Is the Breakup of the Euro Inevitable?

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By all accounts, the euro was an ambitious experiment. Its original architects, including former ECB President Trichet set out a vision of a common currency and a single central bank that would forge a stronger economic and monetary union for the region. A decade has now passed and we are seeing all of the ugly truths of having a currency representing 17 different countries. The problems of one country regardless of how large or small can and has affected the economic health of every other nation in the region. The original architects of the euro probably never imagined that Greece, a country that accounts for only 2% of Eurozone GDP can cause this much havoc in the financial markets. Of course, it was never just about Greece which is why the Greek election results do not remove the risk of euro fracture. This month, Spain became the fourth country in the Eurozone to ask for a bailout. As the fourth largest economy in the monetary union, Spain accounts for approximately 11% of Eurozone GDP. While the Eurozone can manage the failure of Greece, Portugal and Ireland, the failure of Spain poses a far more realistic threat to the viability of the single currency, which leads to the question of whether a breakup of the euro is inevitable.

“If Germany and France no longer have the appetite to bail out their irresponsible neighbors, it would mean the end of the euro”

The answer ultimately lies in the hands of Germany and France, who account for close to 48% of Eurozone GDP. Together they have the power to decide whether the euro survives or dies. If Germany and France no longer have the appetite to bail out their irresponsible neighbors and would rather abandon the euro, then that will mean the end of the common currency. If they decide that the euro is worth fighting for, then the common currency will be here to stay.

But maintaining an economic monetary union poses serious challenges that could make abandoning the euro a more attractive option. Lavish social welfare systems and employment benefits have cost individual nations a tremendous amount of money. The la dolce vita lifestyle has to go but don’t expect Europeans to accept this reality easily. Workers across Europe have staged countless protests against budget cuts, making it difficult for the leaders of Germany and France to justify further bailouts. They can’t keep asking their taxpayers for more of their hard earned money without risking their own political careers. Yet if Germany and France do not commit additional capital to rescuing struggling nations, they will be forced to make their own decision about staying in the euro. When one or two countries drop out of the monetary union, every other country including Germany will be forced to ask themselves whether it is worthwhile to keep the euro. It has proven extremely difficult to manage the policies of independent nations with completely different cultures, history, political systems and laws. The breakup of the euro is a realistic risk as over regulated, over taxed economies find themselves without any control on monetary policy and at the whim of the European Central Bank.

“But no one wants to see €urogeddon”

Yet German Chancellor Merkel once said that the failure of the euro would mean the failure of Europe. The euro is fracturing but if the Germans even hint that they are open to idea of bringing back the Deutschemark, it would mean €urogeddon. The sell-off in the global financial markets would be even worse than the 2008-2009 financial crisis. Investors would panic and there would be widespread bank runs leading to a credit crunch worse than what the world endured 4 years ago. Consumers and businesses would stop spending leading to an even greater slowdown in growth. Volatility would soar as banks deal with renegotiation of all euro denominated financial contracts, defaults, losses and failures. The only potential saviors would central banks and even they may not be able to stabilize the markets. But countries have gone through this before and survived. Good examples include Argentina and the 15-State Ruble Zone.

Given the ugly picture that we have painted, Germany will do all that they can to avoid €urogeddon. The seriousness of the consequences means that the ECB will step in before they let the situation dissolve. They will try to isolate the problems of Italy, Spain, Greece, Portugal and Ireland by being the lender of last resort or get the IMF involved. In the interest of their own economies, other countries such as the U.S. and China will step in and help which is why in contrast to the doomsayers, we are optimistic that the euro will still be here 10 years from now. BUT, all it takes is for one country to go and more to follow.

Attractive euro breakup trades

The more important question to ask then is how to position in the event of a euro breakup. Almost immediately a euro breakup will drive the U.S. dollar higher and volatility would soar which makes buying vol and/or the dollar an attractive play. Safe havens in general will perform well but German assets could outperform as money races into the strongest European economies. Banking stocks would plunge providing opportunities to the downside. More creative currency market trades would be worthwhile to investigate because it may not be a one way downtrend for the euro, particularly if we get responses from policymakers. In this case, it may be better to sell euros against the British pound, Canadian dollar and even the Swiss Franc.

Kathy Lien
Managing Director

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