The cost of disorderly euro breakup

In their latest pronouncements aimed at settling the euro’s problems, Merkel and Sarcozy have advanced the notion of greater fiscal union within Euroland. It may be that the appointment of unelected technocrats to run Greece and Italy will allow this cause to be advanced regardless of the wishes of the voting populations and Germany’s warnings to the UK that it must accept its ultimate destiny within the proposed
Euroland super state could be considered as part of a growing momentum behind the push for greater fiscal union, although the responses of the Bank of England and FSA seem to have been to warn the UK banks to prepare for an imminent disorderly breakup of the single currency. Of course, comments such as
those will only encourage more deposit flight in the periphery (if they are reported there) and therefore become rather self-fulfilling prophecies – something which will have course already occurred to the BoE staffers.

That said, we may wonder why the appetite for some fiscal union has become so much more pronounced. Of course, such a union is necessary to save the Euro in the longer term, as is the creation of the nation state, but this has always been the case and we can wonder whether the recent enthusiasm for greater fiscal cooperation has a more domestic aspect. France is of course within a whisker of a rating agency
downgrade and its poor public and private sector debt positions, coupled with the ongoing slowdown in domestic income growth and its balance of payments deficit vs. Germany (as revealed by its debtor position within the TARGET system) are clear incentives for France to want to lose its own specific
situation relatively quickly into some Euroland “aggregate” system of accounts. However, Germany may also have problems to address: the large German banks are of course heavily exposed to the periphery through both their bond holdings and the interbank markets, and the Landesbanks and the insurance sector are also thought to have provided much of the insurance implicit in the sovereign CDSs that the large banks have then attempted to use to insure their positions. In the event of a Euro break up, some or many of these institutions would presumably need nationalising and recapitalising, at great expense to the
state. Meanwhile, the Bundesbank has c.€600bn in loans to the periphery through TARGET that are notionally collateralised by peripheral sovereigns, that might be described as ‘high yield’. These loans are also notionally guaranteed by the ECB, but of course the Bundesbank is a major shareholder in the ECB, which of course implies that in a real world sense the TARGET loans are not secured or guaranteed. These loans amount to the equivalent of 120 times the Bundesbank’s own capital.

As a further and connected point, if the Euro were to split, then Germany would be liable for some of the EFSF’s losses and presumably if a new German currency was formed and then duly soared as might be expected, the German government would also be forced into some form of domestic fiscal easing policy. Consequently, we could expect that if the Euro were to break in a disorderly way, then the bill to the German public sector could amount to €500 billion, or nearly 20% of GDP, and a budget deficit of 20%-25% of GDP following a Euro Break up would be undesirable, so saving the Euro and setting up Euroland fiscal arrangements to address these risks is much to be preferred.

If there were to be a Euroland Finance Ministry, then the ECB could have its own balance sheet. Contrary to popular wisdom, the ECB does not actually have a balance sheet of its own, it merely tells its component central banks ‘what to do’ on its behalf but this can cause tensions between what the ECB wants them to do and what their own domestic situations and legal positions require. However, if the ECB had its own balance sheet, the ECB could buy sovereign bonds for its own account (even if some of its component banks objected) and the Bundesbank and other central banks could presumably move the whole TARGET edifice onto the ECB’s balance sheet, reducing individual states’ potential contingent liabilities to the system.

We may conclude that partly out of a need to try to save the Euro, and also out of a need to protect against fiscal vulnerability in the event of a Euro break up, Mrs Merkel will push very hard for some form of Euro FinMin over the next few days. This may place her in conflict with those countries which still possess a democratic voice and even parts of her own political system. The next few weeks therefore seem unlikely to get any more peaceful for the Euro system.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla