11/29/2011 06:02 PM

Preparing for the Worst

The High Price of Abandoning the Euro

By David Böcking
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There is mounting speculation that the euro zone will break apart, or even that the single currency will be abandoned altogether. It often sounds as if such scenarios wouldn't be so bad for Germany. In fact the consequences would be catastrophic for Europe and for its largest economy.

The warning signs are mounting, and fresh news is adding to the gloom every day. Britain's financial watchdog has instructed banks to brace for a possible break-up of the euro zone. British currency trader CLS Bank is reportedly conducting stress tests to prepare for this worst-case scenario.
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Polish Foreign Minister Radoslaw Sikorski made a dramatic appeal to Germany on Monday to prevent a collapse of the currency union, saying: "We are standing on the edge of a precipice."
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German investors are jettisoning derivatives on a large scale because they have lost confidence in the instruments. For the first time, it appears, people across Europe regard the downfall of the euro as a real possibility.
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Is it really for the first time, though? In fact, scenarios for the euro's breakup are older than the currency itself. At the end of 1998, Harvard Law School Professor Hal Scott published a paper called "When the Euro Falls Apart." He put the chances of the euro failing at around 10 percent.
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Today, that's a real prospect. According to Mark Cliffe, the chief economist of ING Bank, "even the most ardent euro admirer must concede that the probability of countries leaving or the breakup of the euro zone is no longer zero."
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The economist Nouriel Roubini, known as "Dr. Doom" because he predicted the 2008 financial crisis, recently put the likelihood of the euro zone collapsing at 45 percent. But such expert forecasts sound abstract to most people.
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What would be the concrete consequences and costs of a euro apocalypse -- for Europe and for Germany? Here's an assessment:

Is Leaving the Euro Even Possible? And is it a Nightmare Scenario?

The disintegration of the euro zone is basically possible. Back in 1998, Harvard Law School Professor Scott cited a number of factors that would theoretically permit euro countries to return to their national currencies. The euro zone:

  • minted euro coins with national symbols
  • kept national payments systems and national central banks as well as national debt issuance
  • only merged the foreign currency reserves of the member states to a limited extent

So could Germany simply return to the Deutsche mark? Could Greece simply reintroduce the drachma?

That wouldn't be as easy as euroskeptics are arguing. The European treaties don't envisage nations leaving the euro zone -- a country can only quit the European Union as a whole. Such a departure would take a long time, and investors could use that time to withdraw their capital, warns economist Karsten Junius in a research note for DekaBank. So the country in question would suffer economic damage on its path back into a national currency.
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It is also unclear what would happen to a country's sovereign debt if it left the euro zone. When the single currency was set up, national debt was converted into euros. In many cases, that conversion was enshrined in bond contracts as a one-way street, meaning that a return to national currencies wasn't provided for.
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Collapse of Currency Unions often Accompanied by Unrest

The decisive factor would be whether the country in question had borrowed money under national or international law -- and that varies from member state to member state. According to DekaBank, Germany has issued only 0.2 percent of its debt under international law, while the figure for the Netherlands is just under 40 percent. For Portugal, it stands at 60 percent.
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The bonds would become the subject of legal disputes which would cause lasting damage to investor confidence in the countries that issued them. Investors are already worried by these factors. Japanese bank Nomura is reported to have advised its customers to check the government bonds in their portfolios to see whether they can be converted into a national currency.
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When a currency is abolished, there are always victims, including many citizens whose savings are suddenly worth less or nothing. History shows that the collapse of currency unions is often accompanied by unrest or even civil war. UBS chief economist Stephane Deo believes that it is "virtually impossible to imagine a break-up without severe social consequences."
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Violent protests in Europe? It is a nightmare scenario.
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At the same time, the EU would suffer an immediate loss of influence in the world if it lost the euro. Efforts to forge a common foreign and security policy would be rendered pointless. Without the euro, the voice even of large countries like Germany would amount to no more than "a whisper on the world stage" writes Deo.
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US economist Barry Eichengreen says the disastrous political consequences of a collapse of the euro zone will deter countries from allowing the currency to fail. "The high value that member states attach to their involvement in the larger European process would prevent them from abandoning the euro," he writes, adding: "except under the most extreme circumstances."
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Have these extreme circumstances been reached now? Are the costs of saving the euro -- ever-increasing debt and interest payments on that debt -- so high that they exceed its benefits?
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Exit from Europe Would Cost Each German Thousands
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In no other country is skepticism of the euro as great as it is in Germany. On the one hand, that is understandable given that Germany is responsible for the largest share of the aid packages for the crisis-stricken countries. But it also comes across as a bit absurd considering the high degree to which the country has profited from the introduction of the euro.
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Germany is a proud exporting nation, and around 40 percent of its exports go to other euro-zone nations. On Tuesday, the news broke that German exports will exceed the €1 trillion level for the first time. But the very companies enjoying this current success are accustomed to being able to export their goods at the lowest and most stable prices. The euro made both possible. The common currency eliminated exchange rate fluctuations in the euro zone, the euro appreciated less strongly than the deutsche mark. In other words, it kept prices competitive.

