As we recently discussed, many euroskeptics are pushing Cypriot lawmakers to default, devalue, and decouple from the Euro - understanding that the short-term pain of such a move will lead to much more sustainable gains afterwards. But BofAML raises the question of what damage (and required response) would occur in the remainder of the European Union should Cyprus leave (or be pushed ). Unlike some EU leaders suggestions, BofAML suggests the contagion and growth impacts could last a decade; but it is the policy reaction of the ECB that is most crucial to understand and how it may rapidly lead to a German decision on debt mutualization (or not) that should be most concerning.
alternative scenario: Cyprus defaults, exits, confidence is shaken
In this scenario, the possibility of a country exiting the Eurozone could revive contagion risks, only to be mitigated by much more forceful policy reactions. We would see such a scenario materialising if negotiations failed, leading to a default on private and then public debt in Cyprus. In that scenario, when banks reopened, deposit flights would kill bank solvency and the ECB would veto ELA.
As a result, banks would default and since the sovereign is not in a position to nationalise the banks and cover the deposit insurance, it would be likely to default as well. This would probably be followed by a strong policy response from the ECB. In that case, to contain a potential run on the peripheral banks, the ECB would have to use more of its unconventional tools: first, more LTRO, together with rate cuts and possibly further collateral loosening to cheapen the price of liquidity as much as possible; second, possibly bond buying if there was a sell-off of periphery bond countries.
To contain the run on sovereigns, the ECB would have to proceed with extensive bond buying. OMT is a tool designed for countries with temporary liquidity, which might not be perfectly suited for a rapid deterioration of several countries’ bond markets that would reflect contagion. Against that backdrop, the ECB could be forced to intervene directly, though we believe such purchases could not take place (for more than a couple of days and by a limited amount such as the SMP) without the implicit support of core countries. Given the contentious nature of sovereign bond purchases and fiscal transfers in the eurozone, for markets to be fully convinced, in our view, the agreement by core countries would then have to be followed by a political process endorsing the debt mutualisation by the ECB together with a transfer of sovereignty at the euro level.
What does this mean for economic performance?
In a Cypriot exit scenario, we would expect a significant uncertainty shock but not as severe as that caused by the Lehman collapse, given that the economic cycle and leverage has changed markedly. First, given economies’ positions in the cycle, the current level of inventories is much lower (Chart 2).
Second, financial integration and leverage has diminished. Overall, the shock would be more contained geographically and in magnitude, in our view, but would still be sizeable and only contained thanks to large policy response. In our view, consumption and investment would be particularly affected, albeit much less than in the Lehman episode, as investment is far from fully recovered across most euro-area countries (Chart 3).
However, we would expect a similar contraction in exports – because roughly half of Eurozone countries’ exports are directed to their euro partners.
Although putting a number to such an uncertain outcome is complicated, we use recent research (see Box 1.3 of the World Economic Outlook of October 2012) to provide some guidance. According to this research, a one standard deviation increase in uncertainty is associated with a decline in output growth of between 0.4ppt and 1.25ppt. Assuming the uncertainty shock resembles that of Q4 2011 this would imply a headwind to our 2013 forecast of -0.5% of between -1% and -2.5%. In other words, we would expect a GDP contraction of between 1.5% and 3%, that is, a middle point below 2%.
What about the long run under this scenario? The special treatment of deposits and the imposition of semi-capital control has the implicit effect of underlining the fragmentation between the North and the South. Once again, the lack of respect for capital structure when designing programmes leads to the perception that restructuring in the Eurozone rests on arbitrary decisions, which clearly damages investment cases in the euro area, particularly in countries with pending deleveraging.
Conclusion: endangering Eurozone trend growth
The eurozone crisis has permanently damaged the euro area’s growth potential, unless economic reforms can boost investment and productivity again. In the absence of a considerable boost to economic policy, but assuming a standard recovery, Europe’s large countries trend growth would be lower at c.1.3% in 2015-20. But in our previous work we had assumed as a central scenario that the investment growth rate returns to its pre-crisis level by 2020.
In other words, the underlining of fragmentation that would come with a Cypriot exit would bring us closer to our scenario of much slower investment growth in 2015-20. In this situation trend growth in the four main economies in the Eurozone would be cut by an average of 1%, bringing France and Spain to a growth rate of 0.4%, Germany to 0.0%, and Italy to -0.6% on average during 2015-20.