If it were to break up, what would be the investment implications?
The current EU sovereign debt crisis surfaced as governments and central banks across the developed world undertook drastic measures to shore up financial markets on the brink of collapse.The result wasa transfer of debt burdens from private to public balance sheets, resulting in a surge of debt-to-GDP ratios and public sector deficits. A particularly heavy burden of adjustment fell upon the weaker, peripheral economies in Europe.
Poor service
Along with bail-out packages for Ireland and Greece, the EU and IMF have imposed strict austerity measures. But with low growth, ongoing deficits and rising borrowing costs, Greece and Portugal are unlikely to be able to service their debt. Spain, which has a lower debt level, suffers from high unemployment and its banks are under threat.
Structural inadequacies within the EU framework must be addressed.
To prevent any break-up, the EU authorities have to deal with the transition to moresustainable debt levels, as well as enforce structural changes in periphery countries and the EMU framework. Conditional rescue packages will bring some structural reform in individual countries, but the EU must address the issues of growth convergence and consistent fiscal policy. This involves creating measures to unite European countries and overcome political resistance for the sake of economic stability.
In the interim, the EU could implement a step towards complete fiscal union, by establishing a central institution with governing responsibilities and the authority to punish non-compliance with EU targets encompassed in theMaastricht Treaty and the Growth and Stability Pact. Without a mechanism to override national sovereignty with respect to these targets, any policy remains only a guideline.
Positive exit strategy
Yet an EMU break-up is still possible. Leaving the EMU poses a real alternative to high-debt countries facing strict austerity measures and low growth. It would permit the implementation of an independent monetary policy tailored to domestic needs to stimulate growth and boost competitiveness via aggressive monetary easing and resulting currency devaluation. It would also erode debt levels and avoid the negative impact of rising interest rates.Therefore exiting the eurozone does offer gains to deeply indebted countries.
The consequences of a complete break-up of the eurozone are far-reaching.
In thecase of a eurozone break-up, the consequences for markets are enormous. Credit spreads, asset prices and real estate prices would be likely to fall steeply across Europe. Periphery countries would experience strong devaluation and inflation while core economies would see appreciation of their currency and deflation.
A periphery bond market crisis may emerge as bond prices could rise sharply while core countries’ bond yields would be falling. Default of PIIGS would be certain and currency devaluation could cause a run on banks and possible collapse.
Economic slowdown
The Deutschemark would emerge as the strongest currency among the former EMU countries. Strong capital flight from periphery countries and a deflationary shock could be expected and may reduce ten-year government bond yields to below 1%. Defaultof several peripheral countries could lead to a European banking crisis with substantial losses across banks. Deflation in core economies would eventually result in a severe contraction of economic activity.
Corporate and mortgage default would follow slow or negative growth as credit markets dry up. The collapse of corporate debt is likely to cause a second wave of losses for creditors and countries such as Germany and the US, which have large indirect exposure to peripheral countries.
Throughout such events there would be heavy speculations and attacks on currencies and equities. The new currencies would take some time to calibrate and exhibit significant volatility, further fuelled by speculations and attacks. In short, a complete EMU break-up would create severe financial distress and economic stagnation.
Addressing the EMU’s crisis requires taking into account the dual necessity of political and economic viability. Yet the severe consequences of an EMU break-up should be incentive enough for politicians to compromise. Nevertheless, there will be tears among taxpayers, Greeks and creditors alike. Restructuring and haircuts in peripheral countries would be felt around the world. Ye tthese losses would be notably less severe than the cost of a complete EMU break up.