The result was a boom in exports. Between 1999 and 1993, German exports rose by around 3 percent. But between 1999 and 2003, exports increased by 6.5 percent. Between 2003 and 2007, two years after the introduction of euro notes and coins, German exports rose a staggering 9 percent. The federal government-owned investment bank KfW researched the benefits of this boom and determined that membership in the currency union has created profits in Germany in the last two years alone of €50 billion to €60 billion.
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If Germany were to exit the euro zone, this advantage would vanish quite suddenly. A reintroduced deutsche mark would quickly appreciate against the euro -- UBS chief economist Deo regards a rise by 40 percent to be realistic. The result would be that exports would become more expensive. If a strong country were to leave the euro zone, Deo writes, "it would ultimately have to write off its export industry." For the German economy, this would be a disastrous scenario.
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Would Would Happen If Athens Left the Euro Zone?
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And what would happen to the crisis-plagued countries like Greece and Portugal? Some economists -- like Hans-Werner Sinn, the president of the Institute for Economic Research (Ifo), a leading German think tank in Munich -- believe Greece could actually regain competitiveness by leaving the euro zone by devaluating the drachma. That may sound good at first, but there's a catch: Athens would still have to pay back a large share of its debt, even after exiting from the common currency, in euros. But that repayment would be made far more difficult as a result of the drachma's devaluation. An Athens exit from the euro zone would also hit German and French banks, which have a high degree of exposure to Greek debt.
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A decisive question is that of the total cost Germany would face if it left the euro zone. Economist Dirk Meyer has developed a scenario in which the total costs would fall somewhere between €250 and €340 billion. That would represent 10 to 14 percent of German gross domestic product, a considerable amount.
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UBS chief economist Deo, has even gone so far as to estimate that 20 to 25 percent of GDP might be realistic in the first year after a German exit alone. That would translate to a per capita cost of between €6,000 and €8,000, with costs of between €3,500 and €4,500 in subsequent years. By comparison, if, after Greece, Portugal and Ireland each had to be given a debt haircut of 50 percent, Deo estimates it would only cost around €1,000 per German citizen -- and it would be a one-time cost.
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The calculations undertaken by ING chief economist Cliffe are similarly pessimistic. In his scenario, he assumes that the breakup of the euro zone would create many additional problems: falling stock prices, the need to bail out further banks to the tune of billions and a sharp drop in the euro exchange rate. "Compared to the presumed long-term benefits, the scope of the economic damage in the first two years would weigh heavily," he concludes. "Decision-makers," he warns, "perhaps ought to think of that before they gleefully describe the exit from the currency union as an option."

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This sounds like a clear message to Europe's politicians. But it isn't just the real economy that would be affected massively by the end of the euro zone. The financial sector would also face new perils.

How Reinstating Old Borders Would Ravage the Financial System
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The impressions left by the last financial crisis in 2008 and 2009 remain fresh, the worries of new problems among banks still great. In this situation the exit of a single country from the euro zone could be fatal.

Should a weak country like Greece pull out, a panicked reaction by its citizens is to be expected. In expectation of currency devaluation, hundreds of thousands of people would likely clean out their bank accounts, creating a run on banks. People would subsequently try to put their money in foreign banks. A capital flight like this would finish off banks that are already in distress.
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Were the entire euro zone to dissolve, even a strong country like Germany would suffer. In this case each former member country would have to establish a new exchange rate for their new currency.
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Europeans would then have an incentive to swap their remaining euros against a strong national currency -- like the deutsche mark, for example. Thus Germany would attract piles of capital, in turn increasing inflation pressure.
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According to economist Junius, countries have two possibilities for avoiding these problems: On the one hand they can act so quickly that the financial markets would be surprised by their exit from the euro zone. In this case, however, the move couldn't be communicated politically and legitimized -- making it practically unthinkable.
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On the other hand, countries that pull out could, through the implementation of capital controls, among other things, take precautions for monitoring the amount of money that comes in and out. Harvard economist Scott has already thought extensively about how Italy could introduce a new Lira with temporary border closures and stamping.
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But Junius sees such a step as unrealistic for Europe. "In light of the geographical proximity and intensive trade relationships it would be a very impractical solution that would offer a few days of relief at best," he said. Furthermore, the capital controls would contradict the principle of the common market, putting the concept of the European Union itself in question.


