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21-08-2011, 10:49 PM
When Europe crisis started a year back, I highlighted Greece would not be the major contributor to a Europe turmoil but Spain would be.
Never had I thought that a year later, Italy would join in the fun.
CDS spread between Germany vis a viz Spain & Italy has been rising considerably, till ECB comes in with their QE. But its still high.
How much investors/speculators sentiment would swing would depend how much ECB could come in with their big guns blazing.
In my personal opinion, Eurobonds is out of question. The Germans, though benefitted from a depreciated Euro for their exports than having their sovereign Destuschemark, would find it hard to swallow by paying the debts of every single southern European cousin who comes in saying: "May I have one more?"
Never had I thought that a year later, Italy would join in the fun.
CDS spread between Germany vis a viz Spain & Italy has been rising considerably, till ECB comes in with their QE. But its still high.
How much investors/speculators sentiment would swing would depend how much ECB could come in with their big guns blazing.
In my personal opinion, Eurobonds is out of question. The Germans, though benefitted from a depreciated Euro for their exports than having their sovereign Destuschemark, would find it hard to swallow by paying the debts of every single southern European cousin who comes in saying: "May I have one more?"
Introduction
The economic crisis has exposed serious weaknesses in the euro zone and the resultant strains could lead to its break-up - a key break-point would be if Italy required a bail-out. This scenario envisages either highly indebted peripheral countries breaking off to leave a north European euro zone core, or Germany deciding to leave, which would spell the end for the single currency.
Analysis
The economic crisis has exposed deep flaws in the euro zone. The bloc's fiscal rules were routinely flouted, notably by Greece, while a rapid expansion of private-sector debt in some countries created potentially huge contingent liabilities for governments. Less profligate members now face the prospect of having to backstop these debts to avoid destabilising contagion. In addition, many members of the bloc, notably southern European countries, have experienced a damaging loss of competitiveness that within the single currency can only be addressed by a painful and protracted period of "internal devaluation" - including cuts in wage costs and usually entailing a recession. Bailouts for Greece, Ireland and Portugal and other stabilisation mechanisms established thus far do not fundamentally address either the underlying solvency or competitiveness issues of the weaker members.
Contagion has now spread to Spanish and Italian bond yields. We do not expect these counties to need bail-outs, but the risk is considerable. The size of the Spanish economy means that the need to support Spain would present a particular risk to euro zone stability. Similarly, Italy should be able to avoid a need to request support, but strains in the governing coalition over austerity pose risks.
The 17 euro zone heads of government agreed in March that the EFSF would be reformed so that it can lend €440bn, just enough to cover Ireland, Portugal and Spain. However, a bail-out for Spain would put Italy's public finances under tremendous strain, and Italy and Belgium would likely come under intense market pressure. France could also face difficulties. Alternatively, to head off such an outcome, the ECB could be forced into a massive programme of quantitative easing, including buying large amounts of sovereign debt of weaker economies, or euro-zone governments could be forced to issue joint bonds. Either course would be highly controversial, in particular in Germany.
EU leaders have still failed to agree a comprehensive deal that might draw a line under the crisis. There is now a Very high probability that the euro zone will break up under the strain. There is no provision in the EU treaties for a country to leave the euro zone. Still, a number of highly indebted peripheral euro zone countries could find a way to exit in the event that, in a bid to restore competitiveness, they became trapped in a downward spiral of austerity and recession. In that case, currency depreciation might appear the only remaining option to kick-start growth. This would leave the bloc diminished, and with markets targeting the weaker remaining members further splintering could then occur - there is a strong chance that the euro zone could be reduced to a north European bloc. Alternatively, it is conceivable that Germany, the lynchpin of the euro zone, could itself decide to quit the single currency, in the event that the costs of propping it up became seen as excessive - this would probably prompt the collapse of the single currency as other countries reassessed the benefits of membership.
The break-up of the euro zone would be hugely destabilising. Germany's new currency (or a north European euro) would be bound to strengthen substantially, hitting German exports and forcing the country into a difficult process of deflation. The country would also take losses on euro-denominated assets abroad. The new currencies adopted by weaker members would fall steeply in value, causing inflation to rise dramatically, and competitive gains could only be maintained by preventing wages from also rising. Currency depreciation would make widespread debt default inevitable.
