Evercore Pan Asset

Listening to a lot of commentary on the Euro is like listening to more and more fanciful scripts for a disaster movie. Most seem to agree that the break-up of the Euro would be unthinkable. The consequences we are told could be a large loss of output for the European economies, following a banking collapse.

It is difficult to understand why people are so gloomy about something that is becoming more likely with every summit to save the Euro that fails. If currencies are created to let countries leave the zone, it will be because the rich parts of the area are not prepared to lend and give their money on a big enough scale to support the poorer parts. It will be because the German/northern surplus is too large, and southern trade deficits too huge to be easily financed in the Euro straightjacket. It will be because applying more and more austerity may not curb the deficits of high borrowing countries, as their tax revenues reduce from the falls in output. If weaker countries create different currencies it allows them to devalue to a more competitive position to tackle their trade deficits, and allows them to follow budgetary and monetary policies geared to stimulating their declining economies.

The biggest worries surround the banks. People seem to forget that the banks hold not just the weak country debts, but also the strong country bonds as well. If a supereuro was spun off from the Euro, German and French debt could go up in value as the currency appreciated. If Germany recreated the DM, holders of German bunds would probably enjoy a currency windfall.

The Office of Budget Responsibility set out in its recent report the overall exposures of UK banks to Euro area sovereign debts. Greek bonds accounted for just 1.9% of the banks’ equity, Portuguese bonds for 1% and Italian bonds 7%. So in the doomsday scenario of losing all the money lent to those three countries – an extremely unlikely outcome – the UK banks would suffer a controllable loss of less than 10% of their equity. Meanwhile those same banks own German bunds worth 79% of their equity, and French bonds 44%. They could make useful gains on those if they split off their own currencies or manufactured a new strong Euro without the weaker members. It is true they collectively have 66% of their equity at risk in Spain, which is poised midway between the stronger Euro area countries and the weak ones at current interest rates.

The gloom has been overdone. The break-up of currency blocs in the past, like the rouble area, did not lead to chaos and a lost decade of economic activity. The banks could lose substantial sums on certain state debts – they have at current market prices for these bonds already. They could also make some windfall gains on the substantial holdings in stronger country bonds. This needs to be taken into account to form a sensible judgement about the likely risks.