Bank finance articles and tips

The current issue is not whether the euro has performed as was promised, whether it was mis-sold or even whether it was a bad idea. It is whether or not the single currency is worth saving - would the consequences be worse if the eurozone was broken up, or if it was saved?

The choices

There is no legal way of exiting the euro. However, if a country did leave the union, regardless of the law, there would be a number of ramifications.

If a weak country, like Greece, left the euro, there would be a run on the banks. Depositors would try to withdraw their funds in euros before they were converted into a new currency. This new currency would immediately devalue against the euro (estimates range between 30% and 70% against the euro) to the extent that businesses with international bills would no longer be able to cover them, and this would increase the pressure on other struggling economies with exposure to Greek debt.

If a strong country, like Germany, left the euro, the new currency would soar. This would hit exporters as exports became more expensive and less competitive when converted into euros. Businesses with international dealings would suffer as any assets outside the new currency zone would devalue. And, the rest of the eurozone might divide, as other countries wouldn't want to be stuck with the remaining weaker economies, which could lead to the collapse of the European Union itself.

UBS analysts have estimated that a euro collapse could cost a peripheral economy 40-50% of GDP in the first year, and a core economy 20-25%. That's up to USD152.7 billion for Greece, and USD825 billion for Germany. Without considering the ongoing costs, the immediate cost of breaking up the eurozone could easily reach trillions.

By contrast, a successful rescue, including the money already spend on rescues as well as the cost of recapitalising European banks and potential European Central Bank (ECB) losses, will be in the hundreds of billions.

The rescue

To date, the eurozone's strategy has focused on cutting budgets and saving face. Austerity measures have been intended to both reduce the debt of the peripheral economies as well as prove that they are genuinely acting on this issue.

However, by enforcing strict austerity measures, these governments are unable to stimulate their economies with public spending and, consequently, these economies are unable to grow their way out of debt by increasing productivity and exports.

And, if we argue that the cause of this mess is a loss of credibility (European authorities have been claiming that Greece is both solvent and saveable, while it has been clear for some time that it is neither), we can conclude that budget cutting won't help.

The first step that needs to be taken is determining which of Europe's economies are illiquid, and which are insolvent.

Europe's leaders have denied that Greece is insolvent, and this has caused a loss of credibility because the world now knows that it is. However, the issue with Spain and Italy is not that they are insolvent, but that they are illiquid. Yet, as Europe's leaders have not formed separate strategies between how they are handling these differing situations, Spain and Italy are under fire because investors are worried they will default.

A credible rescue should start with a focus on growth, and restructuring debt where necessary. Greece is insolvent, so its debt should have an orderly write-down, and the second bail-out package should be discarded.

On the other hand, Spain, Italy and Portugal (which is nearly solvent) should be supported with unlimited backing. By creating conditions for renewed growth, such as privatising companies, cutting bureaucracy and lifting legal retirement ages, these economies will have a chance of reducing their debts and returning to productivity.

The next step would be propping up Europe's banks so they can withstand a Greek default.

Moody's has downgraded French banks Societe Generale and Credit Agricole due to their exposure to Greek debt, showing that a Greek default would threaten both international and Greek banks. Some banks may be able to raise money for recapitalisation in the stock markets, but many will need government help. And, while those in Germany and the Netherlands will be able to recapitalise their own banks, peripheral governments may need European Financial Stability Facility funds.

However, this won't work unless the solvent economies have enough time to push through reforms. The simplest way to do this would be the ECB declaring that will back all solvent economies' sovereign debts and that it will use unlimited resources to stave off public panic. As long as the governments are solvent and the bank sells the bonds back to the market after the crisis, this wouldn't amount to monetising government debt (or inflation, in the current recessionary environment).

The risks

Although the monetary cost of a rescue is lower than that of dissolution, Germany will probably be up in arms that Italy and Portugal are getting off Scot free.

The immediate risk is that Germany will demand that Greece is expelled from the eurozone to frighten the other, solvent states. Although this would alarm Portugal and Ireland, Spain and Italy are too large to be thrown out. And this would undermine the security of the small members of the EU. And once Greece's debt is restructured, its economy will have a much better chance to grow in future.

The longer-term risk relates to the future of the EU. The sovereign debt crisis has revealed the difficulties of several separate economies trying to operate under a single currency, and a new central body may be created to manage this - individual countries could become states within a European federation, much like in the US. This raises the question of what happens to the EU countries that kept their own currencies - will they be forced to choose between joining the euro or leaving this new Europe?

Conclusion

We started by asking whether the consequences would be worse if the eurozone was broken up or saved.

Although making the currency more sustainable in future may be a challenge, involving the creation of a new central body or giving more power to existing ones, the monetary and political costs of saving the eurozone are lower than the potential costs of breaking it up. If the intervention is well-planned and well-presented to the market, the ECB may not even have to buy that much debt, as investors would then step in.

Check out my blog Talking Forex - a beginner's guide to forex.

I am not a financial adviser, and the information in this blog is just intended to inform and not advise. Please remember that forex is a leveraged product, so it's possible to lose more than your original investment. Forex trading might not suit everyone, so please ensure that you fully understand the risks involved with this type of trading.

By Sienna Jane Miller
Article Source: http://EzineArticles.com/?expert=Sienna_Jane_Miller