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Nomura’s Peter Westaway, Jens Sondergaard, and Dimitris Drakopoulos present a note called Thinking The Unthinkable in which they note with dismay the “inability and unwillingness of policymakers to take swift action” in Europe.While they still see Europe surviving and muddling through the current crisis, they’ve reassessed their scenarios to give more weight to the bad possibilities.
It’s not pretty, and they assign an extremely low probability of a good “ahead of the curve” outcome.
Odds: Just 5%.
How it could happen: If Europe quickly expanded and enhanced the EFSF, allowed haircuts and restructuring of debt, and the ECB cut rates, alongside a path towards fiscal union, the EMU would survive with little impairment to long-term growth.
How it works: The EFSF is successfully implemented, Spanish and Italian yields come down as their solvency becomes credible and European banks are recapitalized. In this case, the EMU survives, but long-term growth robustness remains down.
How it works: The ECB does not do enough to reduce yields, Spain and Italy lose market access, forcing a massive tripling of the bailout fund. In the end, it's very painful. Ultimately, the continent must continue working towards more fiscal union.
How it works: Greece defaults on its debt either due to a bad Troika outcome or due to a failure of countries to ratify the July 21 bailout. The ECB stops supporting the Greek banking system, but it mooches off the EFSF to survive. Greece enters a deep 10-20% recession, and policymakers are forced to triple the size of the EFS to prevent a crisis in Spain and Italy.
How it works: Greece leaves the eurozone after a default. Within this 8% odds there's a 2% chance that Spain and Italy leave too.
Here's Nomura's full commentary:
• As in scenario 4, capital controls might need to be preemptively imposed to prevent implosion of national banking systems in advance of a formal EMU exit. This would likely be precipitated by Greece failing to meet its austerity targets and official financing lines being withdrawn along with a withdrawal of support for the Greek banking system by the ECB.
• Countries leaving the EMU would undergo strategic devaluations, perhaps in the order of 25% in an attempt to restore competitiveness. Newly independent countries would hand over monetary policy implementation to national central banks, which would need to establish credibility quickly to avoid the devaluations being eroded by surging inflation.
• .As in scenario 4, the periphery countries affected would suffer a severe recession because of the lost access to market funding and the severe banking sector impairment caused by the crystallization of sovereign bond losses. But this would be further accentuated by the likely increases in local debt obligations as currency devaluations increase debt burdens and in all likelihood would lead to increased private sector defaults.
• More generally, the loss of confidence in Europe would likely cause a prolonged recession across the euro area as a whole.
Long-run outcome: The potential gains to be had from being part of a large currency union would be lost to all the euro-area members.
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