Sticking together: the future of the Eurozone

Over the past few months - and more precisely since July 2011 - the Eurozone crisis has escalated. The initial impact was on the financial markets, where government bond spreads, especially in, but not limited to, the socalled peripheral countries, reached previously unimaginable levels. Bank funding had been under severe stress for some time, and had leapt up to levels close to those during the Lehman default of September 2008. During summit after summit, European leaders had fallen short of delivering credible solutions to contain, let alone solve, the crisis. And indeed, in November, even politicians acknowledged that a breakup of the Eurozone, in whatever form, could no longer be excluded.

In this context, Eurozone breakup scenarios have become ‘en vogue’ and it is high time that we too put in our bid. This report starts by describing the current crisis and its background. Then we discuss the likelihood of a Eurozone breakup in some detail, as well as what to us is the more likely ‘Sticking Together’ scenario. Our report also offers an overview of events since the Lehman default. In short, it aims to provide the reader with an overview, in-depth analysis and a likely future path of development.

We highlight that the loss of confidence in financial markets and the rapid contagion stems from the deep financial integration within the Eurozone. Cross-border exposures have become so large that a substantial write-down of foreign debt would make it very difficult for governments to bail out all defaulting banks. Countries with weak growth potential will be even less able to bear significant losses. Throughout the past decade, the relative competitive position of the Eurozone periphery compared to the core has reduced, leading to a gradual worsening of the fundamental imbalances within the Eurozone that were present from the start.
And these imbalances have, in the current environment, become critical. Solving this fundamental divergence will be imperative for keeping the monetary union together over the longer term.

To manage the pressures in the short to medium term, policy makers have several tools at their disposal, including central bank intervention to secure the functioning of the financial system as well as overarching political solutions to prop up countries in distress. Meanwhile, while the threat of a breakup will continue to linger, the probability of its manifestation will be low. Key factors are the Eurozone’s legally binding arrangements such as the Maastricht and Lisbon treaties. For precisely those reasons, an unravelling of the Eurozone - either based on a unilateral initiative or as a result of multilateral agreement - would be accompanied by severe negative consequences: countries may retaliate by re-establishing tariff barriers, eroding the Internal Market. Moreover, these legal issues make the required secrecy for a breakup scenario even more unlikely: any breakup is therefore destined to be disorderly, involving bank runs and posing serious threats to the (global) banking system. Such a scenario is unlikely.

The Eurozone is likely to stick together. We believe that politicians will bring the crisis sufficiently under control in incremental, perhaps grudging, steps towards fiscal union. Peripheral countries will put up with austerity and reform. The European Central Bank (ECB) will add its weight by providing ample liquidity to the banking system. Consequently, tensions in the interbank market will slowly recede and credit conditions will stabilise. Yields of government bonds will decline, reducing the cost of refinancing government debt and preventing large countries from becoming insolvent. But a recession for the Eurozone in 2012, albeit mild, is inevitable.

Given the many legal and political issues facing the crisis management, however, the downside risk to this ‘muddle through’ scenario is substantial. The persistent weakness in confidence and the recessionary conditions will keep the monetary union under severe pressure. Fear of government and bank defaults and of a potential Eurozone breakup is likely to linger for the foreseeable future.