Euro friends with benefits

As economists continue to debate the probability of a full-scale euro collapse, Jennifer Lowe looks at the likely consequences for investors

This month’s warning from a committee of MPs and peers that a partial or full euro collapse remains plausible, triggered the inevitable reaction from global markets.

However, the partial break-up scenario offers traders a potential upside for both northern and southern-tier countries, it would appear. Despite some high-profile brow furrowing in analyst circles, any move to allow Greece to exit the euro may have its benefits.

David Bartlett, economic adviser at RSM International, explains that weak economies like Greece would be freed from the macroeconomic straitjacket of the euro, which could actually permit a return to their now devalued national currencies to stimulate export-led GDP growth.

He says: “Strong economies like Germany and the Netherlands would be relieved of the need to subsidise financially profligate countries in southern Europe. A truncated eurozone would survive, clustered around responsibly managed northern European economies, aligned with the original vision of the economic and monetary union.”

Earlier this year, the eurozone decided it needed not only a temporary crisis fund, which came in the form of the European Financial Stability Fund (ESFS), but also a permanent one. The EFSF was created as an emergency pot of money, but it won’t last forever. Replacing it on a long-term basis is the ESM.

Since then, the European Central Bank injected £443.1 billion (€529.5 billion) into the eurozone’s financial system through its long-term refinancing operation (LTRO). This takes the total of the three-year loan programme to more than £0.84 trillion (€1 trillion).

Furthermore, the ECB broadened collateral rules so that smaller banks are also able to participate. Markets reacted positively to these steps, with ten-year Italian bond yields falling to 5.18 per cent. Michael Hewson, senior markets analyst at CMC Markets, says Europe now needs growth more than anything to sustain the recovery.

He says: “You can have as much austerity as you like, but unless you have growth to go with it, essentially all you are doing is costing your economies. That is what has happened in Greece and now in Spain.

“This fiscal contract that is being instilled is all well and good, but it isn’t addressing the current crisis which is that Europe is swimming in debt.”

Of course, a partial break-up of the eurozone presents significant downside risks, specifically the steep devaluations that would likely result from a restoration of national currencies in southern Europe - Greek drachma, Italian lira, Portuguese escudo, Spanish peseta, to name a few.

Mr Bartlett argues that such currency devaluations would also imperil the ability of exiting countries to settle outstanding euro-denominated liabilities. Mr Hewson agrees: “What has been the main problem with this crisis is that some of these peripheral countries historically had very high interest rates and, when they came into the euro, they were able to borrow at German interest rates, without any concept of fiscal responsibility.”

At the time of writing, the euro was trading against the US dollar at $1.3244 and was trading against sterling at £0.8376.