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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