Euro Exit Remains on the Table

Despite the latest decline in Italian- and Spanish-German 10-year sovereign spreads (to 316 and 377 bps, respectively), the future of the Euro Zone remains in jeopardy. While there has been talk of a European banking union (which is the minimum requirement to keep the Euro Zone intact, in our opinion), German policymakers remain in firm control and are still stuck on “normal policymaking” mode. As the last two years have beautifully demonstrated, both austerity measures and the policy of “kicking the can down the road” are no longer viable. Given the horrible demographics in Western Europe, the bureaucratic red tape, and a general slowdown in the BRIC countries, there needs to be a combination of unprecedented pension/health reforms, employment reforms, as well as quantitative easing from the ECB and a Euro devaluation. Failing such a move, it is likely that one or more Euro Zone peripheral country will default and/or exit the Euro. Note that is still pricing in a 49% chance that one or more country will drop the Euro by the end of 2013:

While today’s 20- and 30-something investors cannot conceive of a Greek or any sovereign default, it is actually a quite common occurrence (Argentina was the last major country to default in January 2002). A partial default and devaluation becomes immensely attractive as the costs of default (e.g. domestic investor losses, a higher yield premium as the country borrows again, etc.) declines relative to the costs to sustain payments of a ballooning debt. A recent Richmond Fed paper (2007) (“The Economics of Sovereign Defaults”) shows that based on empirical evidence, sovereign defaults are very common throughout history. Spain defaulted six times between 1550 and 1650, while France defaulted eight times between 1550 and 1800. Between 1820 and 2004, there were 250 sovereign defaults by 106 countries. The following table shows a list of sovereign defaults from 1824 to 2003 grouped into seven temporal clusters.

More important, the Richmond Fed paper also suggests that the costs of default have actually declined over the last century, given the rising competition to supply sovereign capital between international creditors. For example, in the 19th century, international lending was dominated by a few major lenders, such as Rothschild, Barings, Schroders, and Morgan. These banks can threaten to shut out borrowing countries in the future if they defaulted. Today, international lenders can no longer do so, given the huge variety of potential lenders, such as hedge funds, private equity funds, sovereign wealth funds, fixed income mutual funds, and even ultra-high net worth individuals. In other words, there will come a point (likely next year) when it becomes highly attractive for Greece to default, assuming the ECB does not step in with a more aggressive QE package or a regional banking union. The lack of fear in the market (as indicated by the relatively low VIX reading of 17.06) is also concerning from a bull’s standpoint.

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