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Euroland debt crisis scenarios Document Transcript

  • 1. Investment Research — General Market Conditions 25 January 2011ResearchEuroland: Debt crisis scenarios In this paper we examine different scenarios for the outcome of the European debt 10-year government bonds crisis. We believe the sovereign debt crisis will eventually be contained but that we 14 % 14 should expect continued high market volatility for some time. Greece 12 Ireland 12 Portugal A lot of political capital has been invested in the euro project and ambitious 10 Spain 10 mechanisms have already been put in place to deal with the current crisis. We believe 8 Italy 8 political leaders are willing to go even further to ensure a solution can be found. 6 6 4 4 The EFSM, EFSF and IMF measures are sufficient to cover almost all of the 2 France Germany 2 government financing needs of Ireland, Portugal and Spain over the next three years. 96 98 00 02 04 06 08 10 We expect that European leaders will decide to expand the EFSF’s lending capacity to Source: Reuters EcoWin and Danske Markets restore calm in the markets. If overall sentiment starts changing and the political will vanishes in either the peripheral countries or the core this could trigger the much less likely scenario of Aggregate rescue packages sovereign defaults and/or a break-up of the euro. Euro rescue package Greece EUR 750bn EUR 110bn ESM incl. GreeceScenario 1 – Crisis contained ESM adj. (ex. GR, IR)We believe a scenario in which the crisis can be contained to be the most likely outcome Total - PIGSof the European debt crisis but we should expect continued high market volatility for Spain Govt. financing needs Greece for three yearssome time. Ambitious mechanisms have already been put in place to dampen the crisis Portugaland with the amount of political prestige that is already invested, we believe political Ireland EUR bnleaders are willing to go even further to ensure a solution can be found. 0 200 400 600 800 1000The current measures are extensive and if they are increased further it is less likely that Note: The ESM adj. (ex.GR, IR) is adjusted for boththey will have to be used for e.g. Spain as bolder measures may help to restore calm in the over-collateralisation and lending margins. ESFS contributions from both Greece and Ireland arefinancial markets and thus reduce the cost of sovereign debt financing on market terms subtracted.for peripheral countries. Source: Danske MarketsAccording to our estimates the current European Financial Stability Mechanism (EFSM),the European Financial Stability Facility (EFSF) and IMF measures are sufficient to coveralmost all of the government financing needs of Ireland, Portugal and Spain over the nextthree years (Greece has its own EUR110bn package). If the EFSF is to cover Italy itwould have to be increased substantially. An increase in the EFSF seems to be the mostlikely development and is already partly anticipated in the market.It has also been suggested that the EFSF should be allowed to purchase governmentbonds in the secondary market in much the same way as the ECB does today with itsSecurities Market Programme (SMP), but possibly on a larger scale. Alternatively theEFSF could lend money to the countries themselves so that they can buy their owngovernment bonds back at market prices. This manoeuvre has the advantage that it wouldhelp to reduce the countries’ nominal debt without being a default event. Finally, a Senior Economist Frank Øland Hansenreduction in the interest rate charged to countries in need of help from the EFSF has been +45 45 12 85 26considered. Ireland currently pays a spread of almost 300 basis points, which puts franh@danskebank.dkadditional pressure on fiscal sustainability. Economist Anders Møller Jørgensen +45 45 12 84 98 andjrg@danskebank.dkImportant disclosures and certifications are contained from page 5 of this report. www.danskeresearch.com
  • 2. ResearchECB governor, Jean-Claude Trichet, has been calling for an increase in “both quantityand quality”, which can be interpreted as a call from the ECB to have the EFSF increased ESM including aid for Greecein size and (at least partly) take over the current role of the ECB’s Securities Markets Sweden, UKProgramme. We do not believe that the current uncertainty will prevent the ECB from and Denmark: 4.8 mia.hiking interest rates later this year if needed. IMF: 250 mia.We expect that the Eurogroup will announce a strengthening of the EFSF at their Marchmeeting and that this will include a combination of the above measures with an increase EFSF: 440 mia.in the total amount available and the use of EFSF funds for purchases in the secondary Aid formarket as the most prominent measures. Greece: EFSM:110 mia. 60 mia.Initially the EFSF was to expire on 30 June 2013, but with the agreement on a permanentcrisis mechanism in November 2010 the existence of the facility will continue. What form Source: Danske Marketsit will take after this date, however, is less clear.Continued public consolidation and structural reforms will have to be implemented beforethe crisis can be beaten for good. This will continue to be a central theme throughout theyear.Scenario 2 – E-bonds and quasi fiscal unionPolitical leaders have called for a common European bond, or what is often referred to asan E-bond. In December 2010 the president of the