EUROPEAN ECONOMICS FOCUS

How and when will the euro-zone break up?

The continued escalation of the euro-zone debt crisis suggests that some form of break-up of the currency union is now likely to come sooner rather than later. We expect Greece to leave the euro in 2012, with at least one further departure in 2013. And there is a clear risk of a bigger break-up. Since we first suggested about 18 months ago that the euro-zone would not survive the debt crisis in its current form, developments in the region have generally supported our position. Economic growth has been very weak and fiscal austerity programmes have been largely unsuccessful. However, three recent developments have brought the prospect of some form of break-up closer. First, the policymakers latest failure to bring an end to the Greek situation has cast yet further doubts over their ability to take the action needed to secure the euro-zones future. Second, the crisis has spread to the bigger southern economies and even to some countries in the core. In particular, the growing focus on debt levels and long-term growth prospects has put Italy under the spotlight. And third, the policymakers acknowledgement that countries could leave the euro has shattered the illusion that a euro-zone break-up is technically impossible. Of course, the policymakers will try hard to keep the currency union together and may yet produce the policy bazooka needed to secure the euros future. That might involve bigger steps towards fiscal union, perhaps via euro bonds or more decisive action from the ECB. Alternatively, other countries might step in to prevent a euro-zone crisis from becoming a global catastrophe. But it is unlikely that Germany and the other core economies will ever be prepared to sanction the enormous fiscal transfer that the main proposed solutions would involve. And even if they are, it seems doubtful that any measures will be agreed upon and implemented quickly and decisively enough to prevent the crisis from reaching breaking point. There are, of course, huge uncertainties over how the situation will evolve. However, our central view now assumes that there will be some form of break-up in the form of the exit of Greece in 2012, followed by at least one more departure in 2013. But a bigger break-up is clearly possible. A euro-zone break-up could well bring economic benefits over the long run. But in the near term, it is likely to have severely adverse economic and financial consequences. We have cut our already pessimistic forecasts for euro-zone GDP growth to -1% in 2012 and -2.5% in 2013, giving a total fall in output similar to that seen in 2008-09. However, a bigger break-up perhaps involving the exit of Italy could cause much greater economic damage. Jonathan Loynes Tel: +44 (0)20 7808 4984 North America 2 Bloor Street West, Suite 1740 Toronto, ON M4W 3E2 Canada Tel: +1 416 413 0428 Managing Director Chief European Economist Senior European Economist European Economist Europe 150 Buckingham Palace Road London SW1W 9TR United Kingdom Tel: + 44 (0)20 7823 5000 Asia #26-03, 16 Collyer Quay Singapore 049318 Tel: +65 6595 5190

Roger Bootle (roger.bootle@capitaleconomics.com) Jonathan Loynes (jonathan.loynes@capitaleconomics.com) Jennifer McKeown (jennifer.mckeown@capitaleconomics.com) Ben May (ben.may@capitaleconomics.com)
European Economics Focus 1

28th Nov. 2011

How and when will the euro-zone break up?

Clients and regular readers of our research will be well aware of our long-held views on the future of the euro-zone. As a reminder, though, we said last summer that the likelihood of some form of change to the currency union be that the exit of a single member or a full break-up over the following five years had risen above 50%. That was a controversial view at the time but one which has since become much more widely accepted, apparently even by some euro-zone leaders. There is, of course, still huge uncertainty over just how the situation will evolve from here. However, in the light of recent developments, it no longer seems sufficient simply to warn of the risks and potential economic effects of a euro break-up without attempting to encapsulate them more formally into our forecasts. That is what this Focus aims to do. We begin with a brief review of those recent developments before thinking hard about whether anything could yet save the euro. We then consider different ways in which the euro-zone could break up before describing our central scenario and its implications for our economic forecasts. We cannot, of course, attempt to discuss every aspect of what it is an extremely broad and complex issue in this one piece. However, our thoughts here draw on an extensive programme of research we have undertaken on the subject over the last 18 months or so and we have listed a selection of the major pieces in the Annex. These, and many others on the topic, are available to clients on our website. Break-up risks have steadily risen Since we first suggested that the euro-zone would not survive in its current form, it seems fair to say that developments in the region have generally supported our position. Admittedly, some of the troubled southern and peripheral economies have made some progress in addressing their acute fiscal problems. However, Chart 1 shows that budget deficits have fallen only slightly so far this year and remain very high. Meanwhile, levels of outstanding public sector net debt have continued to climb.
CHART 1: CENTRAL GOVT. BUDGET DEFICITS (% OF GDP)
10 January to September 2010 8 6 4 2 0 Spain Italy Portugal Ireland Greece
Irish figures exclude bank recapitalisation costs

