Endgame looms for Eurozone

FOR anyone involved in politics or markets, catching up with the news last week was like a daily session at the dentist for root canal treatment – and with the surgery out of anaesthetic. From Athens to New York, Brussels to London, we seem headed towards a shattering catharsis. How brutal will the endgame be? And what should we be preparing for exactly?

Massive slides in global stock markets, dire warnings from the World Bank and the International Monetary Fund (IMF) of the world economy “in a dangerous new phase”, Greece in meltdown and America braced for a deepening slowdown: we hardly needed Business Secretary Vince Cable last week to liken our current predicament to “the economic equivalent of war”. For the atmosphere now is ominously akin to 1931 and the chain of events unleashed by the collapse of Credit-Anstalt. Everything seems headed for a denouement, the final spark to a massive pile of dry kindling. All around, the atmosphere crackles with foreboding.

The final spark will almost certainly be a default by Greece. That is now widely expected in markets. Only the timing is in doubt. The issue deeply worrying world leaders now is how disorderly this might be for the global financial system. For it is not Greece alone. It is the exposure of global banks to other tottering Eurozone countries such as Italy that could turn a national storm into a global crisis far greater than the aftermath of the Lehman Brothers collapse three years ago. This time around, politicians are either reluctant to act, or simply do not have the financial wherewithal to intervene with any positive effect. Meanwhile, it is the uncertainty, almost as much as the coming denouement, that is corroding confidence in markets. Businesses and households are bringing down the shutters.

The global extent of the crisis, with both America and Europe precariously close to recession and a lack of confidence in measures announced thus far to turn sentiment round, have now given rise to anxious calls from leaders of the G20 leading industrial countries, including the UK, for “concerted action” by the Eurozone. Developing countries now fear being dragged down into a destructive slump along with America and Europe.

But effective “concerted action” is exactly what has eluded the Eurozone till now. And there is no such thing as an insulated Greek crisis. The markets are frantically calculating the implications of a Greek default on Spain, Portugal, Ireland and, most immediately worrying, Italy. Its debt pile stands at ¤1.9 trillion (£1.7 trillion) and its debt-to-GDP ratio is heading to breach 120 per cent. And who might be next after Italy?

Just to give an idea as to what is at stake, UK banks alone have an exposure of ¤284bn to the government bonds of Greece, Italy, Portugal and Spain combined. German banks have an exposure of ¤353bn. French banks are in for ¤245bn and US banks ¤277bn. Confidence is already draining from the banking system on concerns over liquidity and solvency. No safety net is big enough for a chain-reaction crisis of this magnitude. Little wonder apprehension is now rising as to how the Greek crisis will play out.

This week will be pivotal. Senior officials of the “troika” – the IMF, European Commission and European Central Bank (ECB) – return to Greece to inspect the books and signal final agreement to the release of the latest ¤8bn instalment of the Greek bail-out. Its government has announced fresh austerity measures including cuts in public sector pensions and the shedding of thousands more government workers to secure this package.

But will Greece be good for the money? There are already widespread protests and crippling strikes which make implementation of these measures highly questionable.

Then there is the growing voter hostility in Germany to bail-out assistance. There are looming votes this week on amendments to the European Financial Stability Facility (EFSF) in the German Bundestag and in the Finnish and Austrian parliaments. The Bundestag vote will be a key test for Chancellor Angela Merkel and the stability of Germany’s coalition government.

Official attention is now focused on how a default could be managed without sending the Eurozone banking system and economy into a tailspin. Time is running out, as yields on Greek bonds are now back at stratospheric levels and Italian bond yields are rising yet again – this despite ECB buying support. Something has to give soon.

Ted Scott, director of global strategy at F&C Investments, sets out various endgame scenarios – none of them pleasing, two deeply unsettling, and with the balance of probability moving remorselessly to the ugly end of this spectrum.

Scenario one is an orderly Greek debt default while the country remains within the single currency. Between 75 and 90 per cent of Greece’s ¤300bn debt mountain would have to be written off. Measures would be needed to limit contagion elsewhere, not least a massive rise in the Eurozone’s emergency bail-out fund. To this, Germany has been adamantly opposed. And any agreement would be likely to be on terms humiliating for countries seeking assistance. Scott puts the chances of an orderly default at 10 per cent.

Scenario two is a disorderly default while Greece remains within the euro. A further assessment of the country’s fitness to receive the seventh tranche of bail-out funds will come in December. Troika officials will be anxious to see public compliance with the latest austerity programme. Meanwhile, doubts will almost certainly intensify over Italy, where yields on government bonds have climbed again to 5.7 per cent (yields at 6 per cent are seen as signalling an unsustainable debt repayment programme). Italy is too big to bail out and many European banks would face insolvency if Italian debt was written down to market value. The outcome would be disorderly in the extreme. Scott puts the likelihood of this at 60 per cent.

There are two further scenarios: an orderly default in which Greece leaves the Eurozone. To this he assigns a 5 per cent probability. Finally, there is a disorderly default and a Greek exit from the Eurozone. A re-introduced drachma would be likely to fall 50 per cent against the euro, drastically slashing the value of Greek assets currently held in euros. Many Greek businesses and citizens are already withdrawing money from Greek banks. Business and household defaults would be widespread. Likelihood rating: 20 per cent.

In the meantime, evidence piles up of a continuing deterioration in the UK economy and a slide towards recession – the latest CBI Industrial Trends Survey adding to market fears. The Bank of England’s Monetary Policy Committee has effectively signalled that it will resort to more Quantitative Easing (QE), or monetary easing. That may well be a critical lifeline for the banks in the storm that lies ahead. But if the endgame proves to be towards the “disorderly default” end of the spectrum, QE may prove the very least that the UK government will be obliged to do.