greek economy and society with an element of frustration and resentment, this suggests that any potential referendum on the exit of Greece from the euro would receive very limited support. Will the euro survive? Our central case is one where the euro zone remains intact (albeit with a probable default/restructuring in Greece) and the members gradually move towards closer fiscal union leading to a confederation of sovereign states. This scenario is consistent with the conclusion in our Viewpoint published in February 2011: “The Germans are currently under pressure to accept the suggested increase in the EFSF but are understandably pushing against a mechanism for greater fiscal transfers and more centralised bond issuance. Germany‟s longer term concerns over moral hazard are valid. Who can ensure that the same or other member states will not repeat the mistakes of the past, or who can guarantee to the German public that they won‟t have to subsidise the union again in 15 or 20 years time after the next financial crisis? In our view the moral hazard should be addressed over the medium term by introducing a blueprint for profligate nations to exit the union through an orderly and transparent process. Once a process for orderly exit has been agreed and set out, not only it will act as a deterrent to economic mismanagement, but more importantly it will make it acceptable for politicians and the public at large to accept a more integrated fiscal transfer mechanism. This in turn should be the final catalyst for taking the euro off the critical list in the eyes of the market.” Furthermore, recent thinking from EU policy makers and politicians seem to be echoing our thoughts expressed in February. ECB President, M Trichet in June, the Dutch Prime Minister and Finance Minister in September as well as the recent ECB policy papers, all discuss the benefits of a move towards „fiscal confederation‟: “An interim European Budget Office which over time may potentially form the nucleus of what could become over time and in a step-wise manner a European Ministry of Finance.” ECB paper No.129 However. there are a number of alternative scenarios we can outline in addition to our central case: Scenario 2.A group of core countries such as Germany, Austria, Holland and Finland decide to leave the Euro and form their own new currency with the rest maintaining the euro Scenario 3.A number of the weaker peripheral countries exit the euro, going back to their own national currencies whilst the core maintain the current euro as a currency Scenario 4.A total breakup of the single currency with all nations returning to their respective local currencies Let us consider the arguably impossible task of setting some probabilities around the various scenarios outlined above. The probability of our central scenario of an orderly default taking place will hold if Greece does not exit the euro. In fact, it is more likely for nations to pursue closer fiscal consolidation if Greece is left to default as it deals with the moral hazard concerns of closer cooperation. We therefore pose a 75% probability for a move towards closer fiscal union. The probabilities of Scenarios 2 and 3 are similar. We place a combined 20% probability of either the peripheral nations being „pushed‟ out or for a group of core nations deciding to exit and form their own currency union. For as long as the cost of the break-up scenarios are prohibitively expensive and outweigh the cost of keeping the single currency together, the probability of the euro surviving will be the highest. Apart from the social and political consequences of such a move, UBS has had a first attempt in quantifying the costs of a potential breakup of the euro. They state that if Germany were to leave the euro zone, the cost is expected to be around €6,000 to €8,000 for every German adult and child in the first year and a range €3,500 to €4,500 per person per year thereafter. That is equivalent to 20-25% of GDP in the first year. In comparison, the cost of bailing out Greece, Ireland and Portugal entirely in the wake of the default of those countries with an estimated haircut of 50%, would be little over €1,000 per person, in a single hit. As for the scenario for a weak country deciding to leave the euro, it would incur a cost of around €9,500 to €11,500 per person in the exiting country during the first year, with €3,000 to €4,000 per person costs over subsequent years which equates to a range of 40-50% of GDP in the first year. Finally, we place a 5% probability on Scenario 4 of a total break-up with all member states reverting to their national currencies. This would not only be prohibitively expensive for Europe and the world en large, but more importantly would be going against the grain of historical and political ideology which has been part of Europe since World War II. Equally important, only a unified Europe can compete economically and impact geopolitical developments in the World stage of tomorrow. Conclusion “A crisis is a terrible thing to waste” and so similar to the ERM crisis in 1992 which was the trigger for accelerating the path towards a single currency by 1999, this current crisis could be the trigger for accelerating the single currency towards fiscal confederation. This would require changes to the Treaty which alongside a closer fiscal union would also have a new strategy for the clear and orderly exit of profligate nations which do not wish to abide by the rules of „the Club‟. This would take away the moral hazard which the Germans rightly worry about and allow for a future Finance Ministry to be set up with supervisory powers over the 17 nations. The aim would not be for all member states to have the same tax rates, but for all member states to abide to prudent fiscal management. Once the architecture has been built on such sound foundations of monetary and fiscal prudence, then the eventual departure of weak member states would not threaten the existence of the single currency project as they do today. For as long as the cost of the break-up scenarios are prohibitively expensive and outweigh the cost of keeping the single currency together, the probability of the euro surviving will be the highest. There is a small window of opportunity to address the structural issues of the euro for its third and final stage of development. Policy makers and politicians should not miss it.