10 January to September 2011 8 6 4 2 0

Source Thomson Datastream

The problem, as we have long warned, is that fiscal austerity does not work without economic growth. And yet, with the possible exception of Ireland (more on which later), the troubled member states have had little success in addressing their underlying economic problems and fundamental lack of competitiveness within the single currency. All of this has, of course, led to social unrest and political upheaval across the region, further testing the policymakers ability and resolve to take the difficult and decisive action needed to tackle the crisis. Sooner rather than later? Over and above this general background, however, three recent developments appear to have further dented the euros chances of survival and brought the prospect of some form of break-up closer. First, the policymakers most recent attempts to get to grips with the crisis have, once again, fallen well short of the hoped-for and promised policy bazooka. The proposed 50% haircut on privately held Greek sovereign bonds, for example, will still leave Greek debt at an unsustainably high level, suggesting that

European Economics Focus 2

market worries over Greeces fiscal health and solvency will persist. Meanwhile, the other elements of the plan a proposed leveraging of the European Financial Stability Facility (EFSF) and tougher capital requirements for euro-zone banks look woefully inadequate to tackle financial and economic instability across the region. Second, and no doubt partly as a result of the above, the crisis has recently started to spread from small and economically insignificant countries on the fringes of the euro-zone to much larger peripheral economies and even members of the so-called core. As Chart 2 shows, bond yields have recently risen in a number of countries.
CHART 2: TEN YEAR BOND YIELDS (%)
8 7 6 5 4 3 2 Oct 09 Italy Spain Belgium France 8 7 6 5 4 3 2 Feb 10 Jun 10 Oct 10 Feb 11 Jun 11 Oct 11

the single currency. German Chancellor Angela Merkel and French prime minister Nicolas Sarkozy both stated ahead of the planned Greek referendum that the vote was effectively a vote on whether Greece wanted to stay in the euro. Admittedly, that may have simply been a tactic designed to persuade the Greek public to vote yes to the package (since most want to stay in the euro) and the referendum has since been abandoned anyway. Moreover, nothing real has actually changed. Nonetheless, their admission has clearly dented, if not shattered, the view - often advanced as a counter-argument to our own over the last 18 months - that various financial, mechanical and legal factors mean that it is impossible for a country to leave the euro. (See European Economics Update Greek referendum episode has let the cat out of the bag 3rd Nov.) That itself could hasten the demise of the euro if it means that investors are now more prepared to bet against its survival, a process which recent market movements suggest has already begun. Can anything still save the euro? Despite these developments, it would be wrong to jump to the conclusion that the euros days are numbered without fully considering every possible development which could yet come to its rescue. There are, of course, countless officials and bureaucrats in Brussels and Frankfurt with a very strong vested interest in the survival of the union. And as we previously mentioned, a majority of voters even in Greece still say they want to remain in the single currency. Meanwhile, in Greece and Italy, there are now temporary technocratic governments in place whose sole purpose is to implement the measures needed to remain within the euro. Against that background, despite their limited success so far, it seems sensible to assume that governments and policymakers will at least try very hard to keep the euro-zone together.

Source Thomson Datastream

Most significantly, having remained below the radar in the early stages of the crisis, Italy has come firmly under the spotlight. This has no doubt partly reflected its own political situation and general contagion effects. At the same time, though, as the euro-zone crisis has developed, the focus appears to have shifted from countries nearterm liquidity problems to more fundamental issues like debt levels and long-term growth prospects. Italy looks bad on both counts. Needless to say, this has magnified many times over the size of the challenge facing policymakers to contain the crisis and ensure the euros survival. The third, and perhaps most striking, recent development has been the open acknowledgement by some senior euro-zone policymakers that a country actually could leave

European Economics Focus 3

Can structural reforms yet boost growth? One possibility is that the governments of the troubled peripheral economies significantly step up their efforts to implement the structural reforms required for them to regain competitiveness within the single currency. One possible source of hope and inspiration here is the recent performance of Ireland, which has managed to reduce its relative wage costs dramatically over the last few years. (See Chart 3.) Whats more, Ireland appears to have been quickly rewarded for its efforts in the form of a strong expansion in its economy. Irish GDP grew by over 3% in the first half of 2011, making it by far the fastest growing economy in the euro-zone. But impressive though Irelands recent performance is, it is of limited relevance to the other peripheral euro-zone economies. After all, Ireland is a much more dynamic economy with much smaller structural and regulatory rigidities than the other peripheral countries. Whats more, its recent strong growth performance has primarily reflected rapid growth in exports, in turn reflecting its extraordinary degree of openness and strong trade links with previously solidly expanding economies like the US.

