Euro-zone breakup: The Armageddon of finance

Thirteen years after its launch, Europe’s common currency is now in a major crisis. A Greek debt restructuring is inevitable, and concern is now focusing on contagion among the larger euro-zone economies. The prospect of a cascade of disorderly sovereign defaults is chilling investors, and the departure of some members from the common currency is increasingly being discussed. Most market analysts still expect that the currency area will survive, but the odds of failure are too high to ignore.

Given the bleak outlook for the euro, we should look at what break-up could mean, although in practice numerous possible permutations exist between the extremes of departure by a single country and the exit of all 17 members. There are too many unknowns to make confident predictions about the trajectory of the crisis or the extent and speed of any breakup, should efforts to save the single currency fail. In any case, the consequences of the breakup would be numerous and unpleasant.  

First and foremost, in anticipation of the euro exit, an accelerating bank run would be likely, as institutions and individuals rush to move their deposits out of the country. This would severely threaten the banking system and would have to be halted by a prolonged bank holiday and/or capital controls. If bank withdrawals were frozen, the government would legislate to create a new currency. It would re-denominate existing bank assets and liabilities into the new currency, and new banknotes and coins would be created. The new currency would depreciate dramatically against existing global currencies.

Any debt remaining in euros would be much higher in local-currency terms. So too would debt in other currencies such as US dollars. The result would be massive balance-sheet problems, and many companies would become insolvent. External funding would also be cut off. Public-sector salaries and most private-sector salaries in a euro-defector country would have to be paid in the new currency. The country would suffer a sharp compression of imports, to the point where it could only import goods and services up to the value of hard currency it earned through exports. New trade contracts would have to be denominated in external currencies, as suppliers would want payments in strong currencies.

If the introduction of a new currency had been preceded by sovereign default, this would mitigate the debt-servicing burden. However, any government that had not previously achieved a primary fiscal surplus would either have to implement further austerity (which would be deeply unpopular) or monetise the deficit, which, added to massive currency depreciation, would be highly inflationary. 

Exiting the euro would not in the short term prevent recession. At some point, the country might be able to return to sustainable growth on the basis of regained competitive advantage, although the difficulty of achieving the necessary internal adjustment could be formidable. In any event, successful economic reconstruction would only occur if wages could be reduced in real terms and efforts to compensate for inflation resisted. Recession in the rest of the euro zone would deplete demand for the departed country’s exports even after currency depreciation.

Even under this grim general scenario, some economies would fare better than others. For example, Italy’s well-established export-manufacturing base and reasonably sound economic fundamentals (domestic debt aside) would mitigate the damage. Greece, in contrast, lacks a strong industrial base and would have little in the way of a functioning economy to fall back on.

The impact on global financial markets would depend on the nature and scale of the breakup, but it would certainly be negative for equities and other risk assets, resulting in flight to safety on a potentially epic scale. Stock markets would fall dramatically in most countries. Although investors have already priced in substantial negative expectations, a euro breakup would have a much more dramatic impact on confidence. Government bond markets would probably be split between those seen as relative safe havens and the rest. US bond yields could fall even further as investors piled into the “risk off” trade. German bunds could also benefit similarly, although this would depend on market perceptions of Germany’s success in isolating itself from weaker euro members. As in the aftermath of the collapse of Lehman Brothers in 2008, dislocations in the short-term markets that lubricate the global financial system would emerge. In Europe, the impact of breakup would probably surpass the turmoil seen in the wake of Lehman’s collapse.  

The potential fallout elsewhere in the world is difficult to judge, but with each new country that left the monetary union, the impact would become more severe. For example, departure and default by Italy – the world’s third-largest government bond issuer, with bonds worth about US$2.1 trillion in circulation – would immediately imperil the solvency of financial services companies across the world. Those that could not raise sufficient funds to compensate – a foreseeable problem given that liquidity would be tight – would have to turn to governments for support. The resultant market turmoil could be exacerbated by limited capacity for states to support the financial sector. A breakup would cause a deep recession throughout what is now the euro zone. Demand would weaken because of a combination of consumer retrenchment, higher unemployment, reduced spending power, and weaker exports. At the same time, the need for austerity would make substantial fiscal stimulus unaffordable in most west European countries. Moreover, serious disruption in the euro area would tip the US into recession. 

Even if the euro area avoids outright breakup, the uncertainty over the future of the single currency and associated economic weakness could still have a significant impact on US and global growth. US exports to the euro area, which account for about 14 per cent of the total, would suffer badly. There would also be a negative wealth effect as a result of sharp falls in US equity prices, which would hit US consumer spending. A renewed credit crunch driven by severe strains on the financial system would further limit the economy’s ability to expand. Other economies, including emerging markets in Asia like China, India and Thailand would also be seriously affected as the EU is a major market for many of these export-oriented developing countries.  

The key question is then: What should businesses do now? Obviously, businesses need to make contingency plans and review risk-management processes in much the same way that they would consider the impact of other major events, whether natural disaster, political upheaval or the loss of a major customer. Contingency plans would depend on the nature of the company’s business and its direct exposure to the euro zone, but in general the main issues to consider could include finance and cash management, business continuity, revenue assumptions and targets, and client and supply chains. 

 A few specific actions that might be necessary: (1) Adjust internal budget assumptions and targets to take account of much weaker economic conditions both in the euro zone and globally; (2) examine supply chains (going back several levels, to suppliers’ suppliers) and identify weak links. Which suppliers might go out of business?; (3) prepare for supply-chain disruptions, for example by increasing precautionary inventories of business-critical components sourced from euro-zone countries, in case supply is interrupted; (4) establish or expand alternative supplier arrangements in non-euro countries; (5) examine client relationships to determine which clients might experience financial difficulties that would prevent them from making payments or renewing contracts; (6) as with supply chains, consider diversifying revenue risk by expanding client bases in non-euro countries; and (7) make contingency plans for the possibility of political or social unrest in euro countries, and evaluate the security of physical assets and staff.  

Precautionary actions in this uncertain time are necessary for business survival.  All we can say now is: “Hope for the best, but prepare for the worst.”

 

Dr Chodechai Suwanaporn is executive vice president of economics & energy policy, PTT Public Company Limited. [email protected].