An EU Crisis Scenario

From yesterday’s Kelly Letter comes the following excerpt from the January Policy Brief from The Peterson Institute for International Economics:

Faced with the reality of failing adjustment programs, difficult politics, and rising risks that one or more peripheral nations may rebel, or Germany may rescind its support, investors may simply decide that the cumulative risks mean the euro area has a moderate risk of failing.

If investors decide there is a low but significant probability that the euro area might fail, we believe Rudiger Dornbusch’s observation that crisis happens “much faster than you would have thought” would be realized. Here’s why: The failure of the euro area will be a calamitous financial event. If one believes the euro might fail, one should avoid being invested in European financial institutions, and in euro-denominated assets, until the outcome of the new pattern of currencies is clearer.

As a result, a large swathe of euro-denominated assets would quickly fall in value. The euro itself would cheapen sharply, but so would the value of European bank debt and European shares, and most sovereigns would see their bonds trade off sharply. This in turn would make it expensive for even the Germans to raise finance in euros. Despite their impeccable credit record, they would be attempting to issue bonds in what is perceived as a flawed currency.

A small risk of the euro “breaking up” would have great importance for the euro swap market. This market is used by Europe’s insurance companies, banks, and pension funds to hedge their interest rate risk. A swap contract allows, for example, a pension fund to lock in a long-term interest rate for their investments, in return for promising to pay short-term interest rates to their contract counterparty. It is an important market that underlies the ability of insurance companies, pension funds, and others to make long-term commitments to provide society with annuities, pensions, and savings from insurance policies. The notional value of these swaps is many times euro area GDP.

The trouble is, the euro swap market could quickly collapse if markets begin to question the survival of the euro. Euro swap rates are calculated as the average interest rate paid on euro-denominated interbank loans for 44 of Europe’s banks. Approximately half of these banks are in “troubled nations.” So the interest rate will reflect both inflation risk and credit risk of the participating banks. If investors decided that the euro may not exist in several years’ time, swap interest rates would naturally rise because people would be concerned that
banks could fail and that the “euro” interest rate could turn into something else — for example, the average of a basket of new currencies with some, such as the Greek drachma, likely to be highly inflationary.

If euro swap interest rates start to reflect bank credit risk and inflation risk from a euro breakup, then the market would no longer function. A pension fund could no longer use it to lock in an interest rate on German pensions since it would not reflect the new German currency rates. The holders of these contracts would, effectively, have little idea what they would be in a few years’ time. Hence, investors would try to unwind their swap contracts, while the turmoil from dislocations in this massive market would cause disruptive and rapid wealth
transfers as some holders made gains while others lost. If the euro swap market ran into trouble, Europe’s financial system would undoubtedly face risk of rapid systemic collapse.

This example illustrates why a small perceived risk of a euro area breakup could rapidly cause systemic financial collapse. The swap market is only one mechanism through which collapse could ensue. …

Many financial collapses started this way. … At the least, we expect several more sovereign defaults and multiple further crises to plague Europe in the next several years. There is simply too much debt, and adjustment programs are too slow to prevent it. …

When we combine multiple years of stagnation with leveraged financial institutions and nervous financial markets, a rapid shift from low-level crisis to collapse is very plausible. European leaders could take measures to reduce this risk (through further actions on sovereign debt restructurings, more aggressive economic adjustment, and increased bailout funds). However, so far, there is little political will to take these necessary measures. Europe’s economy remains, therefore, in a dangerous state.

This entry was posted in Global Economy, Sovereign Debt. Bookmark the permalink. Post a comment or leave a trackback: Trackback URL.

One Comment

  1. Posted April 26, 2015 at 5:43 pm | Permalink

    We absolutely love your blog and find most of your post’s to be just what I’m
    looking for. Would you offer guest writers to write content for yourself?
    I wouldn’t mind writing a post or elaborating on many of the subjects you write in relation to here.
    Again, awesome weblog!

Post a Comment

Your email is never published nor shared. Required fields are marked *

*
*

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>

Bestselling Financial Author