Sunday 17 December 2017

The good, the bad, and the likely

Time is limited as European Union leaders meet in Brussels today to try and hit on a panacea for the euro debt crisis -- and in the face of sceptical markets, Donal O'Donovan and Emmet Oliver argue that the realistic options boil down to ...

In a nightmare scenario, the European Council fails to reach any substantive agreement today and markets react with fresh alarm, pushing bond yields across the eurozone to dangerous new highs.

No agreement is reached to give Greece a second bailout worth up to €150bn. Following objections from the ECB, no private sector involvement is announced to make the current Greek debt burden bearable.

In this scenario, a so-called "disorderly" Greek default starts to become a reality and, coupled with similar debt woes in the US, the global economy starts lurching towards a huge financial calamity.

With no sign of a second Greek package, Greece approaches the autumn with the real chance it will simply finally run out of money, with no outside agency there to help with emergency funds, including the IMF and the EU. A parallel failure to raise the US debt ceiling causes colossal losses in the world economy as the US fails to make interest payments (coupon payments) to holders of US Treasury bonds.

Greece finds it can no longer redeem its bonds as they become due and the country crashes towards a default, leaving the French and Germans banks facing huge losses. A disorderly default also collapses the Greek banks that are holding large portfolios of Greek bonds, which are all but worthless as the default occurs.

For Ireland, this means bond yields (effectively borrowing costs) spike to alarming new levels, ending any hope that the Irish Government can re-enter the bond market or Irish banks can end their ECB dependence. The chances of Ireland regaining its economic sovereignty are all but dead.

Worries that Ireland may be next to default cause deposits to flow out of Irish banks, massively ramping up Ireland's need for ECB money. The Frankfurt-based bank starts to baulk at the sheer scale of liquidity its providing to Ireland and concerns rise that the economy here could be close to some kind of financial implosion.

Ireland's chances of getting a cut in the interest rate on its bailout loans disappears and other options -- like stretching out the term of our loans or allowing the Europeans to buy off our existing bonds -- disappear in the chaos that envelopes markets.

The key concern would be bank deposits -- would retail depositors in particular stay faithful to the Irish banks? If they do, the consequences of all this disruption for Ireland could be to some extent limited, but if retail deposits (€134bn in February of this year) flood out of the system, the ECB would have to provide unprecedented injections of liquidity that surely no central bank could accept.

An option at this point would be for the Irish Central Bank to increase its injections of liquidity into the system, but such an increase in its balance sheet would be seriously problematic, essentially forcing the Government to again stand over any losses on this lending.

At that point, the ECB's balance sheet -- which is now funding banks in many European countries and also buying sovereign bonds -- starts to creak at the seams, with talk of the bank being insolvent. The Frankfurt-based bank starts printing euros to pay for all the liabilities it is taking on, in a similar fashion to the quantitive easing undertaken by Fed governor Ben Bernanke.

While a Greek default is one thing, wider disruptions to financial markets could begin far sooner than a formal Greek default.

As European policy-makers are rendered paralysed, rising bond yields and worries over defaults plunge markets into a Lehman-style credit crunch where funding dries up and mutual suspicion and extreme risk aversion breaks out on credit markets.

Markets react to the Greek paralysis by only placing money with so-called "safe-haven" assets, such as the Swiss franc (or depending on the circumstances the US dollar) or gold.

As the Greeks default, the country exits the euro and the EU and reverts back to the Drachma. It has to balance its budget virtually overnight, so it resorts to printing money to simply pay its own bills. Greeks have their euro savings "re-denominated'' overnight into drachmas, meaning the cost of importing goods surges, causing an inflationary spiral. The redenomination of euro implodes the Greek banks and worries rise over Ireland, Portugal, Italy and Spain.

At this stage, Germany fears the euro is no longer sustainable and brings about the break-up of the eurozone, reverting back to the Deutschmark. This forces Ireland to retreat back to the Irish punt, which is likely to be worth at least 40pc less than other leading European currencies. This gives an immediate boost to exports, but leaves the banks in serious trouble, as their debts will be in euro, but their income will be in pounds.

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