Corona Virus and potential for the EURO to break up

The Covid-19 Virus could be very likely to speed up European Integration or cause the Euro to come apart. What seems clear is one of these outcomes is getting nearer and could happen very soon.

The divergent economies within Europe have caused pressures for some years. This divergence now appears to be reaching a tipping point.

Italy

Italy is fast becoming a focus of discontent against the EU.

Italy already has the highest debt to GDP in Europe. Its economy desperately needs a cheaper currency i.e. to devalue which would make its goods and services cheaper. This will not happen because firstly markets feel Germany is still the power house of Europe and keep the Euro relatively high believing Germany is the overall underwriter. Secondly because Italy is not allowed by the EU to issue significant debt of its own. While this keeps the Euro high it leaves Italy desperately short of cash. Cash they are essentially asking Germany to put up.

Unlike a normal currency union, there are no EURO Government bonds. Each country issues debt backed by its own central bank. However, the EU force members of the Euro to limit the debt they issue.

Contrast this to the UK where the Bank of England has been able to act as lender of last resort and issue debt and where needed buying this debt itself. Whilst printing money is not always a good thing, it does mean in this case that the country can fund itself in the short term. Effectively taking on an overdraft until better times. It also keeps money circulating in the economy.

Italy and the other Southern European nations cannot do this. As more businesses fail, so will demands from Italian citizens and their politicians to leave the Euro. Go back to their own currency and devalue.

The only other alternative is that Germany and the Northern European states allow Euro government bonds to be issued. Effectively bonds underwritten by all the countries in the currency union.

Economically and practically speaking either of these scenario’s would work. What will not work is the continued fudge. So either Germany will have to accept a pooling of its fiscal sovereignty or the Euro will come apart.

A Disorderly break up

A disorderly break-up of the Euro would wreak absolute havoc to financial markets. A new Deutsche Mark or North European Euro would rise significantly as their members, Germany, Austria, Finland are all economically conservative. Longer term that could cause considerable harm to Germany as its car and industrial products would become extremely un-competitive. Already German is suffering from losing its leadership in car production as Electric competitors in the US, India and China gain significant footholds in the Car market.

For those countries in the southern bloc, Italy, Spain, Greece, holders of their debt i.e. Italian government bonds issued in Euros would lose significantly. This includes many Southern European banks who hold Italian and Spanish bonds on their balance sheets as collateral. In the short term there would be enormous economic disruptions in those counties, many banks would likely go bust. However, from the ashes, these countries would become significantly more competitive if they began using ‘Southern Euro’s’ which would make their products significantly cheaper. Money would flow in and over 5 years it is quite possible unemployment would fall significantly in those countries.

 

Managed break up of the Euro

An orderly break up should be considered by member states. This could happen in several ways, there could be a North / South Euro. It would be possible to arrange in a similar way to countries which in the past have pegged their currency to the USD. So at the outset, the Southern bloc has Euro 2. This is pegged to Euro 1 at 1 Euro buys 1.1 Euro2. Effectively a 10% devaluation in the southern bloc. The rate could gradually be a manged down to 1.2, 1.5 and so on. This would avoid a blow up which would probably be worse for markets than the 2008 collapse and the Covid-19 situation we are now in.

The speed with which this happens is likely to depend quite soon on what assistance the EU agreed to give Italy and how bad the economic situation gets within the Euro area.

At present the US economy and other areas are benefiting from having so many tech companies. Europe does not have any. Not one single global tech company. They of course do have a lot of very successful firms and regions such in luxury goods, but these are not enough to compensate for losses in of manufacturing and motor. The next six months could see significant change in Europe. For our portfolios at this time this means we are underweight European Equities. For low risk investors we would hold shares in Nordic countries and German Government Bonds.

 

Paul Coffin

Further Reading