eurozone breakup - sr - jan 2012

EUROZONE CRISIS

The Eurozone in 2012

10 January 2012 | PAGE 1

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EUROZONE CRISIS: Eurozone fracture in 2012

This paper outlines a plausible scenario in which the Eurozone fractures in 2012. Events are unlikely to follow

the path precisely as described, given the complexity of the problem and the number of variables which are

continually changing. That said, we feel 2012 is unlikely to end with all the current members still being part of

the Eurozone. Mapping a break-up scenario should help readers understand how fragmentation could occur

and therefore assist businesses contingency planning. To this end the paper highlights some key events and

when they are due to take place. It also identifies some key indicators to monitor which are likely to dictate

how the crisis will unfold.

EXECUTIVE SUMMARY

A plausible scenario for Eurozone fragmentation in 2012 would see elections in Greece, France, Finland and

probably Italy changing the terms of the debate to reflect frustration with economies in recession, rising

unemployment and hostility to proposed or actual austerity measures.

In this scenario, Greece receives an irregular rescue from the European Financial Stability Facility (EFSF) and

negotiates a rescheduling of its debt in March. But once its April elections are over, the new Greek

government is unable to secure bailout funds having missed austerity and reform targets, prompting a

formal sovereign default. Greece announces its withdrawal from the Eurozone, closing its banking sector for

a period, freezing euro denominated accounts and redenominating them as newly created drachmas.

The French and German governments nationalise their weakest banks most exposed to sovereign non-

payment by Greece. This increases their own national debts and prompts a second round of downgrades to

the ratings of the French government and the EFSF (following earlier downgrades in January/February).

With private investor confidence weak, Italy is forced to rely on large EFSF purchases of its sovereign debt

issuance in early 2012, depleting the size of the fund. In the second quarter, Italy suspends its debt

repayments following the collapse of the Monti administration and differences with the IMF and other

Eurozone leaders.

The ECB is likely to increase liquidity provision and work with Eurozone governments to protect their

banking sectors. However, Eurozone leaders remain unable to agree crucial policies in time to stem the

contagion from Greek and Italian sovereign non-payments. Portugal and Spain, unable to access emergency

bailout funding and with no recourse to private investors, suspend their debt repayments and also

announce their intention to leave the Eurozone.

From early 2013 onwards, politics in Europe becomes more polarised and nationalistic. Those nations

withdrawing from the Eurozone impose protectionist measures, in part to limit the loss of their foreign

reserves. Amidst much acrimony, the EU begins the process of scaling back to a free trade agreement.




DETAILED ANALYSIS

Key indicators in 2012:

Alarming Signs:

1. The failure of the PIIGS to get their debt auctions away in full to private buyers at sustainable interest rates

(e.g. < 5%).

2. Ratings downgrades for the French government and the EFSF, increasing investor scepticism that the latter is

able to support PIIGS struggling to sell bonds to private investors.

3. The IMF losing patience with Greeces failure to implement structural reforms, refusing to extend further

support.

4. Mario Monti being unseated in Italy and the governments relationship with European partners and the IMF

turning sour.

5. Weak growth figures in major European economies (e.g. quarterly GDP and employment).

6. A wave of euro-scepticism across the Eurozone with governments under pressure to resist austerity measures

and fiscal union.

Positive Indicators:

1. Eurozone banks making heavy use of the ECBs unlimited supply of three-year loans and investing this in PIIGS

sovereign debt, driving bond yields lower.

2. The ECB making a commitment to purchase sovereign debt directly and in unlimited quantities.

3. The Eurozones AAA rated governments agreeing to issue bonds jointly to support the rollover of PIIGS

sovereign debt.

4. Governments (especially Spain and Italy) making substantial progress on meeting their fiscal targets and

reform measures.

5. Eurozone governments reaching credible agreements to impose legal limits on sovereign debt and deficits,

empowering AAA rated economies to make the political case for more bailout action.

6. Eurozone leaders delivering the promised funding of 200 billion to the IMF and 500 billion to the European

Stability Mechanism (ESM) during the first half of the year.

Some Important Dates in H1 2012:

31 January The EU/ECB/IMF Troikas mission to Greece is likely to conclude haircut negotiations with

creditors and granting a new bailout to cover debt payments up to March.

Late March - The IMF is likely to confirm the transfer of further tranches to Ireland and Portugal but delay

transfers to Greece because of its failure to implement structural reforms.

Late April - Greek elections: radical left and right wing parties are likely to increase their presence in Parliament.

The new government will probably be perceived as too weak to implement reforms, with the IMF suspending

the Greek bailout during its meeting on 20-22 April.

6 May - A Franois Hollande victory in the second round of Frances presidential election looks likely. This would

increase strain on the Franco-German axis, with more open French opposition to the ECBs current monetary

policy and the imposition of fiscal austerity in the PIIGS. This would reduce the support Merkel has in Germany

to arrange solutions for the crisis at the European level.

