Watching the dominos fall

The adverse feedback loop (higher yields=weaker economy =higher default risk=higher yields) remains in full swing in the Eurozone periphery and the dominos are falling one after the other. If nothing changes, then Portugal will have to get a bail-out and after that Spain. With Spain, the capacity of the EFSF would be used up but the capacity of the market to cause more havoc will remain as the focus is likely to shift to Belgium and then Italy. At the latest with a potential bail-out of Spain, something has to happen. What are the options for the Eurozone?

A) Sovereign default: a sovereign default, be it for Greece, Ireland or any other Eurozone member would be disastrous at present. Should any sovereign default on its bond obligations, then the downward spiral would intensify even further and affect even more countries. Furthermore, the banking sectors of the core countries would be affected significantly - amid their holdings of peripheral debts - threatening the core economies. Given the adversity of this scenario, I am convinced that European authorities/politicians will do everything they can to prevent it from happening.
B) Significant quantitative easing by the ECB: As mentioned in my last blog post (Will the real ECB please stand up?), the monetary transmission mechanism in the Eurozone is not working properly. Should the ECB engage in massive quantitative easing (several hundred billions of peripheral bond buying), it could change the dynamics significantly. The ECB bond buying would depress peripheral bond yields sharply and help these sovereigns to continue financing its debt without needing a bail-out. Given such a massive ECB bond buying which breaks the adverse feedback loop, private investors could also move back on the buying side. This could be implemented very easily but the consensus within the ECB for such a course of action is not there (yet).
C) Joint Eurobond issuance. A fairly sensible solution would be to start with joint issuance. A new central agency would issue Eurobonds. Each country could finance up to the criteria set in the stability pact, i.e. up to a maximum outstanding amount of 60% relative to GDP and up to a maximum new issuance each year of 3% of GDP. Any financing needs exceeding these limits would continue to be financed via national bonds (i.e. Bunds, BTPs, BONOs etc.) which, however, would be subordinate to the Eurobonds. Given the much more limited outstanding amounts of the new national bonds, default on these bonds becomes more likely as the risk of contagion and the risk of a systemic financial sector crisis would be much lower. The credit risk and liquidity of these national bonds would be lower and hence yields higher, much higher for the peripheral countries. As a result, the market would continue to differentiate between issuers and hence there would be very strong incentives for each country to remain within the stability pact criteria (much stronger incentives than there were in the past). Additionally, if Eurobond issuance were to start now, the peripheral countries could refinance all their maturing debts and it would take several years before the 60% limit would be reached. The financing via national bonds would be very limited initially (only the part of the deficit exceeding 3%) and could probably be done - at high rates - with short maturity bonds. The implementation, though, seems difficult and there is no political will to engage in such a course of action (yet).
D) A doubling up of the EFSF: this would just prolong the current downward spiral. It would not break the adverse feedback loop (higher yields-weaker economy-higher default risk-higher yields) and the bail-outs would likely continue. However, it would still not be enough to deal with a potential bail-out of Italy. Such a doubling up per se would not offer a lasting solution. Alternatively, a doubling up + ECB buying to a much higher degree where a total of approx. EUR 2trn could be provided would be a different thing as it would guarantee financing and would reduce market rates.
E) A Eurozone break-up. Should the Eurozone break up, the most likely course of action would be for a formation of two separate currency areas (Euro north and Euro south). For a single country to leave, the economic costs would be almost unbearable. A weak country would lose all access to financial markets, could not service its EUR-denominated debts and would need to default. A strong country would see its new currency skyrocket, threatening to kill exports and the banking sector (because they hold a lot of assets denominated in the now weaker EUR). The only half-way realistic scenario would be for the northern block (Germany, Austria, Finland, Netherlands, Luxembourg, potentially Belgium) to form a new currency area which would limit the appreciation effects/reduce the loss of exports/devaluation of banking assets. On the other side a weak country could only leave as a group as well (Greece together with Spain, Portugal, Italy and maybe France) to form a new larger group with a meaningful internal economic and financial market which is still able to attract some foreign capital. However, for such a separation there would need to be a very strong political will (given the super high costs involved) and in turn a democratic legitimation to engage in such a course of action. But for such political movements to form, it needs time, i.e. some years.

Overall, amid the complexity, the costs involved and potential time it needs, a Eurozone break-up remains highly unlikely. Rather, the current path will continue to be taken up until a large country (probably Spain) needs a bail-out and the capacity of the EFSF is being used up. At that stage the political will to start with joint Eurobond issuance or the consensus within the ECB to engage in massive quantitative easing are likely to form, i.e. I think that the most likely scenario is the one of ECB QE (done in conjunction with a topping up in the EFSF), followed by joint Eurobond issuance. Together, I would assign these scenarios a probability of around 60-70%. Up to that point we can continue to watch the dominos fall.