Note too that even Irelands prospects could deteriorate again rapidly as global growth slows. And with its borrowing costs still higher than those of Italy and bank deposits falling, it is too soon to conclude that Ireland is out of the woods. Is fiscal union coming? Assuming that the troubled economies will not soon return to growth, one much-cited solution to the euro-zones problems is some form of fiscal union. Small steps in this direction have already been taken. Both the bail-out fund and the ECBs bond purchases implicitly transfer fiscal risk from the peripheral economies to the core. But recent talk of closer economic integration and stronger governance within the region has encouraged the view that further moves lie ahead. Indeed, some euro-optimists still see the current crisis as a necessary catalyst for a wholesale shift towards the full political and fiscal union which they have long argued is inevitable and which will ensure the survival of monetary union. One much-discussed potential channel for greater fiscal union is the introduction of euro-zone bonds i.e. sovereign bonds issued by individual national governments but backed by guarantees from all member states. A recent EC discussion paper

CHART 3: RELATIVE UNIT WAGE COSTS (2000=100)

150 Ireland 140 130 120 110 100 90 80 2000 Italy Spain Greece Germany Less Competitive 140 130 120 110 100 90 80 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 150

Source European Central Bank

European Economics Focus 4

advanced three different proposals for so-called stability bonds, involving different levels of usage and guarantees. In the extreme case in which such euro bonds entirely replaced national sovereign bonds, the effects on peripheral economies borrowing costs could be enormous. If, for example, the Greek governments borrowing cost fell to the current euro-zone weighted average 10-year yield of 4.7% instead of rising to the pre-bail-out level of 15%, it could save over 15% of GDP per year on interest payments (given that Greek outstanding debt is over 100% of GDP.) (See European Economics Update Are euro bonds the answer? 22nd Nov.) But there are sizeable obstacles. For a start, all but the most moderate plans for euro bonds would require extensive, and very drawn-out, treaty changes. And needless to say, the moderate forms would have much less beneficial effects on the fiscally troubled economies. And, for now at least, the German Government remains firmly opposed to the idea in any shape or form. Of course, this could change. Faced with the alternative of an imminent euro-zone break-up, Germany and other core economies may decide that they have no alternative but to take on more of the peripherys fiscal burden. Nonetheless, given the difficulties policymakers have had agreeing on and implementing far less extensive policy measures, it seems very unlikely that major steps towards fiscal union via euro bonds or other means can be taken in time to prevent the crisis from escalating and the euro from breaking up. Will the ECB fire the silver bullet? With any road towards full fiscal union likely to be long and arduous, a potentially more timely solution to the euro-zones crisis is for the European Central Bank (ECB) to use its theoretically unlimited resources to act as the regions lender of last resort. Of course, the ECB has already responded to the crisis by extending additional liquidity to eurozone banks and by purchasing peripheral

sovereign bonds. But these purchases have been relatively limited in size, at around 190bn. Moreover, the ECB has offset, or sterilised, them by taking in fixed-term deposits in order to limit the resulting expansion of the money supply. However, the continued escalation of the crisis has prompted calls for the ECB to step up its interventions dramatically. One extreme idea is for it to fire a silver bullet by guaranteeing the whole of the Italian and, if necessary, Spanish bond markets. This could amount to additional exposures of up to 3trn and would be financed by quantitative easing or money printing. Admittedly, this would probably contravene the ECB treaty and would arguably compromise the ECBs status as an independent monetary institution. But desperate times call for desperate measures. After all, the US Federal Reserve and Bank of England have already engaged in fullblown quantitative easing. Meanwhile, the Swiss National Bank has grown its balance sheet from 25% of GDP to some 66% of GDP to prevent the Swiss franc from strengthening further. As Chart 4 shows, a 3trn expansion of the ECBs balance sheet would leave it at a lower 58% of GDP.
CHART 4: CENTRAL BANK ASSETS (% OF GDP)
70 60 50 40 30 20 10 0 Jul-08
If the ECB bought all outstanding Italian and Spanish govt. bonds Swiss National Bank ECB Federal Reserve

