The eurozone: Taking the long view

There is a tendency in looking at the eurozone to focus on the crisis du jour, instead of taking the longer-term view. So let’s step back and take a very long term view of the zone, say twelve months.

What will be happening over those months and what decisions will the actors have to make?

I have spent my career in credit, and the most difficult discussion with bond issuers is always the twelve-month “stress scenario”: Assuming you lose access to the unsecured credit markets today, how will you stay alive for the next year? This requires a spreadsheet depicting all expected outflows and all inflows that do not include borrowing money. No one enjoys this exercise.

So let’s look at the peripheral countries’ cashflow over the next year. Outflows consist of (1) budget deficits; (2) maturing long and short term debt; and (3) deposit outflows (bank runs). Budget deficits are generally getting bigger despite austerity, because government revenues are declining. Deposit outflows can be financed by the ECB, so long as all of the banks are adequately capitalized. If they aren’t, the EU can provide the funds for recapitalization via the EFSF/ESM, as it is now doing with Spain and Greece.

That leaves the main problem: maturing debt. None of these countries can borrow at less than 5%. If they refinance their debts at >5%, their current debt levels are unsustainable. If they continue to run deficits and also refund their debt at >5%, they are non-viable. Therefore, at some point over the next twelve months, the peripherals will be forced to seek to refinance their maturing debt using money from the EU.

At present, that money is not on offer. The ECB will lend to solvent banks, but not to impecunious governments. The EFSF/ESM will lend to governments, but its lending capacity is a fraction of the peripherals’ outstanding debt. They can take care of Greece, Cyprus, Portugal and Ireland. But they cannot refinance the debts of Italy and Spain. To rescue Italy and Spain will require eurobonds, which have been repeatedly nixed by Germany and the other AAA countries.

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So the only thing that we know with certainty is that at some point over the next year either one or more of the peripherals will default and leave the eurozone, or else Germany & Co. will consent to eurobonds. Both outcomes seem quite implausible but, as Lady Thatcher used to say, there is no alternative.

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