Are global investors slow to move on euro break-up risk?

November 9, 2011

No longer an idle “what if” game, investors are actively debating the chance of a breakup of the euro as a creditor strike  in the zone’s largest government bond market sends  Italian debt yields into the stratosphere — or at least beyond the circa 7% levels where government funding is seen as sustainable over time.  Emergency funding for Italy, along the lines of bailouts for Greece, Ireland and Portugal over the past two years, may now be needed but no one’s sure there’s enough money available — in large part due to Germany’s refusal to contemplate either a bigger bailout fund or open-ended debt purchases from the European Central Bank as a lender of last resort.

So, if Germany doesn’t move significantly on any of those issues (or at least not without protracted, soul-searching domestic debates and/or tortuous EU Treaty changes), creditor strikes can reasonably be expected to spread elsewhere in the zone until some clarity is restored. The fog surrounding the functioning and makeup of the EFSF rescue fund and now Italian and Greek elections early next year  — not to mention the precise role of the ECB in all this going forward — just thickens. Why invest/lend to these countries now with all those imponderables.

Where it all pans out is now anyone’s guess, but an eventual collapse of the single currency can’t be ruled out now as at least one possible if not likely outcome. The global consequences, according to many economists, are almost incalculable. HSBC, for example, said in September that a euro break-up would lead to a shocking global depression.

A euro break-up would be a disaster, threatening another Great Depression. Cross-border holdings of assets and liabilities within the eurozone have risen dramatically, leading to a tangled web of mutual financial dependency.
With the re-introduction of national currencies, disentanglement would proceed at a rate of knots, undermining financial systems, generating massive currency moves, threatening hyper-inflation in the periphery and
triggering economic collapse in the core.

So world markets outside the debt markets in question should be suffering a paroxysm right now, right?

Well, not so. World equities are higher over the past week and — even through all the Greek and Italian political mayhem and crisis summits — they are basically little changed since August.   Global oil prices are basically net unchanged since mid-year and benchmark shipping prices are still up about 20 percent. Financial “fear indices” such as Wall St volatility gauges are little changed on net since August.

So is all the action just in shunned euro zone securities? Well, aside from the ailing Greek and Italian government debt markets, not really. Euro zone banks have been hit hard since the start of the year but are still up substantially from September lows. Even the euro/dollar exchange rate, althouth  down about 5% from midyear as the ECB shaped up to reverse early year interest rate rises, has done precious little net net since the first week of September.

At the very least this is not the behaviour of a market taking a global “depression” into account. Are investors and markets too complacent and slow and when they finally wake up we will see the mother of all collapses? Or are they simply making a calculated bet that governments will not allow a euro breakup to happen?

There are some good explanations for the stability of the euro exchange rate — not least the fact that the euro zone as it stands is basically self-financing on a current account basis and domestic investors fleeing the hotspots are simply moving to the “safety” of German government bonds — with no exchange rate implications. Unlike the Lehman bust, where European bank writedowns of dollar assets left them with a huge shortage of dollars that subsequently saw the dollar exchange rate surge and caused multiple stresses across the world economy, many of those same European banks do not have a foreign exchange exposure to the current euro area asset woes.

Some also argue that the euro is being traded as a quasi-German mark or at the very least the currency of a fiscally-sound rump of northern European states minus the more profligate bailout countries as well as Italy and Spain.

Harvard economist Kenneth Rogoff has his own series of  explanations and reckons the euro will eventually fall anyway.

But the market “inefficiency” of such a delayed euro drop, if indeed it does happen, would be more than a little puzzling. What is more, the euro FX arguments still don’t explain wider equity and commodity markets’ ignoring the potential risks.

Investor faith in European governments and institutions to eventually sort this out would appear to be a lot higher than much of the daily commentary would suggest. If they are wrong, there is a very big shock still to come.






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