The future of the euro: part two

The euro celebrated its 12th birthday on 1 January in style: Estonia became the seventeenth member of the single currency. But against the backdrop of celebrations in Brussels and Tallinn, fears over contraction, rather than further expansion of the Eurozone grew in strength for the coming year.

Six months ago, Financial Director magazine highlighted dire warnings from leading economists that a break-up of the euro over the next five years was now the more likely outcome. As one pundit, ING’s global head of financial markets Mark Cliffe, put it, the “unthinkable is now thinkable”.

Half a year on and the single currency may still be intact, but doubts over its viability are not abating. “The odds of the survival of the euro are worse than we said in July,” says Ian Bright, a senior economist at ING.

He bases this assessment on warning signs from financial markets, such as the soaring yields on bonds and credit default swaps for the zone’s weaker peripheral economies, both keen weather vanes of market sentiment and belief in the currency union.

“We are looking at Spain where the ten-year yield is the highest since the introduction of the euro,” he says. “It is starting to affect more than the small countries and when you start playing around with Spain and Italy you are talking about major league problems. We can say that with confidence.”

Capital Economics, a consultancy firm run by former government adviser Roger Bootle, is sticking to its forecast that the chances of break-up are more than 50 percent. “We continue to think that some kind of Eurozone break-up over the next three to five years is probably more likely than not,” says its European economist Ben May.

The reason for the gloomy prediction is that, despite managing to cobble together rescue packages for first Greece and then Ireland, there is little sign of the structural reforms they see as necessary to underpin the euro.

Stephen Lewis, chief economist at brokerage house Monument Securities and a longstanding opponent of the euro, says policy makers have failed to tackle the tough issues.

“The turmoil that has erupted in peripheral Eurozone bonds is a symptom of deeper-seated problems relating to governance,” he says. After a lot of dithering, European policy makers in May provided Eurozone governments with a backstop in the form of the €440bn European Financial Stability Facility (EFSF) which expires in June 2013.

At their December summit, leaders signed up to the idea of a new permanent mechanism “to safeguard the financial stability of the euro area as a whole”. But the proposed European Stability Mechanism (ESM), which requires a treaty change by the end of 2012 in order to be up and running by July 2013, has raised more questions than answers.

There are no details about how large the ESM will be or how a sovereign default will be handled in the intervening period. “Even to a casual observer, the ham-fisted, piecemeal efforts of Eurozone leaders to deal with the challenges that bond market turbulence has presented seem to confirm that policy-making mechanisms at the Eurozone level are inadequate,” says Monument’s Lewis.

There is growing speculation that unresolved debt issues could trigger a domino of crises in Portugal, Spain, Italy and even France that the ESM would fail to cover. At the same time politicians have unsettled the markets by talking about the need for private sector creditors to share the pain by bearing losses on their investments. When French president Nicolas Sarkozy and German chancellor Angela Merkel first raised the idea last autumn, it triggered a surge in yields that pushed Ireland to the brink of default.

Janet Henry, chief European economist at HSBC, says the uncertainty has led markets to bet on a sovereign debt restructuring some time over the next two years. “As long as more concrete steps towards a new institutional framework are awaited, in the course of 2011 the markets will continue to price in an earlier restructuring,” she says.

Silvia Ardagna, senior European economist at Bank of America Merrill Lynch (BoAML), puts a 50-60 percent chance of Spain seeking external aid in the first half of this year. But she adds: “I don’t think that asking for external aid is a disaster. It will give countries time to restructure and be able to fund itself at a decent cost.”

ING believes there are three short-term options to fill the policy gap between now and 2013: a step-up of the European Central Bank’s (ECB) bond purchasing programme, an increase of the EFSF, and the introduction of common Eurobonds. But all three are likely to run into opposition from Germany. The central banks opposed to further monetary intervention by the ECB say it would undermine their anti-inflation strategy. And German taxpayers will become increasingly hostile to underpinning spendthrift neighbours, while German politicians will be unwilling to see a common Eurobond push up their borrowing costs.

May at Capital Economics says governments must enact structural reforms to eliminate structural deficits and bring public debt down to a sustainable level in the medium to long term. “We think that some governments will not be able to do that without defaulting,” he says. “What’s more, if a government does restructure its debts, the framework must minimise the risk of contagion.”

One key risk to the euro is that a country facing default will quit the euro rather than risk civil unrest by imposing the fiscal austerity that would come with a rescue package.

IHS Global Insight, a consultancy firm, gives a one-in-five chance of a country binning the euro and reverting to its national currency by 2016.

As a result its currency would collapse, which in turn would lead to major debt defaults or restructuring as the value of their euro-denominated debt surged.

IHS chief European economist Howard Archer says a break-up would also lead to major financial market volatility – and a likely serious hit to business and consumer confidence in all European countries. “Transitional costs of a return to national currencies will be huge, and contracts would have to be renegotiated,” he says. If that triggered a flight from the euro, it would leave a rump of countries anchored around Germany, an outcome to which IHS gives odds of just 5 percent.

The one scenario that commentators are confident to dismiss is Germany deciding to revert to the D-mark in anger at the profligacy of its erstwhile fellow euro colleagues.

“Germany is probably the biggest beneficiary of currency union within Europe,” says Ralf Preusser, head of European rates strategy at BoAML.

He also says a German exit from the euro would have “devastating consequences” for its banking and asset management industry: “It is not clear that a Germany with a currency of its own would improve.” This political support for the euro is one reason why some commentators believe fears of a euro break-up are overplayed.

“It is a political project in which everybody has invested too much capital so a break-up is very unlikely,” says Ardagna at BoAML. “It is in everybody’s interests – both the peripheral countries and Germany – to keep the euro alive.”

Ian Bright at ING agrees that while the economics might point to a break-up, it will be politics that ultimately decides the currency’s fate.

He points to Helmut Kohl’s decision to drive through reunification of West and East Germany. “People were telling Kohl he was nuts to do it but he did it for political reasons. If there’s political will to make this happen, it will happen,” says Bright. However, critics of the euro believe long-term reform is needed and until countries agree to fiscal union – sharing tax revenues or centralised budgets – to match the monetary union put in place in 1999, the project is unviable.

“One reason why fiscal union was not put in place in 1999 was that there was not the degree of solidarity between Eurozone member states,” Lewis says. “It seems that solidarity is still absent and that’s very serious for the European Union (EU) objective. If you saw the euro mechanisms collapse then it is hard to see how the EU could survive that.”

Read Phil’s first installment of the forecast on the euro’s future at www.financialdirector.co.uk/1744911