70 60 50 40 30 20 10 0

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

Jul-11

Source Thomson Datastream, Capital Economics

Whats more, these other episodes have helped to ease fears that modern bouts of money printing by central banks would result in an uncontrollable surge in inflation. Indeed, some proponents of the plan have calculated that the ECBs non-inflation loss absorption capacity (dont ask!) happens to

European Economics Focus 5

be around 3trn, conveniently just enough to support the Italian and Spanish bond markets. None of this gets around the biggest objection to the idea of the ECB acting as lender (or bondbuyer) of the last resort that it would involve a massive increase in fiscal risk for Germany and the other core economies. But it might be argued that, if some form of fiscal transfer is inevitable to save the euro, conducting that via the ECB would be both economically and politically more palatable to Germany and others than making more contributions to the bail-out fund or wholesale moves towards full fiscal union. There may also be hope that, by keeping Italian (and Spanish) governments borrowing costs at manageable levels, such a move would ensure that the ECB would not suffer large losses anyway. Note that the US Fed never made a loss on any of the exposures it took on during the US crisis and, indeed, has made healthy returns on its loan facilities and bond purchases. More international help? A final possible solution to the euro-zones problems is a much greater degree of assistance from outside the region. So far, international support has come in the form of the contributions from the International Monetary Fund (IMF) to the bail-out loans provided to Greece, Portugal and Ireland. Note that Ireland also received bilateral loans from the UK, Sweden and Denmark. Further international support could again come primarily from the IMF. Note that the Fund has recently increased its lending capacity but one more radical idea is for the ECB to lend money to Fund, which would then be lent on to euro-zone countries with IMF guarantees attached. Alternatively, more support could come directly from other countries. There has been optimism, for example, that Asian sovereign wealth funds will make significant contributions to the EFSF, albeit mainly for investment, rather than altruistic, purposes. And faced with the potential bankruptcy of a G7 economy like Italy - with potentially huge

ramifications for the global economy - other countries might decide to ramp up their direct support for the euro-zone considerably. Too little, too late So the euro-zones policymakers are not without options and we have no doubt that the they will come up with further rescue plans and implement further measures to try to stem the crisis and save the euro over the coming months and quarters. Indeed, when push comes to shove, they may yet find the common ground and determination required to produce the so-called grand plan or policy bazooka promised on a number of occasions during the crisis but not yet delivered. That might involve some combination of bigger bail-outs, greater structural reforms, and steps towards fiscal union, perhaps via euro-zone bonds and/or more decisive action from the ECB. At the same time, other countries and the IMF might step in to prevent a euro-zone crisis from becoming a global catastrophe. However, we remain doubtful that whatever action is taken will be sufficient to keep the eurozone together in its current form. It is far from clear that Germany and the other core economies will ever be prepared to sanction the significant fiscal transfers that the main proposed solutions to the crisis - like euro-zone bonds or massive ECB interventions - would necessarily involve. And even if they are, it seems unlikely that any measures will be agreed upon and implemented quickly and decisively enough to prevent the crisis from escalating. The euro-zone decision-making process has proved to be sluggish and cumbersome, with policymakers often only prepared to take decisive action when staring right into the abyss sometimes at 4am over take-away pizza! By contrast, the crisis has shown a tendency to flare up very rapidly. Meanwhile, even a huge new support package from the IMF is unlikely to prevent at least some form of break-up. After all, it would not address the fundamental economic and fiscal problems of

European Economics Focus 6

countries like Greece and may even make things initially harder for those countries, depending on the conditions attached. There have been plenty of examples of countries including Argentina and Russia - which have received hefty support from the IMF only to then default on their debts and/or devalue their currencies. Given all of this, we continue to believe that some form of break-up or change to the euro-zone is likely. Indeed, we would judge that the chances that the euro-zone will survive entirely in its current form have now fallen as low as 10%. There are still, of course, huge uncertainties over just how a break-up might happen. But it is possible to envisage three basic sorts of scenario incorporating different degrees of break-up and corresponding financial and economic effects. We discuss these below before concluding with what should constitute a sensible central scenario. Scenario 1 Greece leaves on its own The first and least disruptive scenario is, of course, the relatively orderly exit of a single small country - probably Greece - which leaves the rest of the currency union intact. This appears to be the scenario which the policymakers are currently prepared to think about. They have, after all, continued to insist that Greece is a unique case. And their willingness to present Greeces proposed referendum as a vote on its membership of the single currency appeared to assume that it could leave without prompting a wider break-up. Of course, such a scenario would still involve major financial and economic effects, both in Greece and across the region, not least because it would probably be accompanied by a much bigger Greek default than that planned. (See Global Markets Focus The market fall-out from a Greek default and possible EMU exit 22nd Nov. 2011.) However, these effects might not be too catastrophic, particularly if banks and investors are able to reduce their exposures to Greece ahead of the event. That process is already underway. Whats more, cutting Greece away from

