Nov 10

Euro Breakup…very painful indeed

The reasons why the Euro is a failing concept have certainly been well documented and spoken about. Basically, without a fiscal union, monetary policy and a single currency are instruments that are too blunt to aid struggling countries when other countries are experiencing different levels of economic growth and/or inflation across Europe.

For example, the German economy, which is performing better than Spain, should have a stronger currency whilst Spain should have a weak currency given its struggles. But what we have is a Euro that is stuck in the middle. Given Spain’s prices are above that of Germany’s, because there is no fiscal union, all Spain has left to be competitive is deflation which is disastrous for its economy (deflation means noone spends today because it is cheaper tomorrow).

Because of this failure of the Euro, the latest talk is breaking up the Euro. Back in September, UBS Economics wrote a paper, “Euro break-up – the consequences”,  analysing the costs of a single country a leaving the Euro and what an ugly result it is. (I unfortunately don’t have a link).

In summary, their estimated costs of a weak country, such as Greece, leaving the Euro was around EUR9500 to EURO11500 per person which is approximately 40% to 50% of GDP in the first year and the following years would cost around EUR3000 to EUR4000 per person…expensive stuff. For a strong country, like Germany, the costs are around 20% to 25% of GDP in the first years and 10% to 15% of GDP  in subsequent years…ouch.

The main reasons for the costs of Greek departure relate to the costs associated with sovereign default plus widespread banking and corporate default. Based on sovereign defaults in the past, currency is expected to depreciate by at least 50% to 60% and it is also expected that departure from the Euro would result in tariffs being imposed on Greek exports so a lower currency won’t automatically translate into competitiveness.

For a German departure, the costs are mostly associated with the reduction in export competitiveness which is bound to be exacerbated by increased political tensions, banks may have an issue on their balance sheet because their current assets and liabilities are in Euro and changing some of the parts into a new appreciating currency may dilute the value of assets and therefore bank recapitalisation may be necessary and costly.

Another part of the UBS paper that is interesting and not widely reported is the fact there is no “provision in the relevant European treaties for a country to exit the Euro…or expelled from the Euro”.  mmm … this is a legal scenario that may not be resolved overnight but perhaps why they have started working on it now.

Finally, the political cost of exiting the Euro whether strong or weak country is likely to be high. As UBS say, “the break-up of a monetary union is a very rare event” and “extremly unusual” for a paper currency union. The break up of Czechoslovakia and its monetary system resulted in social unrest and sealing of the borders.

Overall break up of the Euro is going to be a very expensive exercise no matter what and the final outcome is absolutely unknown. In the opinion of UBS, “the only way to hedge against a Euro break-up scenario is to own no Euro assets at all”.


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  1. BB

    Euro breakup? nooo…. one need only Google ‘official reports’ and statements from 3-6 months ago. If I recall correctly, Greece has no need to default on any debt obligations, and thus any suggestion that Portugal, Spain or Italy may be subject to a similar fate was preposterous. Let’s not forget because all those scenarios are either impossible or highly unlikely that European banks have no need for additional capital, their asset base is sound and reports that their leverage levels may sit somewhere between 30 and 50x are just plain wrong.

    Well, the brilliant minds among us have been right so far? so the only logical thing to do is assume that the market is efficient, the politicians competent and the 3rd party interests (i.e. banks) are providing advice to the former that is conflict of interest free….. No need to worry people, Australian equities are “cheaper than they have ever been” (recent quote from well known fund manager), resume your equity buying and Christmas spending 😉

  2. Afundie

    I am certainly not one to tow the party line, however I am not sure that there is any conspiracy on the part of Aussie fund managers to hoodwink their clients. He bottom line is nobody here really has a clue what will happen in Europe. The decisions to be made are political ones not economic ones, the Euro CAN be saved with the necessary political will. You may doubt whether that will exists, but a centralized fiscal authority and an expanded mandate for the ECB means the Euro remains. I would not make any bets on whether we’ll have a Euro as it is now in 5 years, but I would take bets that the Euro will still exist this time next year. Always remember the Euro is a political project over an Economic one.

  3. BB

    Agreed on the expanded mandate for the ECB, the math I have seen suggests there is simply no other way to raise the capital required if short term bailouts remain the preferred option over managed defaults and subsequent asset right downs (even the later will almost certainly require ECB intervention) either way, it’s painful! painful now, or very painful sometime in the future? Centralized fiscal authority? I’m not a political expert by any means, but here way have a region that doesn’t seem to have the political will to correctly negotiate and manage what now seem to be relatively small issues. Anything can happen and I also agree that no one really knows what the outcome will be, but as an investor you have to keep in mind the balance of probabilities here, on that basis you would have to question the assertion that the balance of probabilities lies with sudden continent wide political agreement and co-ordinated action across a range of issues so large and unprecedented in scale no one is really sure what ‘coordinated action’ is actually necessary.
    What are we trying to coordinate anyway? The survival of the Euro currency experiment is but one issue, regardless of its survival the primary issue remains….. there is simply too much debt and to much leverage, secured against assets that not worth their book value…. someone needs to take that loss at some point in time and the process of doing so will have significant economic impacts? All that is being co-ordinated is how to extend that time frame as long as possible and how best to spread that burden of loss among those exposed. My quip re conflicts of interest refers to this macro issue, namely those providing the advice on how to “manage” those losses are the ones whom should stand to take most of them, of course their advice suggests (among other things) a very different approach.
    What does that mean for asset markets? Who knows? My issue here is that the level of uncertainty and potential for real danger does not seem to be fully reflected in equity prices, Aussie equities certainly don’t look expensive and in some cases I’m prepared to accept they are looking ‘cheap’ but to suggest that “equities are as cheap as they have ever been” well that just over the top and I am yet to see any statistically significant data that backs up such a statement (to clarify, I’ve seen plenty of data, powerpoints and forward P/E ratios but I’m interested in the statistically significant part) And that’s only domestic markets.

    Should all the above culminate in asset prices falling to levels that one can honestly assess as being “cheap” then I will be prepared to tow the party line and suggest a contrarian view, right now, a large scale sovereign debt / repeat banking crisis does not quite seem consensus to me, just like a full blown banking crisis wasn’t in 07/08. That’s not to say that ECB QE would not result in the mother of all risk on trades, but is that something you concern yourself with on a 5-7 year time frame?

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