“the Breakup of the Eurozone Is Inevitable Within the Next Five Years.” Discuss.

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FIN30030 International Financial Management

Group Assignment: “The breakup of the Eurozone is inevitable within the next five years.” Discuss.

Contents


Executive Summary
Background
No alternative
The Greek Problem
Contagion
The Firewall/European Financial Stability Facility (EFSF)
China
Conclusion
References
Appendices



1. Executive Summary

This report addresses the question of whether or not the breakup of the eurozone is inevitable within the next 5 years. When the U.S. property market collapsed and systemically important securities dropped sharply in value, a global financial crisis was triggered and the eurozone entered into recession. Greece in particular suffered from a fall in GDP and an increased deficit. As its cost of capital in the bond markets increased, contagion spread to other peripheral member states such as Ireland and Portugal. All three of these countries required intervention from the European Union/International Monetary Fund. Some commentators have mooted greater Eurozone fiscal union as a potential long-term solution to the currency area’s difficulties. We affirm that the Eurozone will not break up within the next five years; not because we believe it to be financially sound, but because there is sufficient political will to keep it intact. It is strongly asserted in political circles that a breakup would have catastrophic effects, much more costly than the price of bailouts and recapitalisations. Greece has been the most trouble Euro country, with astronomically high yields on its government debt and widespread civil unrest. A 50% ‘voluntary’ writedown on sovereign debt ownded by private creditors has been agreed, as has a second EU-IMF bailout. Severe austerity conditions will be attached to this, and even should there be strict adherence to these, uncertainty remains as to whether Greece will remain in the Eurozone in the long run. Many European banks carry high exposure to contagion on account of their portfolios of sovereign bonds. Banks holding Greek bonds will face a 50% ‘haircut’. A core tier one capital ratio of 9% has been set as a result of examinations of banks’ exposure to sovereign debt. It has been suggested that banks will need to raise up to €108 billion in fresh capital in the next 6-9 months, while the European Central Bank has provided €57 billion in loans to facilitate credit flow to the real economy. The primary means by which the EU hopes to contain contagion is by means of a firewall, preventing the spread of market panic from distressed countries such as Greece. The European Financial Stability Facility is the foundation on which the firewall is built. Currently the EFSF has approximately 440 billion at its disposal, but it is intended to increase this to around 1 trillion. The main requirement on the facility will be the refinancing of Italian and Spanish bonds in the next three years; Italy’s bond yields have risen to record levels in recent weeks. It is likely that China will play a significant role in Europe’s efforts to raise capital for the EFSF. With foreign currency reserves of around $3.2 billion, it is in a position to invest. Significantly, an estimated one quarter of these reserves are in euro, so the survival of the euro currency is of intrinsic value to China. Despite the many adverse factors currently working against the prosperity of the Eurozone, and despite the oftentimes slow political response to these factors, we maintain that the currency area will remain intact for the next five years. The Italian economy and Italian bond yields are the most pressing concern at the time of writing, but we feel that this problem will be contained. Policy reform and stricter controls are in the Eurozone’s future, which should aid the gradual stabilisation process, and maintain a 17-country Eurozone for the next five years.

2. Background

Following the collapse of the US housing market and subsequent fall in...
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