Analysis: Break-up of eurozone needn’t be a difficult process

on December 01 2010 12:14 PM

The force of political will binding together a seemingly crumbling euro zone is still strong, but the imperatives of domestic economic realignments could force members to an exit option, analysts have said; and the road out of the bloc doesn’t exactly look daunting.

The 'north-south divide' within the eurozone is widening by the day as the southern periphery's debt troubles add financial burden on the relatively stronger northern members.

This situation, which has been described as “a certain kind of 'dualism' by European Union Economic and Monetary Affairs Commissioner Olli Rehn, is providing incentives to both the healthy northern nations and the ailing southern ones to look for safe exit routes - albeit for starkly different reasons.

The $113-billion Irish bailout package did not sooth investors' nerves and the markets were bracing for the fall of dominos as Portugal, Spain, and even Italy, came under the scanner. The euro common currency continued its dip notwithstanding the Irish bailout even as Spanish and Italian bonds dropped and the spreads on their yields against those on German bonds widened.

The markets were obviously not listening to European Central Bank President Jean-Claude Trichet, who said in Brussels on Tuesday the 'determination of the governments' in addressing market fears was being underestimated.

Trying to drive home the point that European policy makers were earnestly addressing the peripheral crisis, Trichet said he did not think the financial stability in the eurozone could really be called into question.

INCENTIVES

Both the 'core' eurozone members like Germany and the debt-hit peripheral countries like Ireland have strong incentives to quit the common currency union and set off a domino action leading to the breaking up of the monetary union, analysts have said.

There are several practical obstacles to leaving the euro-zone which mean that this is not an easy option. But if the benefits were deemed large enough, none of the obstacles would be insurmountable. And they apply even less to “core” economies like Germany than to the periphery, Capital Economics economist Jennifer McKeown wrote in a note on Tuesday.

As Ireland tries to repair the damage of the banking collapse and the debt crisis in the years ahead, it will be up against the difficult task of running an export-led recovery in a strong-currency environment. Unlike Iceland, which caved in 2008 and was bailed out, Ireland, Greece and the like don’t have the luxury of devaluing their currencies and exporting their way out of trouble.

This should make for a solid argument in favor of opting out of the bloc and trying to revive the economy under a new currency and policy regime.

The bailout of Greece and Ireland and the impending rescue of Portugal have also increased tension within the union. The Germans decry the lavish spending of their hard-earned money to rescue fiscally indiscipline peripheral countries while the debt-hit countries are smarting under the austerity? whip and dealing with violent public outbursts against belt tightening.

As Rehn pointed out, the common currency union is witnessing increasing polarization. Analysts have long pondered over the chances of the stronger economies, like Germany, exiting the common currency and also of weaker ones like Greece being kicked out.

The disparities between the eurozone economies stretch from budget deficits to economic fundamentals and from current account surplus/deficits to unemployment.

According to the OECD, Germany's current account surplus is slated to hit 7 percent of GDP by 2012 while the current account deficit in Greece is poised to hover near 6 percent and that in Portugal could reach 8 percent.

Data released today showed that while the German and French economies are mainly being driven by domestic demand, robust demand is absent in most other struggling peripheral economies. Austerity measures and growing political uncertainties had negative impact on domestic demand in peripheral economies.

While job creation increased in Germany, the Netherlands, Austria and France, the outlook was downbeat in Spain, Italy, Ireland and Greece.

With parts of the union drifting in diverging directions, the future of the bloc is not all that rosy indeed. Though for most policy makers the break-up of the currency union has been an unthinkable eventuality, there are more people now talking about the elephant in the room.

Analysts have pointed out that the legal barriers, political aftermaths and the economic repercussions of a break-up, or an opting out of the union, are not insurmountable.

Illegality of exit, the cost of installing a new currency, the political cost of leaving, the change in the domestic value of euro-denominated debts and assets, the risk of a banking crisis and a defaulting government’s inability to meet future financing needs are seen as the most important practical barriers of a break-up, writes McKeown of Capital Economics.

The legal barriers are not strong enough to prevent any country from being expelled from or (particularly) choosing to leave the euro-zone, McKeown note, however.

According to McKeown, one of the main risks could be a surge in the domestic currency value of euro-denominated debts. In the event of exit, a domestic currency slump in Greece might easily mean a surge in net international debts amounting to nearly a quarter of GDP, while an appreciation in Germany could see the value of its net external assets tumble by a sum equivalent to nearly 10% of GDP.

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