15 May - Estimate of Q1 2012 Eurozone GDP is likely to confirm the region is in recession.

June G20 summit: the BRICS, Japan and the US are likely to refuse (once more) to finance a wide European

bailout.




in H1 2012:Scheduled Debt Repayments

January (Italy 15 billion, Spain 15 billion). PIIGS total: 36 billion

February (Italy 63 billion, Spain 15 billion). PIIGS total: 82 billion

March (Italy 52 billion, Spain 13 billion). PIIGS total: 90 billion

April (Italy 46 billion Spain 27 billion). PIIGS total: 77 billion

May (Italy 20 billion, Spain 9 billion). PIIGS total: 39 billion

June (Italy 20 billion, Spain 9 billion). PIIGS total: 42 billion

2012 EUROZONE FRAGMENATION SCENARIO

January-March 2012

Sovereign downgrades, heavy bond issuance and political gridlock

The credit rating of France and then the EFSF (which is partially backed by France) is downgraded below AAA.

The ECB renews the 1% three-year lending facility to the banking sector which eases banks funding pressures.

However, banks continue to suffer from a collapse of interbank lending, the rapid withdrawal of bank deposits in

places like Greece and Ireland, the reduced credibility of sovereign bonds as collateral and the economic

downturn that increases the risks of non-payment by corporates and households. Risk-aversion means the banks

still avoid investing this ECB cash in high yielding peripheral European government debt (banks have deposited a

record of 453 billion in the ECBs deposit facility, just beneath the 498 billion they have borrowed from the

ECB since the lending facility was launched).

Very heavy bond issuance by Italy and Spain pushes yields upwards and Italy needs help from the EFSF to buy a

large share of its issuance (115 billion). The EFSF is forced to raise more money from bond investors and is

downgraded for the second time.

The European Council fails to reach an agreement on how to extend the EFSF/ESMs ceiling to 500 billion (in

2012 alone the PIIGS governments have to service 651 billion). The Finnish Parliament votes against a clause

that authorises the use of the EFSF/ESM in an emergency without adequate intergovernmental consultation.

Together with the double EFSF downgrade, investors become more sceptical about the EFSFs capacity to rescue

the PIIGS.

The IMF confirms its commitment to the bailout programmes for Ireland and Portugal, which still have 6 billion

and 13 billion as stand-by credit, respectively. However, the IMF criticises Greece, which fails to implement the

reforms agreed in the bailout programme (e.g. privatisation and lowering labour costs). This delays the transfer

of the 7.5 billion of stand-by credit that Greece has with the IMF. The EFSF then grants some bailout money to

Greece and facilitates a rescheduling of its March debt repayment (16 billion).




April-June 2012

Greece loses IMF and ECB support

Greek Prime Minister Papademos is ousted in the national elections and the New Democracy and the Socialist

parties (right wing and centre left, respectively) form a coalition government. The new government admits that

its predecessor failed to reduce the fiscal deficit, with expenditure cuts having worsened the recession and

reduced tax collection.

The IMF suspends the bailout programme for Greece during its meeting (20-22 April), arguing that the newly

established coalition is even less likely than the Papademos administration to implement the required reforms.

Private creditors refuse to accept further haircuts on Greek debt (that would in any case only reduce the

national debt to 120% of GDP by 2020). Greece suspends payments. The ECB stops accepting Greek debt as

collateral for the three-year lending facility granted to the banking sector and 2011s steady decline in bank

deposits at Greek banks develops into a fully-fledged bank run. The Greek government withdraws from the

Eurozone in order to issue drachmas and bail out its banking sector.

Another French downgrade and EFSF depletion

Already weak banks which are particularly exposed to Greek sovereign debt need government help. The German

government nationalises Commerzbank and France nationalises Socit Gnrale. Frances debt/GDP ratio

increases and its credit rating is downgraded again.

Media reports highlight that the EFSF has insufficient funds to intervene if Italy and Spain need further support

(respectively 87 billion and 44 euros of issuance between April and June 2012). Market conditions deteriorate

remarkably and the banks stop using the liquidity from the ECB to buy sovereign bonds. The yields on the

Spanish and Italian debts reach a record high.

Montis government in Italy falls

The expenditure cuts deepen the recession and increase civil unrest in Italy. The Monti governments measures

include heavy taxes on wealth, annoying Berlusconi who has been criticising the rise in taxes since December

2011. Berlusconi organises a parliamentary vote that leads to the collapse of the Monti government. With the

support of the Lega Nord party, a politician close to Berlusconi (or Berlusconi himself as there are no other viable

options yet) is elected prime minister. The new government declares that austerity has not helped and

announces tax reductions to stimulate economic growth.

