"Prolonged economic weakness will persist - especially in the peripheral countries - with further periods of intense financial market stress" is how Citi's Willem Buiter's economics team sees the future in Europe. While they continue to believe that the probability of a Greece exit from the Euro is around 90% in the next 12-18 months; but more critically it is increasingly likely in the next six months - conceivably as soon as September/October depending on the TROIKA report. There is a crucial series of meetings and events in coming weeks and while they believe that the ECB's conditional bond-buying (and ESM/EFSF) may help avoid a 'Lehman moment' around the GRExit, they believe that there will still be considerably capital flight out of periphery assets should it occur. The reason being simply that even if funding costs were reduced, the current mix of fiscal austerity and supply-side reform will not return any periphery country to a sustainable fiscal path in coming years.
Citigroup: Global Economic Outlook
We continue to expect that the EMU crisis will persist, with prolonged economic weakness — especially in periphery countries — and further periods of intense financial market stress:
Euro area GDP fell in Q2 and we expect that overall euro GDP will fall in both this year and 2013, with severe falls in most periphery countries. The Citi Economic Surprise Index (CESI) for the US recently has moved close to neutral, but for the euro area it remains firmly negative.
Nevertheless, the ECB's efforts probably will not resolve worries over the long-run fiscal sustainability of periphery EMU countries:
Even with the resultant relatively low funding costs, we doubt that the current mix of fiscal austerity and supply-side reform will return any periphery country to a sustainable fiscal path in coming years. Supplyside measures rarely have big short-term effects on growth (indeed, labour market reforms can produce negative short-term effects), especially if limitations in credit supply limit scope for companies and households to borrow in anticipation of the eventual payoff from reforms. Any such boost probably will be overwhelmed by the drag from fiscal austerity — plus a varying mix of poor external competitiveness weak banking systems, weak housing markets, high private debts. Hence, we expect that growth in periphery economies will undershoot official forecasts, leading to above-target and generally rising government debt/GDP ratios in coming years.
And the likelihood of Greece exit is becoming clearer:
...while the ECB’s decisions may help limit the economic and financial market spillovers of Grexit, the likelihood of Grexit itself is coming into even sharper focus, in our view. There appears to be a sizeable — and probably unbridgeable gap between the Greek government’s ability to quickly cut the fiscal deficit and implement major supply-side reforms and privatisations, and the measures that creditor nations would require to extend further funding.
We continue to put the probability that Greece will exit the euro area (ie “Grexit”) in the next 12-18 months at about 90% and, within that timeframe, we think it is increasingly likely that Grexit will occur in the next 6 months or so, conceivably even as early as September/October depending on the outcome of the September Troika report on Greece.
but a range of factors will determine the timing:
The precise timing of Grexit, if it happens, remains uncertain. It could even occur as soon as September/October, if the upcoming Troika report confirms that Greece’s programme is off-track and creditor nations are unwilling to provide Greece any funding extension or extra time. However, creditor nations may provide enough funding to delay Grexit to after the December review, for example to allow plans for common bank supervision to be finalised.
Though the mechanics of the event will be extremely ugly - with dramatic inflationary impacts for the Greeks:
The exact mechanics of Grexit also are uncertain. We envisage an extended bank holiday and some form of capital controls and limits on deposit withdrawals in Greece (and perhaps some temporary restrictions in some other EMU countries as well). Prior examples highlight that currency redenomination need not be uniform: for example, when Argentina abandoned its currency peg to the US$ in 2002, the government decided to apply a 1-to-1 exchange rate for Bank loans and a 1.4-to-1 exchange rate to deposits.
Moreover, when East Germany adopted the Deutsche Mark as legal tender on July 1, 1990, just ahead of German unification in October of the same year, the East German mark was converted at par for wages, prices, pensions and savings up to a limit of 4000 East Mark/person. Financial claims, including corporate and housing loans, and savings in excess of 4000 East Mark were converted at a ratio of 2:1 into the Deutsche Mark. We assume that a new Greek currency would fall by about 60%, pushing inflation markedly higher in 2013-16, but the scale of currency decline is highly uncertain.
And GREexit will not be the cathartic event many hope for:
We think the EMU end-game is likely to be a mix of EMU exit (Greece), a significant amount of sovereign debt and bank debt restructuring (Portugal and, eventually, perhaps Ireland, Italy and Spain), with only limited official fiscal burden sharing (via the ESM, EFSF and ECB losses) and ongoing liquidity support from the ESM and the ECB. We still expect that Portugal will get a second bailout (or a prolonged extension of the current programme), with no PSI initially but a high chance of PSI and OSI over the next three years or so.
Ireland may well also need some external assistance beyond the end of the current programme, although — with the deficit likely to undershoot official forecasts and evidence that the country has some access to markets — this may take the form of partial funding via the EFSF/ESM and the backstop of ECB market purchases if needed.
Nevertheless, for Portugal, Ireland, Italy and Spain, the crisis looks set to leave a legacy of high unemployment and very high government debt/GDP ratios (90%+, and, in most cases, well above that level). We doubt that any of these countries will be able to sustain normal market access at a tolerable yield without the backstop of official support in coming years.