German student Caroline Duong has won the 2011 Threadneedle Investment Award for an essay on the debt crisis in Europe and the investment implications of a Eurozone break-up.
Yet an EMU break up is still possible. Exit from the EMU would permit the implementation of independent monetary policy tailored to domestic needs to stimulate growth and boost competitiveness via aggressive monetary easing and resulting currency devaluation.
Also, it would add the benefit of debt erosion and avoid the malign snowball effect from rising interest rates. Therefore leaving the EMU poses a real alternative to high-debt countries facing strict austerity and low growth.
As a consequence of a complete break-up, credit spreads, asset prices as well as real estate prices are likely fall steeply across Europe (Cliffe et al., 2010). Periphery countries would experience strong devaluation and inflation whilst core economies would see appreciation of their currency and deflation. A possible periphery bond market crisis may emerge as bond prices could rise sharply to figures between 7%-10%, whereas core countries’ bond yields would be falling (ibid).
Default of PIIGS would be certain, and currency devaluation could cause a run on banks. Together, those events would cause a periphery banking collapse. The deutschmark would emerge as the strongest currency among the former EMU members, trading above the old EURO/Dollar exchange rate. Strong capital flight from periphery countries and a deflationary shock would be expected, and may reduce 10-year government bond yields to below 1% (Cliffe et al.,2010).
Default of several peripheral countries could lead to a European banking crisis with substantial losses across banks. Deflation in core economies would eventually result in a severe contraction of economic activity.
Corporate and mortgage default would follow slow or negative growth as credit markets dry up. The collapse of corporate debt is likely to cause a second wave of losses for creditors and foreign countries with large indirect exposure to peripheral countries such as Germany and the US. America holds only $2 billion worth of periphery debt, but is owed about $70 billion by the private sector of peripheral countries (Bryson, 2011).
It, too, would feel the break-up and default of PIIGS.
Subsequent stagnation in western countries would affect Chinese exports and ultimately also depress commodity prices, albeit on a temporary basis. Throughout such events there will be heavy speculation and attacks on currencies and equities.
The new ‘old’ currencies would take some time to calibrate and exhibit significant volatility, further fuelled by speculation and attacks.
In short, a complete EMU break up would be worse than what was seen in 2008 and cause severe financial distress and economic stagnation.
Naturally, during a period of austerity, low demand and uncertainty, gold along with inferior goods and services are likely to benefit from a growth in demand. Gold is the safe haven for investors fearing inflation or general uncertainty especially in the exchange market, whilst low cost retailers and services cater to price-conscious customers.
Therefore, besides gold itself, mining companies as well as low-cost retail and service providers are likely to perform better during an EMU break up.
Nevertheless, with such a dire outlook across Europe, many investors will turn to opportunities like Latin America, where strong domestic demand stimulates growth. Asia, too, has seen strong economic growth and rising domestic demand. It has also suffered least during the recent financial crisis and dividends continued to grow steadily over the past two years (Wall, 2011).
There are several options to address the EMU’s current crisis in the short- and in the long-run, but few include the dual necessity of political and economic viability. Yet, the severe consequences of an EMU break up should be incentive enough for politicians to come to a compromise.
Nevertheless, there will be tears among taxpayers, Greeks and creditors alike.
Restructuring and haircuts in peripheral countries would be felt around the world as a direct and indirect consequence. Yet these losses would be notably less severe than the cost of a complete EMU break-up.
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