Will the euro survive the debt crisis?

Yes

Bill O'Neill

Chief Investment Officer, Merrill Lynch Wealth Management EMEA

While a breakup of the European Monetary Union (EMU) should not be ruled out, it is unlikely to occur. Such an event would not be economically optimal for any member state. The associated costs of a breakup are significant and would outweigh the benefits of exit.

A breakup of the EMU would likely lead to a banking crisis across the continent, alongside high corporate defaults and recession. Peripheral economies would probably experience bank-crippling capital flight. Northern banking systems could experience large deposit growth, but this would perhaps coincide with substantial defaults on peripheral sovereign debt holdings. National central banks in the northern eurozone, which have extended capital to the periphery, would almost certainly go bankrupt. The ensuing credit crunch would have real economy implications – high corporate defaults, low credit, deteriorating confidence and higher unemployment.

Then there are the costs of physically switching to a new currency and possibility of higher interest rates in the periphery following exit – the stock of debt would be lower, but the flow of debt would probably still be in deficit. Arguments in favour of a breakup point towards the opportunity for “external” nominal currency devaluation leading to an instantaneous improvement in the current account (rather than the much tougher “internal” real depreciation through lower unit labour costs).

However, currency devaluation is no panacea to growth. The 20 per cent plus depreciation in sterling has done more to increase inflation then rebalance the UK economy toward exports. Currency devaluation in the periphery could even force northern eurozone countries to pursue policies to protect their export markets. Households in the periphery, anticipating devaluation, could also force up wages. Furthermore, northern eurozone currencies would probably experience considerable appreciation against most trading partners –a headwind to their own growth.

A breakup of the currency union would likely lead to volatility comparable to the Lehman event. Investors should position portfolios towards structural growth, focusing on yield and quality. Portfolios should also ensure sufficient exposure to “safe haven plays” such as the US dollar and German bunds, that would likely benefit in the event of a breakup.

While not in the “pro-breakup” camp, the eurozone does appear unsustainable in its current structure. Attention is garnered toward the sizeable differences in fiscal responsibility and the lack of a system for fiscal transfers. A European Central Bank with too strict a central mandate hardly creates a framework to resolve the EMU failures. But other imbalances also exist – inter-eurozone current account imbalances and varying levels of competitiveness. Policies to correct these are required, alongside a legal framework allowing some common fiscal policy and a single central bank with a mandate to target growth and unemployment, as well as inflation.

A breakup of the eurozone would probably do little to resolve the underlying structural productivity weakness of many of the current member states. It might merely paper over the cracks through false expectation of higher export driven growth, with independent central banks offered the luxury to delay the necessary deleveraging and reform. Less attention should be focused on the breakup, more on adopting pro-growth strategies.

Ultimately, a fully fledged integrated currency and economic union is preferred, yet progress towards this is slow. In the meantime, the current “muddle through” scenario is likely to continue. Still, this is better than the most disastrous economic and political outcome of breaking up the EMU.

Elisa Parisi-Capone, Roubini Global Economics

No

Elisa Parisi-Capone

Senior Economist for Western Europe and Finance and Banking at Roubini Global Economics

Restoring confidence in the eurozone (EZ) rests on its ability to generate growth and reduce the competitiveness gap in the periphery. As fiscal austerity is bound to deepen the recession, the possibility of debt restructurings, exits and the eventual breakup of the EZ must be taken into account.

The financial crisis has exposed the institutional inconsistencies underpinning the large intra-EMU macroeconomic imbalances that have built up since the inception of the EMU. In our view, nothing short of a sovereign lender of last resort (LOLR) and a countercyclical fiscal shock-absorbing or risk-pooling mechanism, such as eurobonds, are required for a stable institutional framework.

Policymakers’ focus on stricter fiscal safeguards is too restrictive without counterbalancing macro policies in surplus countries. At the same time, the treaty’s constraints prevent the ECB from assuming the LOLR role in an unlimited fashion. Meanwhile, eurobonds are only conceivable at the end of a political integration process that is still a few years down the line — too late for some of the weakest member countries to avoid a sovereign debt restructuring and an exit from the EMU, starting with Greece as early as this year. German parliamentarians’ open speculation about a Greek exit underlines the shifting attitude in policy circles.

The main policy options include a sharp fall in the common currency, aggressive implementation of structural, supply-side reforms or internal devaluation. The ECB’s hawkish policy stance compared to other central banks constrains the devaluation option in an environment of competitive devaluations at the global level. Structural reform would take a decade to show results, whereas the deflationary route is potentially self-defeating for the periphery as surplus countries are unlikely to tolerate higher inflation to accommodate the periphery’s competitiveness adjustment. The insufficient financial backstop capacity for large member countries like Italy and Spain further undermines confidence in the entire EZ project.

In order to make an eventual exit an orderly one, the priority must be taming contagion to other weak links, especially Spain and Italy, by augmenting the EZ’s financial backstop capacity and ring-fencing the EZ banking system. For the exiting country, an orderly process must include a negotiated sovereign debt restructuring and a managed exchange rate regime in order to limit disruptive exchange rate movements. Even so, the economic costs of a unilateral exit include potentially massive capital losses incurred by creditor countries, in addition to trade losses imposed by the new competitor on the rest of the EZ.

For the exiting country, coercive asset and savings redenomination, potential bank runs, deposit freezes, capital controls and inflationary bouts of currency devaluations, which in turn fuel export and growth spurts, need to be weighed against the long-term stagnation and decline in living standards that would result from staying inside the EMU.

Market participants have already started considering the redenomination risk by shifting deposits into core EZ safe havens or abroad. Similarly, companies in peripheral countries are reportedly moving their headquarters into core EZ countries, while high-net-worth individuals are buying property outside the EZ. And in the Greek private-sector involvement deal that still needs to be finalised, the new bonds will be issued under British law in order to incentivise participation by reducing Greece’s ability to change the terms or the currency of payments if a further restructuring is needed.

As the recession in 2012 is bound to deepen, we expect such “flight to safety” dynamics to intensify.