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Friday, January 06, 2012

Will the euro crack in 2012? It'll be turbulent but probably not...

In a blog post for the Telegraph, we ask this simple and yet brutally complicated question. This is what we argue:

In truth, as the crisis is overwhelmingly about erratic domestic politics, it’s absolutely impossible to predict when the euro will bite the dust. What’s clear is that in the absence of some sort of fiscal union (likely to be collective borrowing amongst euro states in return for German-style budget rules), the single currency is doomed in the long-term. In the short term, however, there is still scope for plenty of muddling through – which is to say that there’s a strong chance that the euro survives 2012. So what is the likely good (an expression used loosely here) and bad news for the eurozone moving in 2012? And what would, to complete the phrase, an “ugly” scenario look like?

The “good”

The ECB stepping up: Arguably the biggest threat to the survival of the eurozone in 2012 is a deep freeze in the banking system. That is, banks get so incredibly nervous that they completely stop lending money to each other, leaving some banks bust. Governments would find it very hard to refinance themselves and credit to the wider economy would be choked off.

Now, for those who think short-term (which is most people), the good news is that the ECB has stepped in to offer ridiculously cheap loans to any bank in the eurozone that asks for it (under a new euro acronym known as the LTRO), giving them the cash and confidence to continue lending this year – at least in theory. There is a catch of course: as with all other ECB intervention, the LTRO serves to transfer more risks from private creditors to European taxpayers (as the ECB is ultimately taxpayer-backed) and there are little signs of a plan to wean banks’ off their growing reliance on public money. How all 523 banks that have taken loans so far will be able to rollover nearly €500bn in funds, all due for repayment in 2015 – when the ECB wants its money back – is a question few are asking at the moment.

There’s bailout cash left: Though not nearly enough to act as proper lender of last resort, there’s bailout money left in the pot for the eurozone to play with this year. Following a second Greek bailout, the temporary and permanent euro bailout funds (the EFSF and the ESM), set to run in parallel in 2012, have a combined lending capacity of between €500bn and €750bn with potentially another €170bn of IMF money to add. In addition, the ECB can still buy a limited amount of government bonds, albeit reluctantly. Compare this to the roughly €800bn that eurozone governments need to raise between them (including countries that are safe) this year, and it might just about add up – for 2012, that is.

The bad

Recession inevitable: No matter what happens, it will be an incredibly painful year for the eurozone, with recession plaguing several countries, exacerbated by a slowdown in the rest of the world. Low growth and poor competitiveness remain the euro's greatest curse.

The Greek factor: Without the next tranche of EU bailout cash, Greece will default in March, and is almost certain to default sooner or later anyway. Greece is currently in negotiations with private creditors over a ‘voluntary’ restructuring of its €360bn debt mountain – it remains uncertain whether it can remain inside the eurozone absent a deal, which would mean a ‘forced’ restructuring. However, both the Greek electorate and the political elite remain committed to the euro and I doubt eurozone leaders will have the nerve to force Greece out this year. But anything can happen should, say, the present Greek technocratic government fall (it's worth reading Paul Mason's take on it).

A French downgrade: Due to the large exposure of the country’s banks, France could well be downgraded at least one notch. Among other things, this would hit the creditworthiness of the euro bailout funds, meaning higher borrowing costs for those countries that tap them and even more reliance on German taxpayers’ cash.

Risk of unexpected bank collapse: Despite ECB liquidity, the sudden collapse of a large eurozone bank is an ever present risk. The radical increase in banks’ use of ECB cash (via the LTRO and other programmes) is an alarming sign that one or several banks are in serious trouble.

Europe stands alone: No one seems willing to come to Europe’s rescue, with international lenders from Beijing to Washington frustrated by the EU’s dithering.

The ugly

Though the risk is still small, there’s a possible perfect ‘storm scenario’ for the euro in 2012. As events are so incredibly intertwined, it’s impossible to tell which would come first. But the scary thing is that just one or two of the below factors may be enough to start a chain of events which would lead to the disorderly break-up of the eurozone:

• Widespread downgrades, including of the eurozone’s remaining Triple A countries, by credit rating agencies. Serious questions would be raised over the viability of the eurozone’s bailout funds as they rely on an ever thinner list of Triple A eurozone states, leaving the euro with little more than a paper tiger as a backstop.

• Spanish banks could hit the iceberg as households fail to pay their mortgages and the level of non-performing loans pile up. If it gets bad enough, the Spanish government wouldn't afford to recapitalise these banks on its own and must seek a potentially huge bailout from the EU/IMF.

• In addition to those in Spain, one or more banks in Italy or France could sink due to large exposure to weaker euro states - following a hard Greek default for example. As in Spain, there are doubts as to whether these governments could afford to bail out their banks without outside help.

In parallel to these economic concerns, the political tensions between what’s required to keep the euro together versus what citizens are willing to swallow could reach breaking point. A new French government might try to renegotiate the euro’s new budget and fiscal rules, causing uncertainty and delays, while Angela Merkel’s opposition to bailouts and ECB intervention could increase as national elections loom large in early 2013. Meanwhile, the push by unelected governments in Greece and Italy for ever more austerity, could trigger a fresh wave of political unrest. Though still unlikely, the Monti government in Italy could lose its support in Parliament, leading to fresh elections, more uncertainty and spiralling borrowing costs for Italy. The country remains too big to be bailed out.

Ultimately, it is how these political tensions are played out in various countries that is likely to determine the eurozone’s fate. My best bet is still on the euro surviving this year – we haven’t yet reached rock bottom. But make no mistake, this will be another incredibly messy year for the euro and the choice between what’s right for democracy in Europe and what’s right for the euro cannot be avoided forever.

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