The IMF refuses to grant a bailout loan to Italy, in part because of the sheer sums involved. Germany refuses to

issue Eurobonds unless Italy agrees to apply the tax rises proposed under the Monti government. Following a

series of failed bond auctions, Italy suspends payments on its sovereign debt and enters into negotiations with

creditors to reschedule its debt repayments.




Eurozone contagion from Italys sovereign non-payment

European leaders discuss jointly issuing Eurobonds to contain the contagion. However, the discussion deadlocks

over whether to include Italy in the scheme given its size and the implications for the debt positions of other

AAA rated nations (e.g. Austria, Finland, Luxembourg and Netherlands).

The IMF does not renew Portugals bailout programme, arguing that it has failed to implement the austerity

budget passed in late November 2011. The Portuguese government is unable to repay the 12 billion is owes in

June. The EFSF has no further funds to rescue Portugal, which suspends payments on its sovereign debt.

The IMF continues to transfer resources to Ireland, whose debt payments scheduled for April-June are relatively

small (2 billion), and arranges a bailout for Belgium. However, Ireland refuses to increase corporate taxes and

start a process that will result in its departure from the Eurozone.

In France, high unemployment, Sarkozys inability to deal with the euro crisis and credit downgrades mean

Franois Hollande is elected President in Mays second round. Hollande states his government will be more

aggressive in pressuring Germany to allow the ECB to print out money and to agree on the issuing of Eurobonds.

July-December 2012

Under threat of losing her majority in Parliament ahead of the 2013 elections, Merkel declares that Germany will

not participate in bailout programmes or jointly issue Eurobonds. The EFSF and the IMF lack the funds for any

substantial rescue.

In Spain, investors lose what confidence they took from the tough December budget, with recession preventing

any material improvement in the governments above-target 8% deficit in 2011. With regional governments

struggling to avert non-payments to staff and creditors (e.g. Valencia and Catalonia), and a banking sector still

severely distressed from the property implosion, the Spanish government is unable to service its payments

scheduled for July (32 billion). A haircut is proposed by the EU but creditors do not agree and the Spanish

government suspends the payments on its sovereign debt.

The ECB extends the 1% lending facilities to the banking sector in order to prevent the sovereign non-payments

by Italy and Spain from causing banking crises across Europe. All European governments, and in particular France

and Germany, borrow extensively to recapitalise their banking sectors, resulting in partial nationalisations. The

ECB buys this new sovereign debt extensively without entirely sterilising, which increases liquidity in the system

and leads to euro depreciation.

The Spanish, Italian and Portuguese banks do not receive liquidity from the ECB as the latter refuses to accept

defaulted sovereign bonds from these countries as collateral. Faced with a number of bank failures and a bank

run, Italy, Spain and Portugal abandon the Euro and announce the reintroduction of their national currencies.

Following Greeces footsteps, the governments temporarily close the banks, convert deposits into the new

currencies and impose capital controls.




A wide corporate debt crisis follows the breakup of the Eurozone

The debts (sovereign and corporate) contracted under the national laws of Spain, Italy and Portugal are

converted into the new currencies. These currencies depreciate sharply and many companies are unable to

service their external foreign currency debts. As the corporate debt crisis deepens, Eurozone governments

pressure the ECB to accept any bond as collateral for liquidity. In this way much of the Spanish, Italian and

Portuguese debt held in the Eurozone is monetised i.e. sold to the ECB for liquidity. As liquidity rises, the euro

depreciates and inflation increases. Given the continued lack of confidence among investors and creditors, the

Eurozone economy takes longer to recover in spite of the exchange rate depreciation. Civil unrest increases

across Europe due to a combination of high unemployment and rising inflation.

January 2013 onwards

Politics becomes highly polarised. Protests and strike action increase and right-wing governments respond to

protests with more violent repression. Following new anti-immigration policies, most European governments

intensify the repatriation of illegal migrants, in some cases breaching the EU treaty.

The PIIGS introduce protectionist measures to deal with the lack of foreign exchange. Other European countries

retaliate, starting a process that leads to the scaling back of the EU to a free trade agreement.

The exchange rate depreciation and fall in wages deliver a slow economic recovery in the PIIGS, especially in

labour intensive sectors such as agriculture and textiles. By mid-2014, inflation has stabilised and capital controls

are relaxed. Chinese, Japanese and US entities buy Italian and Spanish companies and property, providing much

needed capital inflows that strengthen the recovery.

The Eurozone membership reduces to a handful of nations, all of which have debt to GDP ratios that exceed

100% of GDP. They experience sharp recessions and no signs of recovery until late 2014. Nevertheless, all

members have fiscal rules enshrined in their national constitutions and some government bonds are jointly

issued as Eurobonds to address continuing market volatility. Important French and German companies are also

sold to Asian and US groups.

eurozone breakup - sr - jan 2012

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