Oxstones Investment Club™By Agustino Fontevecchia, Forbes,
The mess that has become the sovereign debt crisis in Europe has stirred the pot of secession, as commentators look at the possibility of Greece or any other peripherals leaving the Union. But what would happen if Germany were to leave the EU?
Germany would see its new national currency, let’s call it the neo-Mark, rally strongly, about 40% UBS says, effectively forcing banks to recapitalize, taking a hit on corporate balance sheets, and, most importantly, delivering a strong blow to its all-important export sector, as trade would fall initially by 20%, and then maybe by more.
I’ve already explained the consequences of a “weak country” Euro exit, modeled on the case of Greece. Some of the same considerations apply, particularly, the fact that the EU counts with no legal framework to deal with a break up. The Lisbon, Maastricht, and Rome treaties don’t delve into the intricacies of legally leaving the Union. But, given the EU is made up of sovereign states, the decision to secede could be taken unilaterally.
While most speculation has been about the possibility of a smaller, peripheral European nation either being expelled or leaving (so as to devalue its currency and take control of its monetary policy), the situation could be the exact opposite, with Germany or France deciding to leave.
(A “weak country” exit would probably lead to both sovereign and corporate defaults, a massive-at least 60%-currency devaluation, a total meltdown of the banking system, and probably years of high unemployment and subdued economic growth).
If Germany were to leave the EU, the initial reaction would be a strong appreciation of its new currency, the neo-Mark. Given the strength of the underlying economy, demand for the neo-Mark would propel it into pseudo-reserve status. “Given the dominance of intra-European trade for Euro area countries as a starting point,” trade-weighted appreciation is highly likely, with appreciation against non-Euro countries contingent on the extent of capital flight from Euros to neo-Marks and the extent of capital controls, among other things. The neo-Mark would appreciate by about 40%, UBS explained.
The two most significant effects would be a substantial blow to the export-sector and a hit on domestic firms’ balance sheets, particularly within the banking sector, which would be forced to recapitalize.
“The strong seceding country would effectively have to write off its export industry,” wrote UBS’ analysts. Germany, or any strong seceding country, would find itself at a competitive disadvantage against its main competitors in its principal export market (“there is little reason to suppose that the rump Euro would welcome a continuation of the free trade aspects of the EU with an apostate state”).
Trade volumes would tank by 20% according to UBS’ “conservative estimates.” Added to a loss of exclusive access, our strong country would have to face a currency that just appreciated by about 40% and a “growth shock” to the remaining Euro countries (further worsening their terms of trade).
Aside from the export-sector, the seceding nation would face problems with its private sector. A default on domestic debt won’t occur as the conversion to the neo-Mark actually favors the country’s fiscal position (assuming the new currency appreciates).
Domestic balance sheets would take a big hit, particularly in the financial sector. While liabilities will be denominated in neo-Marks, banks’ assets will fare a mixed bag, some of them redenominated, others remaining in Euros. With euro-denominated assets loosing 40% to 50% of their value, banks’ capital would be drained.
At the same time, companies “with a significant portion of revenues deriving from euro denominated exports, but which [have] liabilities to the domestic banking system, [will be] vulnerable to default,” given the rapid deterioration in value of revenues in neo-Mark terms.
The cost of capital would jump, “as banks ascribe a higher premium to existing risks, and contemplate an increase in the risk of default in the corporate sector.” UBS estimates a 200 basis point increase is reasonable, which also includes the risks of bank recapitalization and default on euro-denominated assets.
Given the parameters stated above, UBS’ analysts estimate the cost of leaving the EU for Germany, or any other similar “strong country,” would be about €6,000 to €8,000 per person in the first year ($8,662 to $11,549). Given a jump in the risk premium and trade disruptions, each citizen would incur a cost of €3,500 to €4,500 in coming years ($5,053 to $6,496). From the report:
To put this into context, if Greece, Ireland and Portugal all defaulted on their debt with a 50% haircut, and the remainder of the Euro area bought all outstanding government debt in the market (including IMF debt), that would generate a cost of a little over EUR1,000 per person in Germany. The banking system would have sold its debt (at market) to the remainder of the Euro area, which might entail some recapitalization requirements in addition to that, where banks have failed to mark to market existing holdings of bonds. However, the idea that the Euro area purchases all outstanding debt of the three countries and then accepts a 50% haircut can be thought to be a fairly extreme bail-out scenario.
While social and political consequences are excluded from most of this analysis (imagine a majority of Germany’s manufacturing sector out of jobs because of a fall in trade volumes), it demonstrates that the costs of leaving the Union are way higher than the costs of bailing out its partners. Germany and France, essentially, seem to be doing the right thing, trying to save the EU so that a bad situation doesn’t turn into something worse.
Tags: cost of bailouts, cost of leaving the EU for Germany, ECB, EU, Germany, Greece, meltdown of the banking system, sovereign and corporate defaults, What-If scenario for EU Debt Crisis