“The Euro should not exist,” reads the first line of a note released by UBS Tuesday, which analyzes the possibility of an EU break-up and concludes that the costs are too high to bear, both for “strong” and “weak” European nations.
The cost of a peripheral secession would be about €9,500 to €11,500 per person the first year ($13,360 to $16,172), then €3,000 to €4,000 annually in coming years ($4,219 to $5,625) , according to UBS, along with a collapse of the domestic banking system, corporate and sovereign default, massive currency devaluation, and a fall in the volume of trade of about 50%.
The case for a “strong” country ala Germany isn’t as bad, but would still constitute a substantial blow to that economy, a collapse in the banking sector, and a complete loss of export-competitiveness.
Recurring sovereign debt problems in Europe have escalated beyond smallperipheral nations and currently jeopardize the existence of the whole Union, as Italy and Spain (the third and fourth largest economies within the block) have come under fire by bond vigilantes and now require ECB help. (ReadEurope’s QE? A Look At The ECB’s Purchases Of Italian Debt).
It is common knowledge today that the EU was an ambitious project that idealistically sought to integrate Europe, socially, politically, and economically, but failed in taking into account internal imbalances.
The EU’s monetary policy was clearly dysfunctional, as low rates fueled asset bubbles in peripheral nations, which, as the EU-wide economy expanded, grew larger and larger. “Politicians generally fail to appreciate that economic threats can also wear a (temporarily) positive appearance, in the form of bubbles,” reads the UBS note. As the bubble began to pop, the underlying economic programs exploded in tandem.
As the gravity of Europe’s problems grew, commentators have begun speculating about the possibility of an EU break-up, either in the form of a country deciding to leave or being forced to leave by its peers. This essentially leaves two scenarios, which the UBS note takes into account: a “weak country” exit (Greece, Ireland, Portugal, for example), and a “strong country” exit (Germany, France, for example) We are going to focus on the former. (Read Risk Of Euro Break Up Higher Than Ever As Political Storm Hits In September).
As an aside, UBS’ analysts point to the legal difficulties of a member country leaving the Eurozone. The EU, constituted by a series of treaties including the Lisbon Treaty, the Maastricht Treaty, and the Rome Treaty, wasn’t built to deal with break-up, and doing so would require amending the treaties and face protracted political limbo. Sovereign nations, though, could unilaterally leave. So what would happen if, say, Greece left the Euro?
The costs of leaving the monetary union and establishing a new national currency (NNC) are huge, according to UBS. The first major hurdle would be a sovereign default. Secession from the EU would practically require a redenomination of foreign debt in NNC, so as to guarantee some sort of control over the debt. “This would constitute default in the eyes of most investors.” Default means billions in losses for EU banks, local banks, creditors and probably debtors around the globe.
Currency devaluation would be severe. While many have said a 15% to 20% devaluation would help weak countries gain competitiveness, the situation would be much more extreme: UBS estimates our “weak country” would see its currency fall by 60% (taking Argentina and the fall of the US monetary union in the ‘30s as precedents). This, in turn, would lead to a spike in the cost of capital.
“At a very conservative estimate, this would entail a 700bp risk premium surge. If the banking system is completely paralyzed then the cost of capital de facto increases an infinite amount. In the extreme paralysis of finance, capital is not available at any price.”
Rising capital costs would both take their toll on local firms, from large to small, and banks. Firms would collapse as funding dries up and the possibility of bringing in money from abroad becomes increasingly difficult(people have to accept the new NNC). The banking system would completely collapse. Investors will withdraw money en masse in response to the uncertainty surrounding the forcible revaluation of accounts into NNC. From the note:
Confronted with the obvious uncertainties surrounding the establishment of a NNC, the obvious response of anyone with exposure to the secessionist banking system is to withdraw money from the bank as quickly as possible. This could be done electronically – unless the government puts in place stringent capital controls. In that event, the wise depositor anticipating the creation of a NNC would withdraw their money in physical Euro form, pack it into a suitcase and head over the nearest international border – unless the government seals their borders to the movement of people. In that event, the sensible depositor would withdraw their money in physical Euro form, pack it into a suitcase and bury it in their garden. The only way that can be prevented is to shut the banking system entirely, or perhaps place a limit on the amount of withdrawals that can be made over the transition period.
The costs of recapitalizing the banking system would probably be borne by depositors. In Argentina, the government enforced the conversion of dollar accounts into pesos “at the old official exchange rate” and then devalued against the dollar. Along with an expected bank run, the depositors in our weak country would see their accounts’ value fall by 60% in the case of 60% devaluation, according to UBS. (Read Euro Banks Stocking Up On Dollars To Avoid Liquidity Squeeze).
Trade would completely break down as well, as a forced devaluation wouldn’t be met by a host of idle trading partners willing to accept NNC-denominated goods that are 60% cheaper. It would be reasonable to expect a 60% tariff in response to a 60% depreciation of the NNC, a response the European Commission “explicitly alludes to,” according to UBS, bringing trading volumes down by about 50%.
Finally, along with a corporate default, we would face civil unrest and a society tipped into chaos, as unemployment spikes and people are left without basic necessities, much like in Argentina back in 2001-2002. A very rough estimate leads UBS’ analysts to estimate secession would cost each person in that country €9,500 to €11,500 per person the initial year. “These are conservative estimates. The economic consequences of civil disorder, break-up of the seceding country, etc, are not included in these costs,” warn the analysts.
Despite much talk of the possibility of a break up, if UBS’ analysts are right, “conservative” estimates show that secession is pretty much a death wish for any small European nation. The situation for a large country is similarly prohibitive. No one wants riots, looting, and long-term poverty. No one wants a repeat of Argentina back in 2002. (The video below shows what the situation was like in Argentina as the crisis hit).
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