They admit that the probability of such a breakup is unlikely (about 10%!!), but with chatter circulating about the possibility of a Greek exit, other ailing nations could decide to follow suit.
Here’s their sketch on the disastrous consequences of the ultimate break-up (we convert euros to dollars):
– A change in currencies would result in an immediate depreciation of the new currency, with the nominal exchange rate falling about 60%. This would push liabilities in peripheral Europe up to 200-250% of GDP (they hover around 100% right now), given the debt were not redenominated in the new currency.
– Private and public bondholders would see defaults on as much as 40% of their bond holdings. If all the PIGS (not Italy) left the euro, core European banks would have to write off over $400 billion in assets. Peripheral European banks could see nearly $850 billion vanish.
– The subsequent banking crisis would be worse than it would be in emerging markets, because wages are inflexible and banks are much more vulnerable. Banks in peripheral EU countries might have to be nationalized.
– Disorderly defaults generally cause GDP in the defaulting country to fall by about 9%. The EU area would see a contraction of about 5% GDP and the U.S. would see a contraction of around 4%. The report sees the S&P falling to 750.
– Assets would be frozen to avoid a run on banks, huge legal problems would arise from the switch to a new currency, and a trade war would likely ensue between members of the EU.
– Any nation that left the euro would have to leave the EU.
BUT, they only give this about a 10% chance of happening. Here’s why:
– The cost of bailing out the periphery is not as high as the cost of a euro break-up, not to mention the contagion that would spread through bank loans. The cost is even too high for Greece, particularly since it’s still running a budget deficit.
– The euro area is in a sustainable leverage position and has a better current account and budget deficit that the U.S.
– The report’s authors do not think Italy and Spain will default, despite Italy’s recent downgrade.
– No political parties in the periphery are advocating leaving the euro.
They finish off the report with three alternatives to this scenario: Greece leaves the euro (but no other countries follow); the core EMU area would institute a new, stronger currency union but the periphery would maintain the euro; or Italy would leave the euro voluntarily.
While all these solutions would provoke controversy, rattle markets, and perhaps even spark trade wars, the Italian option is most interesting, in their opinion. Because it runs a surplus, default is more for Italy than other peripheral euro countries. It might also be able to avoid a private sector default, since its economy entertains minimal foreign net liabilities.
Clearly a euro exit would still cause major domestic problems for Italy — particularly in regards to servicing the country’s massive debt — but Credit Suisse thinks its decision would be “a lot less clear-cut.” Such a decision would also cause massive deflation for the rest of peripheral Europe, and could provoke other exits.
The report’s ideal solution is some combination of eurobonds with a leveraged EFSF, a solution which would require significant political manoeuvring. Regardless of the solution, the authors write, we’re going to see a weaker euro.
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