the rest of the euro-zone may help to limit contagion effects on other countries and leave the currency union looking fundamentally healthier. Scenario 2 Others follow, including Italy The second sort of scenario is a more substantial form of break-up in which a Greek exit is followed or accompanied by the departure of other countries. This might happen in several ways. Other countries could be forced out of the euro shortly after Greece, or even at the same time, by irresistible market pressures as investors and depositors withdrew their money from prospective leavers en masse. The consequent damage to the economy and banking system could leave countries with little choice but to leave the euro and default. Alternatively, other countries might elect to follow Greece if, after the initially adverse effects, the latter were to start to visibly prosper outside the euro, as we think it would. Obviously, much would depend on how many other countries left and which ones. The additional departure of Portugal and even Ireland might not make too much difference in terms of economic effects. But the exit of Italy and/or Spain would obviously change the picture dramatically. Indeed, it is not impossible that Italy is the first to leave the euro if Greece and the other small economies receive continued support but Italy proves to be too big to save. There might be parallels here with the US banking crisis of 200809, with Greece the equivalent of the rescued Bear Sterns and Italy the doomed Lehman Brothers. Another variation of this scenario would be the splitting of the currency area into two a core or Northern euro-zone with a strong currency and a Southern or peripheral euro-zone with a weaker currency. This might involve the exit of a group of Southern economies together. Or it might even be driven by the departure of Germany and its northern neighbours, should they decide that the costs to them of staying in the euro are too high. Either way, the short-term financial and economic disruption associated with this scenario would

European Economics Focus 7

clearly be far greater than in the case of the single small country exit. However, the longer-term prospects for the region would surely be better. More economies would regain control of their own monetary policy and be able to devalue their currencies. Meanwhile, what was left of the eurozone would more closely resemble an optimal currency area and hence might enjoy stronger and more stable growth in its reduced form. Scenario 3 Complete break-up The third scenario is the most dramatic a complete or at least near-complete break-up of the euro-zone. It is possible that a few countries might remain in some form of currency union perhaps Germany, Austria and one or two others. But most of the 17 member states would leave the euro and re-introduce national currencies. Such an extensive break-up would presumably occur if the general disruption and damage is so great that keeping even a sizeable core currency union together proves impossible. At the same time, though, a key factor would be the position of France. Should it choose or be forced to leave the euro as a result of its economic weakness and banking problems, that would surely put an end to any hopes of keeping any meaningful sort of currency union in place. Once again, the longer-term economic prospects for the (ex) euro-zone economy may be improved by the ability of former member states to set their own policy and allow their currencies to fluctuate. But the initial economic and financial damage across the region - and in the rest of the world would be extremely severe. And the political and social consequences might be unthinkable. How and when? So which of these different sorts of scenarios is it sensible to adopt as a central forecast? This is clearly a difficult judgement. The safest option from a forecasting perspective is obviously to incorporate the mildest form of break-up, that is, the orderly exit of Greece on its own. After all, while other forecasters have recently begun to

acknowledge the danger of a euro-zone break-up, few - if any have yet been bold enough to incorporate such an event into their projections. As such, explicitly building in even a Greek exit would put us out on a considerable limb. Note too that even our existing economic forecasts for the euro-zone which assumed a general escalation of the debt crisis over the next two years but no actual break-up until beyond our forecast horizon were already significantly weaker than consensus forecasts for the region in anticipating falls in euro-zone GDP in the next two years. While the latter have fallen sharply over recent months, they still envisage positive real GDP growth of some 0.4% in 2012. Against this though, we have suggested on a number of occasions that the crisis is unlikely to end with the departure of Greece alone. After all, a number of other countries share the same fundamental economic and fiscal problems as Greece and have therefore come under similar pressures. Whats more, given the policymakers performance so far, it is putting a lot of faith in them to assume that they can prevent major domino effects after or alongside Greeces departure from forcing other countries out too. Indeed, in that respect, it might be argued that a Greek-only exit is actually the least likely scenario. Either the euro-zone holds together, or it breaks up in a substantial manner. Against this background, it seems sensible to assume that a Greek exit is followed or accompanied by the exit of at least one other country. Portugal and Ireland are clearly the most obvious candidates. What about timing? As already mentioned, recent developments appear to have brought the prospect of some form of euro-zone break-up closer. But what might be the actual trigger? On the face of it, none of the most troubled economies appear to be on the brink of the sort of financial disaster that might force them out of the euro. If, as looks likely under the technocrat government, Greece receives its proposed new

