Deutsche Bank DB Research

The Future of the Euro

Dr. Thomas Mayer, CFA
Chief Economist of Deutsche Bank Group tom.mayer@db.com (+49) 69 910 30800

July 2011

The first 10 years of EMU were a big party for some

140 135 130
Germany France GIIPS

Index, Q1' 00= 100

Real GDP

125 120 115 110 105 100 95 2000

Source: Haver

2002

2004

2006

2008

2010

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where cost discipline was lost

140 135 130
Germany France GIIPS

Index, Q1' 00= 100

Unit labour costs

125 120 115 110 105 100 95 2000

Source: Haver

2002

2004

2006

2008

2010

Deutsche Bank DB Research

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where price discipline was lost

140 135 130
Germany France GIIPS

Index, Q1' 99= 100

CPI

125 120 115 110 105 100 95 1999

Source: Haver

2001

2003

2005

2007

2009

2011

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and where financing of external deficits was not (seen as) a problem
10 8 6 4 2 0 -2 -4 -6 -8 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: Haver
CA % of GDP

Germany France GIIPS

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Net borrowing surged

Cumulated net borrowing by the public and private sector, 1999-2007

Source: Haver

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...debt reached worrisome levels...

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leading to dependence on foreign investors

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Costly reliance on foreign borrowing

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Sovereign debt crisis affecting banks

2011 CDS: Gov't vs. bank spreads

in bp 2500 2000 CDS 5Y - Banks
IE

1500
GR

1000 500 0

PT

FR NL IT FI AT DE BE

ES

500

1000 1500 CDS 5Y - Sovereign

2000

2500

Source: Bloomberg, DB Research

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Banks relying on ECB

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ECB lending concentrating on GIP

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Eurosystem funding government debt

Bank credit to government

Holdings of bonds under the ECBs securities markets purchase programme

EUR bn

Source: ECB, National Central Banks

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and external imbalances

Claims of the Bundesbank against the Eurosystem

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Intra-Eurosystem positions End-2010

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Shifting exposures
GIP: Public Debt by lender (EUR bn) 2009 Total public debt Domestic banks Foreign banks National central banks Other domestic investors Other foreign investors EU / IMF assistance ECB SMP 531.1 68.0 137.0 13.0 51.4 261.8 0.0 0.0 2010 623.5 133.5 106.5 18.8 39.0 220.6 31.5 73.5 2011E 678.3 117.0 95.5 18.8 33.5 198.0 148.4 66.8

Source: IFS, BIS, ECB, Bank of Greece, DB Research

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Bank exposures to risky countries

GIP debt owed to foreign banks (EUR bn, end 2010) Greece German banks French banks Spanish banks Italian banks British banks Japanese banks US banks Other EA banks ROW Total
Source: BIS, DB Research

Ireland 2.5 4.8 0.2 0.6 4.8 1.1 1.1 2.7 0.5 18.3

Portugal 6.0 11.8 6.4 0.7 1.9 0.9 1.2 5.7 1.1 35.6

Total 27.7 31.0 7.1 3.1 9.1 2.4 3.6 19.9 2.7 106.5

19.2 14.5 0.4 1.9 2.3 0.4 1.3 11.5 1.1 52.6

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Who can role and who cant?

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Real GDP
EUR bn, base year = 2000

Source: DB Research
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Euroland forecast: Reversed growth divergence

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Who could succeed?

Primary budget balance under different assumptions
Greece 5% interest rate (stable debt ratio) 10% interest rate (stable debt ratio) 80% debt ratio in 2020, 5% rate Memorandum: 2011 debt ratio Nominal GDP gr.
Source: DB Global Markets Research

Ireland 1.0 6.1

Portugal 0.9 5.1

1.4 8.1

7.8

3.7

1.8

140 4%

105 4%

89 4%

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Agreement on EMU reform: Missing another opportunity

Technical shortfalls:
i. ii. iii. iv. v.

SGP reform omits automatic fines; Pact for the Euro vague if not firmly anchored in national legislation; Rise in EFSF lending capacity without clear purpose; Purchase of government bonds in primary market only a marginal improvement; Operational details of ESM unclear (how is liquidity problem distinguished from solvency problem).

Basic flaw: Present insolvencies continue to be treated as liquidity problems. Consequence: Continuous pressure for austerity in insolvent countries and continuous payments by solvent countries will create public resistance against EMU in both country groups. Risk of EMU breakup increases.

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Centrifugal forces within the EMU

Over-borrowing during the decade of easy credit has subjected EMU to a stress test

Creditor nations
Consolidation programmes

Debtor nations
Less social spending

Nationalistic movements

More transfers

Majority against adjustment

Without clear assignment of responsibilities of 1. national governments for national debt and 2. ECB for price stability a Eurozone break-up cannot be excluded.
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Hypothetic scenarios for an EMU-breakup

Big bang Capital flight leads to unsustainable Eurosystem imbalances Eurosystem creditor central banks refuse payment to debtor central banks Locally held money in debtor countries (deposits and cash) depreciates against core euro
Adapted from Garber (1998, 2010)
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Gradual dissolution Discontent in hard currency countries leads to emergence of privately issued parallel currency Parallel currency crowds out euro in hard currency countries When credit is created in parallel currency hard currency central bank takes over
Adapted from All Saints Day Manifesto 1975

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The (optimistic) view of the future EMU: a big Italy

Italy
Strong north Weak south Medium centre Weakish government

EMU
Strong centre (Germany, et al.) Weak periphery (Greece, et al.) Medium middle circle (France et al.) Weakish government (in Brussels)

Both holding together

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Disclaimer

Copyright 2011. Deutsche Bank AG, DB Research, D-60262 Frankfurt am Main, Germany. All rights reserved. When quoting please cite Deutsche Bank Research. The above information does not constitute the provision of investment, legal or tax advice. Any views expressed reflect the current views of the author, which do not necessarily correspond to the opinions of Deutsche Bank AG or its affiliates. Opinions expressed may change without notice. Opinions expressed may differ from views set out in other documents, including research, published by Deutsche Bank. The above information is provided for informational purposes only and without any obligation, whether contractual or otherwise. No warranty or representation is made as to the correctness, completeness and accuracy of the information given or the assessments made. In Germany this information is approved and/or communicated by Deutsche Bank AG Frankfurt, authorised by Bundesanstalt fr Finanzdienstleistungsaufsicht. In the United Kingdom this information is approved and/or communicated by Deutsche Bank AG London, a member of the London Stock Exchange regulated by the Financial Services Authority for the conduct of investment business in the UK. This information is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Korea by Deutsche Securities Korea Co. and in Singapore by Deutsche Bank AG, Singapore Branch. In Japan this information is approved and/or distributed by Deutsche Securities Limited, Tokyo Branch. In Australia, retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to any financial product referred to in this report and consider the PDS before making any decision about whether to acquire the product. .
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