Eurogroup, Jean-Claude Juncker,proposed the issuance of E-bonds of up to 40% of euro area GDP. The idea is that eachmember state would be allowed to borrow up to 40% of its GDP at low interest ratesthrough an AAA rated E-bond market. To achieve an AAA rating the best performingcountries will have to guarantee for part of the less well performing countries debt. Debtabove 40% of GDP would have to be issued by the member states themselves at anexpected higher interest rate. This structure should give the member states an incentive toconsolidate and ensure sound public finances. Furthermore, the E-bond market depth andwide basis would be similar to that of US public debt, ensuring better access to capital forthe minor countries despite their economic difficulties.The proposal has so far been rejected by Germany, indicating that an enlargement of theEFSF is probably more likely. German Chancellor Angela Merkel is concerned aboutmoral hazards and has said that: “We must not make the mistake of thinking thatcollectivising risk is the answer”. To avoid moral hazard problems an E-bond would haveto be supplemented by a more coordinated fiscal policy and further central supervisionfrom EU authorities. The introduction of E-bonds could thus lead to the “quasi” fiscalunion that Trichet has been calling for.Japan has said that it would like to purchase 20% of the issued E-bonds and moreimportantly, it did not say anything about potential purchases of any of the PIIGSsovereign debt.Scenario 3 – Default or euro break-upIf overall sentiment starts changing and the political will vanishes in either the peripheralcountries or the core this could trigger sovereign defaults. The defining event could be ifItaly needs help, but it could also simply be a change in power following deterioration inthe general support to further belt-tightening in periphery countries and/or an increase inresistance to further financial support in core countries. Another option that has beenmentioned is an actual break-up of the EMU where all member states leave the euro.We see the probability of a euro break-up as very low. However, it may still be worthconsidering some scenarios of how it could take place. There exist different default andbreak-up scenarios that vary in terms of how serious an impact they would have on thefinancial system and economic growth. Common to all of these is that we do not exactlyknow how they would look as we are entering unchartered waters.2| 25 January 2011 www.danskeresearch.com
  • 3. Research 1. The mildest version would be that one, or maybe a few of the periphery countries default on their debt resulting in a debt restructuring. The candidates most in danger of this are Greece, Ireland and Portugal in descending order. It is less clear how this technically would be done. However, this does not automatically mean that they would have to leave the EMU, just as nobody expects Florida to leave the US should it default. A sovereign debt restructuring within the euro area is not necessarily a “quick fix”. If , for example, Greek sovereign debt is restructured this would result in losses for German and French banks among others, but more importantly it would also result in renewed fears about which other countries could decide to restructure with both Italy and Belgium being likely candidates for speculative attacks. The country that defaults would also have to be prepared for a period with limited access to financial markets and the default option thus appears most attractive for a high-debt country that isn’t far from having a balanced primary budget. A debt restructuring also does not help the country to improve its competitiveness due to the common currency. Alternatively a periphery country may decide to leave the EMU if it deems it too tough to get the economy out of the doldrums without being able to devalue and regain some competitiveness this way or if internal public opposition becomes too strong. This is likely to initially cause a bank run in the respective country due to fear of losses on deposits relative to banks in the core euro area. A capital flight from assets likely to be redenominated should also be expected. The risk of redenomination of the government debt (from the euro to e.g. the drachma in the hypothetical case of a Greek exit) and expectations of currency depreciation will result in higher sovereign spreads. But if the government decides not to re-denominate, the debt to GDP ratio will increase, which would put further pressure on fiscal sustainability. It is likely that confidence in the new currency would be so low that the country could see “dollarization” with euros to be used in parallel to, or instead of, the reintroduced domestic currency. A way to go would be to undertake an initial depreciation/devaluation followed Credibility takes years to win, but can by a peg to, for instance, the euro at a much lower level. If the country doesn’t be lost in a minute peg the currency but instead allows it to depreciate further, increasing inflation 8 8 %-point, 10 year sovereign spread to Germany from imported goods could result in a vicious cycle with increasing inflation 7 Denmark 7 6 6 and inflation expectations. To defend the peg, sound public finances have to be 5 5 4 4 combined with high official interest rates until confidence in the currency is 3 3 restored. Confidence in a peg may take years to establish as