European Economics Focus 8

bail-out of around 100bn, this would cover its projected financing needs until beyond 2014. Meanwhile, the existing bail-outs for Portugal and Ireland are expected to cover their financing needs until 2013 and 2014 respectively. (See Chart 5.)
CHART 5: BAIL-OUT PERIODS

countries to the point where they either choose or are forced to leave the euro. Greece to leave in 2012, others to follow in 2013 Given all of this, we have adopted the central view that there will be a limited form of euro-zone break-up - consisting of the exit of Greece - during 2012. This will then be followed by the departure of Portugal, and perhaps Ireland, during 2013. For now, we are assuming that the policymakers will pull out all of the stops to keep Italy and Spain in the currency union and will succeed, at least over the next two years. Indeed, it is easy to imagine a two-pronged plan in which the policy bazookas firepower is concentrated on Italy and Spain, while the smaller and arguably unsaveable smaller economies are allowed to leave or cut away as part of the attempt to prevent contagion effects and bring the crisis to an end. Nonetheless, there is certainly a very clear risk that Italy, and perhaps Spain, will also have to leave the euro sooner or later. And if nothing else, the mere threat that they might could cast a long shadow over the euro-zone. We would stress again the uncertainty surrounding these predictions, or perhaps we should call them assumptions. We are certainly not going to try to predict the precise months in which these developments might occur. Nor are we going to try to forecast at this stage what will happen to the new national currencies or monetary policy of the leavers, whenever they might be established (although the currencies are very likely to fall sharply). Nonetheless, this seems to us like a sensible starting position from which, if necessary, to respond to further developments. What are the economic implications of all of this? Again this is extremely uncertain, but it seems clear that the near-term consequences of even a limited form of break-up will be fairly severe. As already mentioned, our existing forecasts already expected the euro-zone economy to fall back into recession over the next two years, with

Portugal

Ireland

Greece

Dec 11

Dec 12

Dec 13

Dec 14

Dec 15

Source Capital Economics

Even Italy, which may prove too big to bail out in the same fashion, would probably cope for some time - perhaps via asset sales and other means - if rising bond yields shut it out from the markets. However, none of that means that the euro-zone will definitely hold together for any particular period. Remember that Greece and the other bailed-out countries are required to meet ongoing economic and fiscal targets in order to receive the next tranche of their bail-outs. This has led to regular, quarterly bouts of uncertainty over whether Greece has done enough to satisfy the Troika and save it from disaster, with destabilising effects on markets. At the same time, the general recognition that bail-outs do not solve countries fundamental economic and fiscal problems means that they wont prevent and indeed, have not prevented periodic bouts of extreme market pressures. Accordingly, even without the threat of imminent insolvency, we suspect that the combination of acute economic weakness, painful fiscal austerity, banking sector fragility and constant market speculation not to mention the political and social consequences of all that - could push

European Economics Focus 9

GDP contracting by 0.5% in 2012 and by 1% in 2013. However, recent lead indicators have suggested that the risks to those forecasts are firmly on the downside. As Chart 6 shows, the composite PMI index, for example, appears consistent with quarterly falls in GDP of some 1%.
CHART 6: COMPOSITE INDEX & GDP
65 60 55 50 45 40 35 99 00 01 02 03 04 05 06 07 08 09 10 11 Composite Output PMI (LHS) GDP (% q/q, RHS) 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0

