Thursday, September 6, 2012

What's in store for Euro zone?

European debt crisis, simply put, is inability of some of the countries (Greece, Portugal, Ireland, Italy and Spain) in the region to pay back bondholders. Slow down in global economy made it unsustainable for countries with loose fiscal discipline. Greece for instance, (which historically ran high budget deficit) was the first to go under with its growth and tax revenues falling.  With increased sovereign risk, investors' expectation of returns has been going up pushing the bond yields of some of the countries in the region.  This is a vicious cycle -  higher bond yields mean higher fiscal strain which prompts the investors to demand even higher yields and this could go on.  

EU (along with IMF and EFSF) has been bailing out Greece, Portugal and Ireland.  European Central Bank announced a plan to purchase government bonds in order to contain the spiraling bond yields of countries like Spain and Italy.  Also through it's LTRO (Long Term Refinancing Operation) made credit available to troubled European banks at very low rates.  While these help stabilize the financial markets in the short term, they have been "kicking the can down the road" and postponing a more decisive step to a later date. 

So where is  EU and Euro headed? Nouriel Roubini, the economist credited with having foreseen the credit crunch has warned that euro zone will collapse within this year;  Nassim Taleb (author of Black Swan) also opines that the end of common currency is no big deal.  Structural flaws that remain in the European Monetary Union need to be addressed; but does the measure have to be extreme?  There are a number of ways that this crisis could play itself out.  We briefly discuss here a few scenarios that could be potential resolution to this now almost three year old crisis. 

Greek (Or peripheral)  exit: Tax payers of other nations (Germany for instance) of the union may push for this.  The short term impact for Greece may be quite severe; however in the long run they may be able to rebuild credibility through tighter fiscal measures and sustainable competitive advantage.  Euro zone may not be significantly impacted by Greece exit per se, provided it works on preventing contagion effect. 

New improved European union Or a full break up: The existing union with its structural flaws seems unsustainable and may pave way to a new, core and better regulated currency union. The resultant "new" euro (or its derivative) could be a far stronger currency.  The weaker members who leave the union may have to devalue their currencies to remain competitive.  But will this be the preferred path with export heavy Germany currently benefiting from a weak euro? Or all this pressure of austerity will lead to a full break up of the union?  

Fiscal union Or monetary expansion:  Fiscal union in the real sense of the term, I mean. Will there be political will to give up sovereignty and readiness to issue what you may call, Euro bonds? Else, Significant monetary expansion or liquidity injection by ECB to protect vulnerable banks and countries could be a potential resolution.  However what will this do to inflation is anybody's guess!

The probability of Greek exit and / or use of monetary expansion as preferred tool seem high, at least in the near term.  Break up of the union? Nah, what with ECB President Mario Draghi claiming (this evening) that "Euro is irreversible" and that "Fears of Euro reversibility are unfounded"!

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