Denmark 2 2 1 1 experienced after it pegged the currency in 1982 and stopped with occasional 0 0 devaluations in 1986. It was not until 1991 that the 10-year sovereign spread to -1 -1 83 86 88 90 92 94 96 98 00 02 04 06 08 10 Germany tightened to below 1%. Source: Reuters EcoWin and Danske Markets The implications for financial markets and the global economy of periphery countries leaving the euro area would depend on the fragility of the financial system at the time. Concerns about which other euro area countries may leave could result in a prolonged period of high volatility and a continuation of the debt crisis. We believe that this scenario has a very small likelihood of materialising as the economic cost seems to outweigh the economic benefits – at least in the short term. However, in the end the decision really depends on public opinion and political leadership. The scenario can thus not be fully ruled out.3| 25 January 2011 www.danskeresearch.com
  • 4. Research 2. Germany leaving the euro. This scenario is very unlikely in our view. But it cannot be completely ruled out if, for example, public opinion against financial support for the periphery countries increases significantly, e.g. if a “tea-party movement” demands that Germany leaves the euro. It could also be triggered by the German constitutional court saying that politicians have gone too far and breached the no bail-out clause. We doubt that the court would do more than issue a warning not to go further though. In any case an objection from the constitutional court does not imply that Germany would have to leave the euro. If Germany were to leave the euro zone, the D-mark is likely to be in high demand from day one and would be expected to appreciate. There would not be any bank runs or capital flight in Germany. However, bank runs could occur in the peripherals as the euro is likely to depreciate relative to the D-mark. Germany would, however, lose competitiveness. The flipside of the coin is that the euro zone would benefit from a much needed increase in competiveness as the euro depreciates. If Germany decides not to denominate its debt it would benefit from a decline in the debt-to-GDP ratio. On the other hand German banks and other investors could face substantial losses on their holdings in the rest of the euro area. Another uncertainty in this scenario is whether other countries would follow Germany. This uncertainly could prevail for quite some time resulting in higher sovereign spreads and volatility in FX markets. In this scenario there are good arguments for Finland and the Netherlands to consider leaving too. But then we could see a monetary union continuation, with France taking the lead role. We believe that this scenario has a small likelihood of occurring. The costs for Germany of solving the current problems within the EMU are probably smaller than the costs of leaving and the political will invested in the project clearly weighs against this scenario. But if Italy needs help this could be a game changer. 3. The worst-case scenario is a total breakup of the EMU. This could happen by mutual agreement or as a resulting domino effect if Germany decides to leave. It is likely that some of the core countries would peg their currency to the D-mark. German banks could experience severe losses due to currency depreciation on its holdings as well as potential defaults. A period of wide sovereign spreads and high volatility in the foreign exchange market would be expected. Devaluations and expectation of further depreciation could also result in a period of high inflation in a number of countries. The national central banks would have to set policy rates high to gain credibility.A break-up of the euro would affect the global economy, which is one of the reasons wesee both China and Japan as willing to invest in funding for the most indebted countries.The turmoil and uncertainty could lead to severe losses in the financial sector that wouldimpact the real economy, as we experienced it during the financial crisis.In contrast a scenario with a debt restructuring in Greece and maybe even Ireland wouldonly have minor impact on the global economy as long as other member states canmaintain their credibility. Since we believe a break-up is very unlikely we are notparticularly worried about the impact of the debt crisis on the outlook for the globaleconomy.In any of the default/break-up scenarios, risk premia could be expected go up for sometime. This would result in increases in swap spreads and an overall increase in creditspreads, as the current collateralisation and expectations to future collateralisationdisappear.4| 25 January 2011 www.danskeresearch.com