forecasts, though we would expect the latter to drop sharply over time as more forecasters start to contemplate some form of break-up. Note, though, that even if the euro-zone manages to hold together over the period, we suspect that the effects of continued extreme uncertainty and regular bouts of market turbulence will weigh very heavily on the euro-zone economy anyway. We will, of course, fill out the new forecasts for individual countries in later publications. Likewise, we will discuss the market implications of all of this in depth. We have warned for some time that an escalation of the debt crisis would weigh on the euro over the coming quarters and prompt further rises in bond yields across the region, even in Germany. In the short term at least, even a limited form of actual break-up would presumably exacerbate those trends markedly. Conclusions Making economic forecasts is always difficult, particularly when they challenge the conventional wisdom. And we are painfully aware of the sensitivities of explicitly predicting what might be perceived as the failure of a project in which a great many people some of our paying clients no doubt included have invested a great deal; financially, professionally and emotionally. Nonetheless, it surely would be doing those clients and others a disservice not to express our honest thoughts. There comes a point when the likelihood of an event or development reaches a level at which it is no longer sufficient merely to highlight it as a risk, even if that is the far more comfortable position for the forecaster. We think that point has been reached in the case of a euro-zone break-up. But we would stress again that, while the shortterm effects of even a limited form of break-up will be negative, the medium- to longer-term implications may well be strongly positive. Indeed, perhaps the really pessimistic view to take would be one which sees the euro-zone holding completely together and hence carrying on year after year as it has done over the last 18 months.

Source Thomson Datastream, Markit

Against this background, and allowing for the negative effects of a minor euro-zone break-up, we have cut our growth forecasts to -1% in 2012 and to -2.5% in 2013. This would give a total fall in euro-zone output of some 5%, similar to that seen during the global credit crunch and recession of 2008-09, though we would expect the fall to be more gradual and drawn out. (See Chart 7.) However, it is quite possible that GDP will fall again in 2014 and beyond, particularly if Italy and/or Spain exit in those years or before.
CHART 7: EURO-ZONE GDP FORECASTS
4 3 2 1 0 -1 -2 -3 -4 -5 -6 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 -3
% q/q (RHS) % y/y (LHS)

2 Forecast 1 0 -1 -2

Source Thomson Datastream, Capital Economics

These numbers obviously put us a country mile away from the latest published consensus

European Economics Focus 10

Annex: Key research pieces on euro-zone debt crisis/break-up

Date
Euro-zone 28 April 2010 6 July 2010 7 July 2010 11th August 2010 17 August 2010 27 October 2010 30 November 2010 13 December 2010 7 April 2011 27 April 2011 28 March 2011 31 May 2011 15 June 2011 12 July 2011 18 July 2011 19 July 2011 4 August 2011 17 August 2011 13 September 2011 26 September 2011 18 October 2011 27 October 2011 28 October 2011 3rd November 2011 14th November 2011 16 November 2011 22 November 2011 22 November 2011
nd nd th th th th th th th th th th th th st th th th th th th th th th th

Publication

Title

European Economics Focus European Economics Update European Economics Focus European Economics Focus European Economics Update European Economics Focus European Economics Focus European Economics Focus European Economics Update European Economics Focus European Economics Update European Economics Focus European Economics Update European Economics Update European Economics Focus European Economics Update European Economics Update European Economics Update European Economics Update European Economics Update European Economics Focus European Economics Update Global Markets Update European Economics Update European Economics Update European Economics Update European Economics Update Global Markets Focus

Will the euro-zone survive? Euro-zone break-up now more likely than not Why the euro-zone needs to break up Could a weaker euro save the euro-zone? Two-speed euro-zone still on shaky ground Would a break-up of the euro help or hinder recovery? Can the euro-zone really break up? What can euro-zone policymakers do? Portugal succumbs. Now what? Is the euro doomed to fail? Why are default concerns not hitting the euro? Can strong growth save the euro? Euros unwanted strength heightens break-up dangers The beginning of the end for the euro? How a banking crisis could sink the euro Last chance saloon for euro-zone policymakers? ECB softens its stance On the road to fiscal union? Deepening debt crisis points to new recession New rescue plans are unlikely to save the euro Can the euro survive the sovereign debt crisis? Euro-zone plans more peashooter than bazooka Chinese whispers alone wont save the euro Greek referendum episode has let the cat out of the bag ECB unlikely to fire the silver bullet Are markets starting to price in a euro break-up? Are euro bonds the answer? The market fall-out from a Greek default and possible EMU exit

Greece 24 February 2010 14 April 2010 28 April 2010 30 April 2010 27 May 2010 8 September 2010 10 November 2010 9 February 2011 9 March 2011 9 May 2011 16 May 2011 26 May 2011
th th th th th th th th th th th th

European Economics Update European Economics Update European Economics Update European Economics Focus European Economics Focus European Economics Update European Economics Update European Economics Update European Economics Update European Economics Update European Economics Focus European Economics Update

Greek bail-out now more likely than not The broader implications of the Greek bail-out Is Greece the next Lehmans? Greek default The whys and wherefores Greece: From crisis to tragedy and then salvation? Greeces fiscal headwinds gather strength Greeces problems still mounting Greek fiscal position remains deeply worrying Is Greece still facing a funding crisis? What next for Greece? Greek default causes and effects Would banks cope with a Greek debt reprofiling?

