Euro crash: The possibility

The path that the economic activities of the European Union countries are headed and the expenditure patterns and corruption of some of the countries in the euro zone leads us to believe that at least a partial breakup of the EU is inevitable and as a result, there could be tremendous change impact on the euro – a currency that is presently shared by 17 nations accounting for one-eighth of world GDP.

Criticality in restoring growth

Politicians keep pumping in money to support the weaker nations’ debt problem. What they should do is to talk about restoring growth. Looking at the present disastrous state that the EU is in, one cannot help but guess that the only way to bring back growth and get Europe out of this mess is the breakup of the euro. With politicians refusing to face reality I can’t see this happening soon enough. What is happening instead is that Europe’s political leaders and regulators strongly back the euro’s survival and claim that a breakup would result in an economic catastrophe.

There was a belief in September that the EU will hold when Mario Draghi, Chief of the European Central Bank, announced a program for purchasing the sovereign debt of weak euro zone nations. Draghi further said that the euro is irreversible.

Then, on 12 September, a German Court approved the country’s participation in the European stability mechanism, a rescue fund with a lending capacity of $ 645 billion. These continued bailouts are only buying time. Even economists admit that the euro zone may collapse eventually unless Germany and the other four to five healthy nations provide far greater support to their weak neighbours.

Yanis Varoufakis, a Greek economist, says: “Europe needs to create Federal-style debt shared by all the euro zone nations.” If that does not happen, the euro zone may probably dissolve.

If the current situation continues in the EU, the euro will fracture in the next three to four years. The result will cause an extreme mess in the immediate aftermath, bringing with it severe hardship to the existing countries where we may see bankruptcies, major defaults on sovereign debt and panic in the world stock markets.

The ‘pain’ that a breakup compresses into a one-time shock will happen anyway if weak nations remain in the euro. Roger Bootle, a British Economist who predicted the bursting of the ‘dot.com’ bubble, argues “Europe must choose growth and a split in the euro will bring it back with surprising speed.”

Painful devaluations

To restore competitiveness, Europe’s weak economies need to devalue their currencies. Table 1 as published by ‘Capital Economics’ shows how much each new currency needs to fall against the euro after an exit.

The continent’s weaker nations cannot possibly solve their big problems if they remain in the common currency. The first of the big problems is what the politicians and regulators talk about the most, i.e., the huge overhang of sovereign debt, exceeding 100% of GDP in nations such as Greece and Italy.

The second of the big problems is that the Europe’s PIIGS (Portugal, Ireland, Italy, Greece and Spain) all suffer from a drastic loss of competitiveness because they are faced with an excessive cost of production, especially when compared with Germany. Manufacturers in Spain and Italy are struggling, as a result, to compete with imports.

The debt and interest payments of countries such as Greece, Spain and Italy would remain in euros and keep rising while tax receipts fall. It would be almost impossible for those nations to default on their debt and stay in the euro zone.

Re-denominate loans

With regard to the private sector, Bootle recommends re-denominating loans to the stricken banks in the local currency. If not, their capital and all domestic lending would evaporate. For corporations, loans would remain in euros. It is common sense that a multitude of companies would be unable to service their debt with revenues in local currencies now worth far less in euros. This is perhaps the most difficult part of a euro exit. Bankruptcies would proliferate and lenders would engage in negotiations for restructuring debt.

With the weaker nations out from the euro zone, Germany, the Netherlands, Austria and other Northern  European nations  will maintain the euro in their own single-currency zone an outcome that would be likely to cause the euro to strengthen over time against the dollar and the pound sterling.

An exit would bring a surge in inflation in newly departed countries as the cost of imports rise. Hence, wages would also rise. Bootle calculates that a large drop in the value of the new currencies against the euro is necessary. The Greek currency will need to fall 55%, those of Spain and Italy 40% and the new Irish pound by 25%.

The Italian Prime Minister who is an academic and not a politician was strongly inclined in the early part of this year, to get a bill passed in Parliament to tax, for the first time, the Roman Catholic Church. The Catholic Church owns several prime properties from which the church earns very high untaxed revenue. This bill was proposed to tax the revenue earned from the assets of the Catholic Church. It was believed that huge sums of money could be earned to contribute even in a little way towards stabilising the falling economy.   

Hope in the post-devaluation

The departing nations would suffer several months of declining growth and rising unemployment. World stock markets would collapse. However, as happened in Argentina, after its currency was devalued 10 years ago, the economies would start growing again within a year, driven by strength of exports. Germany would suffer from a far higher, properly valued currency that would hurt its exports. But, it would also benefit from lower import prices and growing, rather than failing neighbours to the South.

Fundamental economics will ultimately dictate the outcome. Politicians dazzle communities with ‘fairy tales’ and get lots of money from the public sector to buy time, but the markets win in the end. For Europe, abandoning the single currency is no longer an unthinkable choice, but the right choice.

(Nalin Jayasuriya is the Managing Director & CEO, McQuire Rens & Jones (Pvt) Ltd. He has held regional responsibilities of two multinational companies, of which one, Smithkline Beecham International, was a Fortune 500 company before merging to become GSK. He carries out consultancy assignments and management training in Dubai, India, Maldives, Singapore, Malaysia, Indonesia and Bangladesh. Nalin has been Consultant to assignments in the CEB, Airport and Aviation Services and setting up the PUCSL. He is a much sought-after Business Consultant and Corporate Management Trainer in Sri Lanka. He has won special commendation from the UN Headquarters in New York for his record speed in re-profiling and re-structuring the UNDP. He has lead consultancy assignments for the World Bank and the ADB. Nalin is an executive coach to top teams of several multinational and blue chip companies. He is non-Executive Director on the Boards of Entrust Securities Plc and Eswaran Brothers Exports Ltd.)