  • 5. ResearchDisclosureThis research report has been prepared by Danske Research, a division of Danske Bank A/S ("Danske Bank").Analyst certificationEach research analyst responsible for the content of this research report certifies that the views expressed in theresearch report accurately reflect the research analyst’s personal view about the financial instruments and issuerscovered by the research report. Each responsible research analyst further certifies that no part of the compensationof the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressedin the research report.RegulationDanske Bank is authorized and subject to regulation by the Danish Financial Supervisory Authority and is subjectto the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. DanskeBank is subject to limited regulation by the Financial Services Authority (UK). Details on the extent of theregulation by the Financial Services Authority are available from Danske Bank upon request.The research reports of Danske Bank are prepared in accordance with the Danish Society of Financial Analysts’rules of ethics and the recommendations of the Danish Securities Dealers Association.Conflicts of interestDanske Bank has established procedures to prevent conflicts of interest and to ensure the provision of highquality research based on research objectivity and independence. These procedures are documented in theresearch policies of Danske Bank. Employees within the Danske Bank Research Departments have beeninstructed that any request that might impair the objectivity and independence of research shall be referred to theResearch Management and the Compliance Department. Danske Bank Research Departments are organisedindependently from and do not report to other business areas within Danske Bank.Research analysts are remunerated in part based on the over-all profitability of Danske Bank, which includesinvestment banking revenues, but do not receive bonuses or other remuneration linked to specific corporatefinance or debt capital transactions.Financial models and/or methodology used in this research reportCalculations and presentations in this research report are based on standard econometric tools and methodologyas well as publicly available statistics for each individual security, issuer and/or country. Documentation can beobtained from the authors upon request.Risk warningMajor risks connected with recommendations or opinions in this research report, including as sensitivity analysisof relevant assumptions, are stated throughout the text.First date of publicationPlease see the front page of this research report for the first date of publication. Price-related data is calculatedusing the closing price from the day before publication.DisclaimerGeneral disclaimerThis research has been prepared by Danske Markets (a division of Danske Bank A/S). It is provided forinformational purposes only. It does not constitute or form part of, and shall under no circumstances beconsidered as, an offer to sell or a solicitation of an offer to purchase or sell any relevant financial instruments(i.e. financial instruments mentioned herein or other financial instruments of any issuer mentioned herein and/oroptions, warrants, rights or other interests with respect to any such financial instruments) ("Relevant FinancialInstruments").The research report has been prepared independently and solely on the basis of publicly available informationwhich Danske Bank considers to be reliable. Whilst reasonable care has been taken to ensure that its contents arenot untrue or misleading, no representation is made as to its accuracy or completeness, and Danske Bank, itsaffiliates and subsidiaries accept no liability whatsoever for any direct or consequential loss, including withoutlimitation any loss of profits, arising from reliance on this research report.The opinions expressed herein are the opinions of the research analysts responsible for the research report andreflect their judgment as of the date hereof. These opinions are subject to change, and Danske Bank does not5 | 25 January 2011 www.danskeresearch.com
  • 6. Researchundertake to notify any recipient of this research report of any such change nor of any other changes related to theinformation provided in the research report.This research report is not intended for retail customers in the United Kingdom or the United States.This research report is protected by copyright and is intended solely for the designated addressee. It may not bereproduced or distributed, in whole or in part, by any recipient for any purpose without Danske Bank’s priorwritten consent.Disclaimer related to distribution in the United StatesThis research report is distributed in the United States by Danske Markets Inc., a U.S. registered broker-dealerand subsidiary of Danske Bank, pursuant to SEC Rule 15a-6 and related interpretations issued by the U.S.Securities and Exchange Commission. The research report is intended for distribution in the United States solelyto "U.S. institutional investors" as defined in SEC Rule 15a-6. Danske Markets Inc. accepts responsibility for thisresearch report in connection with distribution in the United States solely to “U.S. institutional investors”.Danske Bank is not subject to U.S. rules with regard to the preparation of research reports and the independenceof research analysts. In addition, the research analysts of Danske Bank who have prepared this research report arenot registered or qualified as research analysts with the NYSE or FINRA, but satisfy the applicable requirementsof a non-U.S. jurisdiction.Any U.S. investor recipient of this research report who wishes to purchase or sell any Relevant FinancialInstrument may do so only by contacting Danske Markets Inc. directly and should be aware that investing in non-U.S. financial instruments may entail certain risks. Financial instruments of non-U.S. issuers may not beregistered with the U.S. Securities and Exchange Commission and may not be subject to the reporting andauditing standards of the U.S. Securities and Exchange Commission.6| 25 January 2011 www.danskeresearch.com