In addition to huge losses from defaults, the chaos for the global financial system would far exceed the impact of the bankruptcy of Lehman Brothers, as the relationship between formerly euro-denominated assets and liabilities would be very unclear. The value of the US dollar, seen as a safe haven by investors, would soar. This would choke off recovery in the US. The accompanying appreciation of the renminbi would also lead to a slowdown in China, removing another key support for the global economy.
Conclusion
The break-up of the euro zone would be hugely destabilising for the global economy. The weaker former members would default as their currencies plummeted and funding costs soared. Banks globally would be severely shaken. The US dollar would shoot up, choking off US recovery and hitting countries with currencies tied to the dollar, notably China.
The economic crisis has exposed serious weaknesses in the euro zone and the resultant strains could lead to its break-up - a key break-point would be if Italy required a bail-out. This scenario envisages either highly indebted peripheral countries breaking off to leave a north European euro zone core, or Germany deciding to leave, which would spell the end for the single currency.
Analysis
The economic crisis has exposed deep flaws in the euro zone. The bloc's fiscal rules were routinely flouted, notably by Greece, while a rapid expansion of private-sector debt in some countries created potentially huge contingent liabilities for governments. Less profligate members now face the prospect of having to backstop these debts to avoid destabilising contagion. In addition, many members of the bloc, notably southern European countries, have experienced a damaging loss of competitiveness that within the single currency can only be addressed by a painful and protracted period of "internal devaluation" - including cuts in wage costs and usually entailing a recession. Bailouts for Greece, Ireland and Portugal and other stabilisation mechanisms established thus far do not fundamentally address either the underlying solvency or competitiveness issues of the weaker members.
Contagion has now spread to Spanish and Italian bond yields. We do not expect these counties to need bail-outs, but the risk is considerable. The size of the Spanish economy means that the need to support Spain would present a particular risk to euro zone stability. Similarly, Italy should be able to avoid a need to request support, but strains in the governing coalition over austerity pose risks.
The 17 euro zone heads of government agreed in March that the EFSF would be reformed so that it can lend €440bn, just enough to cover Ireland, Portugal and Spain. However, a bail-out for Spain would put Italy's public finances under tremendous strain, and Italy and Belgium would likely come under intense market pressure. France could also face difficulties. Alternatively, to head off such an outcome, the ECB could be forced into a massive programme of quantitative easing, including buying large amounts of sovereign debt of weaker economies, or euro-zone governments could be forced to issue joint bonds. Either course would be highly controversial, in particular in Germany.
EU leaders have still failed to agree a comprehensive deal that might draw a line under the crisis. There is now a Very high probability that the euro zone will break up under the strain. There is no provision in the EU treaties for a country to leave the euro zone. Still, a number of highly indebted peripheral euro zone countries could find a way to exit in the event that, in a bid to restore competitiveness, they became trapped in a downward spiral of austerity and recession. In that case, currency depreciation might appear the only remaining option to kick-start growth. This would leave the bloc diminished, and with markets targeting the weaker remaining members further splintering could then occur - there is a strong chance that the euro zone could be reduced to a north European bloc. Alternatively, it is conceivable that Germany, the lynchpin of the euro zone, could itself decide to quit the single currency, in the event that the costs of propping it up became seen as excessive - this would probably prompt the collapse of the single currency as other countries reassessed the benefits of membership.
The break-up of the euro zone would be hugely destabilising. Germany's new currency (or a north European euro) would be bound to strengthen substantially, hitting German exports and forcing the country into a difficult process of deflation. The country would also take losses on euro-denominated assets abroad. The new currencies adopted by weaker members would fall steeply in value, causing inflation to rise dramatically, and competitive gains could only be maintained by preventing wages from also rising. Currency depreciation would make widespread debt default inevitable.
In addition to huge losses from defaults, the chaos for the global financial system would far exceed the impact of the bankruptcy of Lehman Brothers, as the relationship between formerly euro-denominated assets and liabilities would be very unclear. The value of the US dollar, seen as a safe haven by investors, would soar. This would choke off recovery in the US. The accompanying appreciation of the renminbi would also lead to a slowdown in China, removing another key support for the global economy.
Conclusion
The break-up of the euro zone would be hugely destabilising for the global economy. The weaker former members would default as their currencies plummeted and funding costs soared. Banks globally would be severely shaken. The US dollar would shoot up, choking off US recovery and hitting countries with currencies tied to the dollar, notably China.