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Analysis
Five scenarios for EMU denouement

Five scenarios for EMU denouement

Greeks will leave, but only after a fight
Don’t presume the Germans will always give in

by David Marsh and Gabriel Stein

Wed 6 Jun 2012

The 17 June Greek election is widely seen as a referendum on whether Athens remains in the euro. The language used by protagonists resembles the Cold War vocabulary of ‘mutually assured destruction’, with the worries stemming from fears of violent contagion from default, devaluation and depression. Whatever happens with Greece and economic and monetary union (EMU) is likely to be messy and protracted. Next steps will probably be the result not of coolly-worked out contingency plans but of rapidly-evolving chaos.

Following the forced departure of most other European leaders since the euro crisis accelerated two years ago, German chancellor Angela Merkel is the pivotal player, but as a result of domestic political setbacks and repeated accusations of indecisiveness, she is hardly a commanding figure.

Forecasts that EMU will survive and prosper depend on the assumption that, as the crisis deteriorates, Germany will relent on previous hard-line undertakings, decide an all-encompassing bail-out and forestall a break-up.

In the midst of an elaborate game of bluff of convoluted varieties, this is an assumption that is not totally devoid of plausibility, but one that plainly cannot be fulfilled in all circumstances. It would be unwise to bank on it. It ignores the likelihood that, as the crisis worsens, the rising costs for Germany of a rescue will exceed the costs of break-up.

Policy-makers and investors face a wide combination of permutations. In decreasing order of probability, on the following pages are five possible scenarios that could unfold in coming months.

SCENARIO ONE: Greece says Yes to the euro but leaves after a protracted legal and political wrangle

This could happen if Greece votes in a government that says it will stay in the euro but defaults on its recent commitments as well as on its debts. This is likely if Alex Tsipras and his Syriza party win the election; but could also occur if Antonis Samaras and New Democracy win.

Samaras, nominally in favour of further Greek austerity, could clinch a poll victory by persuading Greeks that he is a safer choice than Tsipras. He has opposed Greece’s bail-out packages all along and may well need Syriza to form a viable coalition.

The result would be a legal and political stand-off that results eventually in Greece’s departure during the summer or autumn. The process has to move relatively swiftly, as Athens is due to run out of money in August.

An eventual Greek departure could be triggered by further weakness in Greek banks and by the European Central Bank council voting (by a two-thirds majority) to stop the Bank of Greece’s emergency liquidity support for these institutions.

Wary of being blamed for a fateful and historic step, the ECB would wish to pass responsibility to governments. This could result in a political quagmire. There is no legal mechanism for countries to leave the euro.

Greece could be suspended in a ‘half-in-half-out’ limbo, introducing exchange controls and a dual currency for domestic (drachma) and foreign (euro) payments, before finally implementing the decision to leave.

SCENARIO TWO: Greece makes a ‘clean’ exit, leading to further pressure on the periphery – and potential EMU unravelling

A ‘clean break’ from the euro could follow relatively quickly after a Tsipras victory. Greece would leave in orderly or disorderly circumstances, prompting fresh pressure on sovereign debt and banks in Portugal, Ireland, Spain and Italy, and, possibly, the unravelling of EMU.

On the other hand, the ‘firewalls’ around Greece could turn out to be effective in limiting the damage – especially if Spain (as many in Germany advocate) approaches the IMF and the EU for official lending.

The prospect of EMU hanging together and perhaps strengthening after Athens departs rests on the assumption that a Greek exit results in maximum hardship for the Greek population and would therefore dissuade other EMU members against similar steps.

On this interpretation, the danger of fragility passing to the much larger economies of Spain and Italy could be offset by sufficient alarm in Madrid and Rome that they redouble austerity, reform their economies and stay the EMU course.

This could work – but it is a high-risk gamble that could go wrong. Moreover, it ultimately depends on Germany being willing to force the pace of fiscal union.

SCENARIO THREE: Greece remains in EMU after concessions from Germany

Greece votes to stay. A new Athens government reaches agreement on a fresh support package after significant concessions by Germany and other creditors.
This would include support for hard-up countries through issues of mutualised Eurobonds as well as massive further ECB purchases of government bonds to limit borrowing costs in peripheral countries.
This combination is the goal of French President François Hollande’s lobbying for German ‘solidarity’ towards the peripheral states.

It could transpire if Germany and other creditor states believe a disorganised EMU break-up would be more costly than holding it together, reflecting hundreds of billions of euros owed to private and (increasingly) official creditors.

Even though Chancellor Merkel has ruled out mutualising debts, that could be the outcome, for example if Germany backed a Europe-wide scheme for deposit insurance or for other forms of bank resolution. Merkel’s predecessor, Gerhard Schröder, says this is the most likely eventuality.

Such rescue measures could mitigate the dangers of bank runs in countries like Spain – but would run into significant political, constitutional, legal and financial hurdles from the countries footing the bill.

SCENARIO FOUR: Greece remains in euro with no change in policies

Greece and other countries stay in the euro on the basic of present tough conditions, meaning a continuation of unpopular (and so far unsuccessful) austerity without any significant climb-down by Germany and the other creditor nations.

Pressure abates on the other problem countries. With some adjustment to present economic planning, EMU’s errant states would all find themselves on the path to balanced budgets and streamlined economies by 2015.

The ‘soft landing’ would allow creditor nations to save face (and money) and would enable a raft of longer-term European support measures, ranging from plans for medium-term oversight of countries’ budgets and economies to Europe-wide bank resolution schemes, to take effect in two or three years.

This conclusion favoured by euro enthusiasts would require a heroic combination of positive circumstances.

But it could ensue as the result of signs of a progressive rebalancing of the pan-European economy, as current account deficits improve in the peripheral countries and Germany’s economy remains robust.

The difficulty with such favourable prognoses is that they rely on far more time given for adjustment of Europe’s imbalanced economies than is likely to be available from sceptical financial markets.

SCENARIO FIVE: Germany and others leave EMU

Anti-euro opposition gains ground in Germany, support for the fiscal pact and other EMU remedies ebbs away in the German parliament - and Germany (probably accompanied by other creditor countries such as the Netherlands, Finland and Austria) leaves the euro and inaugurates a new currency grouping.

Under this scenario, Germany would face a substantial revaluation of any new currency. In view of strong German competitiveness, this would not be fatal.

The political consequences of abandoning the high point of 60 years of post-war European integration would be enormously adverse.
Yet if other countries embroiled in euro disarray cannot enact remedial measures, Germany could find itself with no choice but to take unilateral action.

This could be the result, for example, of a German constitutional court challenge, brought about by rapidly-rising clearing and settlement debts within the Eurosystem of European central banks, which could produce a ban on further Bundesbank involvement in the Target-2 intra-euro debt mechanism. Nobody thinks that a German exit could solve Europe’s challenges.

But in Europe’s rapidly deteriorating disorder, a denouement that was purely theoretical a year ago is no longer impossible.

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