The Euro in a Break-up Scenario

Author: Michael Hart  ·  November 24th, 2011  ·  261419http%3A%2F%2Fwww.economonitor.com%2Fanalysts%2F2011%2F11%2F24%2Fthe-euro-in-a-break-up-scenario%2FThe+Euro+in+a+Break-up+Scenario2011-11-24+16%3A24%3A42Michael+Harthttp%3A%2F%2Fwww.economonitor.com%2Fanalysts%2F%3Fp%3D261419 › Share This Print

A Greek debt restructuring, so long in the making, is now mostly priced in and would likely upset FX markets only temporarily and in a limited manner. An exit from EMU would matter much more, not because Greece is an important economy but because there is no legal provision for leaving EMU and it would thus set a precedent. It is likely to spark a severe round of contagion, with the extent of it depending on reform progress and credibility in other countries under pressure.

The initial pressure on EURUSD would be downwards and as it is driven by the EUR-side, also evident in other crosses. I would expect EURUSD to witness heightened volatility (+25%?) and a testing of the low near 1.19. An Italian restructuring would be much more disruptive given the size of its economy, it status as a core EU/EZ member and the enmeshing of its debt in the EZ financial system. Depending on the severity of the shock to the EZ banking system and depending on the path chosen by Greece, it may also raise fears of an Italian departure from the Eurozone. An IT restructuring without a Greek exit can perhaps be digested, with EURUSD not declining beyond previous lows but with a Greek precedent, FX pressure is likely to be much more severe. If Italy were indeed to exit and devalue it would be more catastrophic by several orders of magnitude. In this case, the bilateral EURUSD rate would be driven not just by EUR weakness but also by a rapid ratcheting up of global risk aversion and the resultant safe-haven flight into USD. Not only can a debt restructuring involving a 50% reduction be expected but in addition no less than 30/40% nominal FX devaluation losses would be on the table as well. The latter would draw wider circles through the EZ economy as, in addition to the sovereign, many Italian corporates indebted to non-resident lenders would immediately become insolvent. It would affect not only EZ financials but also its corporates who may be both suppliers and be supplied to. Converting contracts at a fixed exchange rate would limit the burden for Italians and thus perhaps stem losses for non-Italian EZ agents, but market driven depreciation beyond the conversion rate would make the subsequent conduct of business only more difficult.

Because of the risk that the EZ might break up altogether, EURUSD would likely decline severely in this scenario, say to parity and perhaps beyond. Visibility decreases further from there on: does the EZ stay together ex Greece, Italy and perhaps Spain, does it re-form around a rump of “Nordic” (creditor?) countries with strong fundamentals or does it fall apart altogether? The option that probably makes the least economic sense (though it has been advocated by some), is a unilateral exit by Germany, perhaps because it is unwilling to shoulder the required fiscal transfers or face the inflationary risk induced by ongoing ECB accommodation. Such a move would be equivalent to a deval/exit by all 16 other EZ member states though and compound the aforementioned currency mismatch problems on corporate and financial balance sheets.

But what all split-up scenarios have in common is a likely rise in the intra-European exchange rate of the core vs the periphery (for example, our calculations suggest that Greece could require a 120% real devaluation). Less clear is its likely behavior against third countries. For example, Germany’s growth model is explicitly export-based and thus at least partly reliant on demand in peripheral countries. With the change in relative prices and the likely collapse in output, this model would be severely impaired and prospects for rump-EURUSD appreciation would thus be in doubt.