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February 03, 2009

What if One of the Euro-zone Countries Defaults?
by Victoria Marklew

This question has been triggered by the fact that the price of insurance against debt default by Euro-zone members Ireland, Greece, Italy, Spain, and even Belgium, has jumped in recent weeks; that yield spreads against German bunds have ballooned; and that the sovereign debt ratings of Greece, Portugal, and Spain have recently been downgraded. These developments do not reflect an increased risk of default by any Euro-zone member, but rather show that investors have finally woken up to the fact that not all Euro-zone sovereigns are equal. The global credit crunch has led to an overdue market re-evaluation of the Euro-zone members.

There are 27 countries in the European Union, of which 16 are members of the Euro-zone. However, while the 16 share a common currency and monetary policy, no political union preceded the monetary one, and the 16 are still fundamentally sovereign nations, with separate fiscal policies. Debt is issued by the individual countries, not by any Euro-zone institutions, although until recently the markets had acted as if all Euro-zone members were basically synonymous with Germany. The European Central Bank (ECB) is not obliged to support the debt of any Euro-zone member who gets into trouble, and the 'zone's members are explicitly banned from assuming the debt of fellow members in the event of default.

Most of the 16 have fiscal deficits that are swelling by the day, and some are also burdened by the domestic economic and financial sector fall-out from the bursting of their own housing bubbles - hence the recent sovereign rating downgrade in Spain and the risk that Ireland may soon be downgraded also. Some have singularly failed to enact structural reforms over the past decade and hence are saddled with an increasingly uncompetitive economy - which is a large part of the reason why Greece is now paying something like 2.5 percentage points more for ten-year debt than benchmark Germany.

The weaker 'zone countries essentially took a free ride on a decade of cheap access to funding. But they do not control their own currency or monetary policy, which means they cannot devalue or inflate their way out of trouble now that the good times have ended so abruptly. Their only alternative is to improve competitiveness the hard way, with reform.

Even so, none of the Euro-zone members is realistically likely to default anytime soon. Spain's downgrade by S&P only took it to one notch below AAA. Italy and Greece are still far from default-level. And while there is no obligation for any EU-based institution to bail out a member country, last October's events involving Hungary - a member of the EU but not of the Euro-zone - show that the EU will find a way to look after its own to avoid an outright crisis. Hungary's problems revolved around the domestic banks' huge foreign exchange swap positions, rather than an issue of sovereign debt service per se. In October, the National Bank of Hungary reached an agreement with the ECB allowing it to draw up to €5 billion from the ECB to provide liquidity to the domestic foreign-exchange swap market. The subsequent loan agreement with the IMF to stabilize the Hungarian banking sector and public finances also included emergency financing from the EU. It is clear that the ECB and the EU authorities recognize the increasingly interconnected nature of obligations across the Union. (Note that ECB President Trichet hinted recently that he does not see such obligations extending to prospective EU members.)

So, not all Euro-zone sovereigns have the status of Germany, and some are in for a rough few years of sluggish growth while they try to implement politically-contentious reforms. Nevertheless, none is likely to default and, whatever the rules say, the EU would find a way to prevent an outright crisis - if for no other reason than that the potential contagion impact for other members after a default would be severe.

What if a country leaves the Euro-zone? Can the euro survive?

The global credit crunch and ongoing recession have thrown into high relief both the benefits and the costs of membership in the Euro-zone. Widening debt spreads (see above) and a deepening recession have placed into stark relief that there are still fundamental macroeconomic differences between the 16 member countries. Nevertheless, the cost and practical difficulties of leaving the 'zone far outweigh any pain associated with staying in.

The question of leaving is being raised because countries such as Italy and Greece can no longer devalue or inflate their way out of their current problems. This causes some local politicians to blame the 'zone for their countries' sliding exports or rising unemployment. However, being a part of the Euro-zone is only proving painful for those countries that have failed to improve their competitiveness in recent years. For example, German exports have surged over the past decade while those from Italy (and France) have not. The discipline of a single currency was supposed to unleash a wave of supply-side reforms, but some countries used the protection of the 'zone to avoid the politically-difficult decisions needed to make their economies flexible and competitive, i.e., structural reform and control of public finances.

On the other side of the coin, the ongoing crisis has reinvigorated the debate on the merits of membership for those EU members who are not yet in the 'zone, such as the Czech Republic and Poland. Even Denmark, which (along with the UK) has an opt-out from having to adopt the common currency, looks to be moving toward holding a referendum on joining, probably later this year.

While the likes of Italy and Greece are now waking up to the costs of a decade of avoiding reform, Euro-zone membership has undoubtedly protected some small, open economies with big banking sectors, such as Belgium and Luxembourg, from suffering runs on their currency during the current turmoil. It has also protected Spain and Ireland, as their housing bubbles burst, from either having to hike interest rates going into a recession in order to protect their currencies, or having to allow a hefty devaluation that could further exacerbate debt service costs. Even the less-afflicted members have benefited over the past year or so - over half of all Euro-zone exports are to other Euro-zone countries, so sharing a common currency has helped to prevent market disruptions at a time of crisis.

The biggest problem for the euro is not that some members will really try to pull out of the currency zone, but that membership becomes an easy scapegoat for some politicians when the going gets tough.

What if sterling drops to near parity with the US dollar?

Sterling is trading at a 23-year low versus the dollar as investors get increasingly nervous about the UK's economic prospects, the liabilities in its banking system, the increasing national debt, and how much lower interest rates may go. Are Britain's policymakers really content to let the pound keep falling?

Chart 1

Unlike Italy or Greece, the UK has gone a long way in implementing structural reforms over the past 20 years, and its economy is much more diversified than the likes of Ireland or Spain. Nevertheless, the UK undoubtedly is suffering its worst recession in many years, thanks to the triple blows of the global drop in export demand, the bursting of its own housing market bubble, and the turmoil in the global financial system - with the latter hitting the UK particularly hard thanks to London's prominent role in global finance. Real GDP shrank at its fastest pace since 1980 in the three months to December. Recovery is likely to come slower than in the rest of the EU, with a return to growth delayed until 2010.

And unlike some of the aforementioned countries, the UK is not a member of the Euro-zone, meaning it has the option of letting its currency slide - not as a way to avoid the hard decisions about reform (although it could be argued that the government has not done enough to tackle the fiscal deficit in recent years), but as a way to support the economy while meeting the hefty costs of supporting the financial sector. A weaker pound does mean that the banking system's debts are more expensive to fund, but bear in mind that much of the foreign currency debt in the UK banking system is held at the UK-based branches of foreign banks; and that the domestic banks, and indeed the system as a whole, has foreign currency assets that meet or exceed their liabilities.

Prime Minister Gordon Brown and Bank of England Governor Mervyn King have unequivocally and repeatedly stated that the UK does not target the exchange rate as a matter of policy. The inflationary consequences of a weaker currency will have to be faced at some point, but for now both men are reiterating that a weaker currency will be good for the country's exports (assuming global demand returns at some point). France has started to demand that the UK support the pound, apparently worried that sterling's slide is a further threat to France's already-weak global competitiveness. British policymakers are likely to conclude that if Paris is getting upset, then the UK must be doing something right.

Victoria Marklew
The Northern Trust Company
Economic Research Department
"The economics of what is, rather than what you might like it to be."
50 South LaSalle Street, Chicago, Illinois 60675

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

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