Daily Themes 25 January 2012

Event risk remains high in euro-zone

In our 18 January Daily Theme we highlighted the continuing risk that events in the eurozone could create market volatility. We see at least six possible events that could do this. However, depending on the severity of the event and the ensuing policy response, they could also represent potential buying opportunities.

In order of increasing severity, and generally decreasing probability, the potential risks are:

1. Further downgrades for euro-zone countries

   The recent downgrade to France, the euro-zone’s second largest economy, and subsequent cut to the ratings for the European Financial Stability Facility (EFSF) will potentially make it harder to raise funds for the bailout packages of Greece, Portugal and Ireland. In this scenario, further downgrades could follow, especially if Europe’s recession is deeper than expected. This could force banks to raise additional capital to offset against the euro-zone sovereign debt they hold, and further accelerate European bank de-leveraging, or debt reduction.

Policy response

In order to restore investor confidence in the event of further downgrades, and trigger a rebound in risk assets, the European Central Bank (ECB) would need to intervene in bond markets on a large scale to stop yields from rising further (yields move inversely to prices). National banks would also need to be leaned on to buy their domestic sovereign bonds. The ECB may potentially have to buy EFSF bonds in the secondary market to make the funding of the existing bailout plans more credible. The planned replacement of the EFSF with the European Stability Mechanism (ESM), which would have greater fire power, could also be brought forward.

2. Italian 10-year bond yields go substantially above 7%, and remain there

   Italian 10-year bond yields recently hit the critical 7% level, though they have since fallen back. Italy can afford such a borrowing cost for a few months, and perhaps even a year or two. But remaining above there would quickly make Italy’s debt position unsustainable and its credit rating would slip ever closer towards non-investment-grade status. Each downgrade would in turn lessen the pool of potential buyers, given minimum ratings restrictions for many institutional investors.

   Policy response

   In the event of Italian bond yields remaining above 7%, Italy would be too large to be bailed out by euro-zone governments. Only large-scale intervention by the ECB, or in an extreme case a credit line from the IMF, would be sufficient to drive a rebound in risks assets - Italy’s outstanding debt is around €1.9trn, of which about €340bn matures this year.

3. New EU treaty rejected by one or more countries

   While markets have reacted positively to the recent agreement to move toward fiscal union, a new European Union (EU) treaty has to be designed and then ratified independently by the 17 euro-zone countries, either through a Parliamentary vote or a referendum. The risk here is that one or more of these countries, at least initially, rejects it, delaying the whole process significantly and pushing risk assets lower.

   Policy response

   The country, or countries, rejecting the treaty would have to put it to a second vote, and it is likely that a revised treaty would eventually be passed, albeit by a reluctant electorate and only after much campaigning, coercing and partial amendment. While this would fix things in the near term and allow integration to proceed, it would come at the cost of increased civil opposition and continued political instability. Markets could be volatile while policy-makers placate the electorate.

4. Greece has a hard default

   Perhaps the most immediate risk is a hard Greek default. This could be triggered if Greece fails to reach agreement on private-sector involvement (PSI) in time to receive the next tranche of bailout funds and pay off debt maturing in March. Greece has consistently failed to meet the fiscal targets imposed as a condition for its original bailout, complicating efforts to agree on the PSI. With Greek and other European banks holding around €50bn and €40bn of Greek debt, respectively, significant losses would cause some banks to default themselves. The ECB would also have to take a loss on its Greek debt holdings.

   Policy response

   In the case of a disorderly Greek default, the ECB would have to further increase its liquidity provision to the European banking sector as interbank could dry up. Governments might also have to provide support to their national banking sectors. However, these actions would increase the risk of further government bond-rating downgrades, meaning the ECB would have to step up its government bond purchases to prevent bond yields from rising further. It would take some time to comprehend the full impact that a hard Greek default would have and investors would be hesitant to venture into risk assets, given significant fears of contagion in this scenario.

5. Greece leaves euro-zone, but rest stay together

   Another subset of the hard-default scenario is if Greece leaves the euro-zone, which would trigger default. Political risk remains high as Greece persists with its austerity programme. Eventual austerity fatigue may lead to Greeks voting to leave the euro-zone, either through a referendum or by the election of a euro-sceptic government. Alternatively, they may be “asked” to leave by the rest of euro-zone. Either way, Greece’s exit would very likely lead to contagion to other peripheral euro-zone countries as investors and citizens speculate which country will be next to leave.

   Policy response

   Loss of credibility means that it will be very hard to stop the domino effect. For example, it would be extremely difficult for European authorities to convince investors that no other country will follow. The ECB would have to buy peripheral European bonds en masse as investors flee to quality safe-haven government bonds, such as those of Germany and Holland within the euro-zone and the US and Japan outside. The ECB would have to significantly increase its liquidity provision to European banks as a loss of confidence and dried-up interbank lending push some of them to the brink of bankruptcy.

6. Euro-zone breaks up completely

   And in the most severe – though least likely – scenario, plummeting investor and depositor confidence as Greece leaves the euro-zone leads to bank runs spreading to other countries. In this scenario, capital would rapidly flow out these countries into safe-haven countries, putting intense pressure on the banking sector in multiple euro-zone countries. Credit growth would turn very negative and there would likely be a severe decline in trade. Countries across Europe would be pushed into deep recession, leading to further deterioration of their fiscal positions. In the end, such a vicious circle could result in additional peripheral countries deciding to leave the euro-zone in an attempt to boost growth through currency depreciation. The eurozone would cease to exist or adopt a very different form.

   Policy response

   It would be almost impossible to restore confidence quickly under such a scenario. The ECB would cease to exist or its powers would be significantly impaired. The US, Chinese and international authorities (e.g. the IMF) would have to share the burden of trying to stabilise the global financial system. Another round of quantitative easing from the US would be very probable, as would substantial monetary and fiscal easing from the Chinese and other Asian and emerging-market authorities. The member countries of the Organisation for Economic Cooperation and Development (OECD) would have to co-ordinate at a global level as they did in 2008/2009 and the IMF would have to open credit lines to most of the countries leaving the euro-zone. The IMF, though, may not be able to raise the required funds to achieve this immediately. This sequence of events would require a much bigger policy response and more time to stabilise the markets than the 2008 Lehman collapse.

Euro-zone survival in its current form still most likely

We continue to see euro-zone survival in its present form as the most likely scenario, with the costs of failure being potentially much higher than bailing out indebted members. How severe the euro-zone recession turns out to be will be governed by the policy response and whether any of these risks materialise. But depending on the policy response, and the severity of the event, they could also provide buying opportunities. The risk of these events occurring, even if our main scenario holds true, will create continuing volatility for risk assets this year as investor concerns ebb and flow.

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