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Against the tide: Euro’s end game

Unless crucial links in the chain of contagion are broken and sufficient resources are provided to cover all sovereign liabilities, the eurozone is doomed.

We seem to be in the endgame for the euro. Unless contagion between countries (Greece to Italy to France) and between sectors (sovereign debt to banks and back to governments) is overcome, the costs will defeat the euro. Right now, it looks hopeless.

Italy is a mess that matters because of size; France risks losing its credit rating; European Financial Stability Facility bonds are becoming difficult and expensive to sell; and the figures for the required bank recapitalizations are way understated (at least €300 billion is needed). Worse, recession in Europe looms, making debt sustainability, even in those states with Troika programmes, more doubtful, difficult and distant.

However, contagion is exponential both ways. It spreads from sovereign debt to bank assets and their self-financing capability and then back again to affect the economy, which makes debt sustainability worse again. It also spreads across countries.

Contagion can be reversed by taking out a big compartment of fear, such as bank recapitalization, in a convincing manner. It can also be reversed by taking out a country. Italy has €650 billion of the total refinancing needs of the Piigs (up to €1.2 trillion) between now and 2015; and it has €1.9 trillion of the €3.2 trillion stock of Piigs debt. So tackle Italy and the stock and flow of the sovereign problem would look a lot better.

Spillover effects
Eurozone banks’ potential losses
Source: Instrategy

Italy hasn’t grown for a decade and has no productivity to allow it to do so in the future. That’s the core of the Italian problem. Of course, it has too much sovereign debt. But the key to sustainability is economic growth, as the primary budget is in rough balance. That is why reform of the domestic economy is so crucial.

This positive prospect has been put on the table by the Troika and the IMF and the ball is now in the Italians’ court. The Italians could well screw up this last opportunity – the Greeks look like doing so.

Silvio Berlusconi wasted 14 years not achieving it. But if Italians now follow the technocratic government under Mario Monti with IMF/Troika control and a reform plan signed off by the main political parties, the contagion loop could be broken and the costs of saving the euro will reverse exponentially.

Of course, this would not be the end of the eurozone’s challenges. Resources to fight the crisis still look sparse relative to needs. And the issue of achieving competitiveness and growth by the weaker states in the face of a recession is daunting.

The euro itself is now under threat. All Italian and Spanish budget deficits, rollovers and outstanding sovereign debt have to be covered. That requires €1 trillion. The stock of sovereign debt of all Piigs (excluding rollovers) is another €2 trillion. So we need to see €3 trillion protected. If only €1 trillion of new issuance and rollovers are covered, then much of the outstanding stock will have to be bought by the European Central Bank, potentially increasing its balance sheet by more than 50% (it has already risen 15% since August). Otherwise the current holders of old debt will dump it for the new debt, which would be guaranteed. Assuming the old debt sank to 50% of face value, this would mean further losses for the banks and insurance companies of between €400 billion and €500 billion.

This is why the EFSF and special purpose vehicle resources must be adequate for 100% of Piigs’ debt and not just rollovers and budget deficits.


The chances of the euro surviving as is (or just without Greece) is now only 50:50. Euro break-up can be avoided if three things happen: Monti and the new Spanish government stay the course; the ECB helps by purchasing more government securities (but not becoming the backstop for all sovereign euro debt); and there is more EFSF/European Stability Mechanism money on the table – real cash, not smoke-and-mirrors leverage.

If that does not happen, there is the possibility that the eurozone will shrink to a core of states with Germany at its centre. This would not be a new euro but the old one shorn of weak countries. France would be a part of this as there will be no orderly second tier of eurozone countries for France to lead, just a bunch of countries in a pretty chaotic state.

Less likely is a total break-up as Germany just walks away to revive its Deutschemark. Schizophrenic about the euro as the Germans are, there is no sign that they will do that.

David Roche is president of Independent Strategy Ltd, a London-based research firm.

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