European Economics Focus 11

Date
1 June 2011 9 June 2011 14 June 2011 16 June 2011 1 August 2011 7 September 2011 13 September 2011 4 October 2011 14 June 2011 16 June 2011 1 August 2011 7 September 2011 13 September 2011 4 October 2011 25 October 2011 1st November 2011 3rd November 2011 22nd November 2011
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Publication
European Economics Update European Economics Update European Economics Update European Economics Update European Economics Update European Economics Update European Economics Update European Economics Update European Economics Update European Economics Update European Economics Update European Economics Update European Economics Update European Economics Update Global Economics Update European Economics Update European Economics Update Global Markets Focus

Title
Greek bail-out 2 will merely delay the inevitable ECB signals July rate hike & stands firm on Greek default Where would a second bail-out leave Greece? Greece on the brink Can the new rescue package solve Greeces problems? Is Greece at risk of an imminent default? Is Greeces second bail-out dead and buried? Greek budget does not eliminate near-term default risks Where would a second bail-out leave Greece? Greece on the brink Can the new rescue package solve Greeces problems? Is Greece at risk of an imminent default? Is Greeces second bail-out dead and buried? Greek budget does not eliminate near-term default risks How damaging will a Greek default be? Greek referendum throws whole rescue plan into doubt What next for Greece? The market fall-out from a Greek default and possible EMU exit

Ireland 28 September 2010 4 November 2010 26 January 2011 11 November 2010 21st June 2011 27th September 2011
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European Economics Update European Economics Update European Economics Focus European Economics Update European Economics Update European Economics Update

Is Ireland on the brink? Irelands fiscal squeeze unlikely to calm markets nerves Will the Emerald Isle ever regain its sparkle? Can anything save Ireland from a Greek tragedy? Will Ireland and Portugal roll over their debt too? Does Irelands recovery provide hope for Southern Europe?

Italy 5 July 2010 13 July 2011 3 August 2011 9 August 2011 29 September 2011 8 September 2011 9 November 2011 14 November 2011
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European Economics Focus European Economics Update European Economics Update European Economics Update European Economics Focus European Economics Update European Economics Update European Economics Update

Is Italy Europes ticking time-bomb? Italys troubles raise risk of euro-zone break-up What next for Italy and Spain? Italys fiscal measures will need to be seen to be believed Is Italy close to buckling? Concerns about Italy to resurface Italy moves closer to the brink Italy needs more than a new government

Portugal 11 January 2011 10 February 2011 22 March 2011 24 March 2011 17 May 2011 21st June 2011 16 August 2011
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European Economics Update European Economics Update European Economics Focus European Economics Update European Economics Update European Economics Update European Economics Update

Portugal the end of Act 1? Portugal remains on the frontline Can Portugal avoid another lost decade? Portuguese bail-out now even more likely Can Portugal push away debt restructuring fears? Will Ireland and Portugal roll over their debt too? Market relief for Portugal likely to be short-lived

European Economics Focus 12

Date
Spain 25 August 2010 23 November 2010 12 April 2011 18 May 2011 13 June 2011 3 August 2011
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Publication

Title

European Economics Focus European Economics Update European Economics Focus European Economics Update European Economics Update European Economics Update

Can Spain take the pain? Will Spain be the undoing of the euro-zone? Can Spain stay out of the crisis? Spain: are cracks starting to show? How far is Spain from a tipping point? What next for Italy and Spain?

Belgium 17 February 2010 2 June 2010 8 September 2010 24th May 2011 24 August 2011
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European Economics Update European Economics Update European Economics Update European Economics Update European Economics Update

Is Belgium the Greece of the North? Belgium: The weak link of the North Belgian political stalemate increases debt concerns Will the domino effect hit Belgium? Belgiums political crisis yet to take its toll

France 8 February 2010 9 August 2011 16 November 2011

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European Economics Update European Economics Update European Economics Update

Is France next in the markets sights? Frances problems threaten policymakers firepower Is France falling out of the core?

Germany 7th April 2010 17 August 2011

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European Economics Focus European Economics Update

Can Germany save the euro-zone? Does Germany still want to save the euro?

European Economics Focus 13