Europe is Not the United States

Martin Feldstein

2011-11-29
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CAMBRIDGE – Europe is now struggling with the inevitable adverse consequences of imposing a single currency on a very heterogeneous collection of countries. But the budget crisis in Greece and the risk of insolvency in Italy and Spain are just part of the problem caused by the single currency. The fragility of the major European banks, high unemployment rates, and the large intra-European trade imbalance (Germany’s $200 billion current-account surplus versus the combined $300 billion current-account deficit in the rest of the eurozone) also reflect the use of the euro.
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European politicians who insisted on introducing the euro in 1999 ignored the warnings of economists who predicted that a single currency for all of Europe would create serious problems. The euro’s advocates were focused on the goal of European political integration, and saw the single currency as part of the process of creating a sense of political community in Europe. They rallied popular support with the sloganOne Market, One Money,” arguing that the free-trade area created by the European Union would succeed only with a single currency.
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Neither history nor economic logic supported that view. Indeed, EU trade functions well, despite the fact that only 17 of the Union’s 27 members use the euro.
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But the key argument made by European officials and other defenders of the euro has been that, because a single currency works well in the United States, it should also work well in Europe. After all, both are large, continental, and diverse economies. But that argument overlooks three important differences between the US and Europe.
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First, the US is effectively a single labor market, with workers moving from areas of high and rising unemployment to places where jobs are more plentiful. In Europe, national labor markets are effectively separated by barriers of language, culture, religion, union membership, and social-insurance systems.
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To be sure, some workers in Europe do migrate. In the absence of the high degree of mobility seen in the US, however, overall unemployment can be lowered only if high-unemployment countries can ease monetary policy, an option precluded by the single currency.
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A second important difference is that the US has a centralized fiscal system. Individuals and businesses pay the majority of their taxes to the federal government in Washington, rather than to their state (or local) authorities.

When a US state’s economic activity slows relative to the rest of the country, the taxes that its individuals and businesses pay to the federal government decline, and the funds that it receives from the federal government (for unemployment benefits and other transfer programs) increase. Roughly speaking, each dollar of GDP decline in a state like Massachusetts or Ohio triggers changes in taxes and transfers that offset about 40 cents of that drop, providing a substantial fiscal stimulus.

There is no comparable offset in Europe, where taxes are almost exclusively paid to, and transfers received from, national governments. The EU’s Maastricht Treaty specifically reserves this tax-and-transfer authority to the member states, a reflection of Europeans’ unwillingness to transfer funds to other countries’ people in the way that Americans are willing to do among people in different states.
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The third important difference is that all US states are required by their constitutions to balance their annual operating budgets. While “rainy dayfunds that accumulate in boom years are used to deal with temporary revenue shortfalls, the states’general obligationborrowing is limited to capital projects like roads and schools. Even a state like California, seen by many as a poster child for fiscal profligacy, now has an annual budget deficit of just 1% of its GDP and a general obligation debt of just 4% of GDP.

These limits on state-level budget deficits are a logical implication of the fact that US states cannot create money to fill fiscal gaps. These constitutional rules prevent the kind of deficit and debt problems that have beset the eurozone, where capital markets ignored individual countries’ lack of monetary independence.
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None of these features of the US economy would develop in Europe even if the eurozone evolved into a more explicitly political union. Although the form of political union advocated by Germany and others remains vague, it would not involve centralized revenue collection, as in the US, because that would place a greater burden on German taxpayers to finance government programs in other countries.
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Nor would political union enhance labor mobility within the eurozone, overcome the problems caused by imposing a common monetary policy on countries with different cyclical conditions, or improve the trade performance of countries that cannot devalue their exchange rates to regain competitiveness.
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The most likely effect of strengthening political union in the eurozone would be to give Germany the power to control the other members’ budgets and prescribe changes in their taxes and spending. This formal transfer of sovereignty would only increase the tensions and conflicts that already exist between Germany and other EU countries.
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Martin Feldstein, Professor of Economics at Harvard, was Chairman of President Ronald Reagan's Council of Economic Advisers and is former President of the National Bureau for Economic Research.


Markets Insight

November 28, 2011 2:57 pm

Low growth and high debt is the sovereign curse

By Satyajit Das

It has become accepted wisdom – as popularised by economists Carmen Reinhart and Kenneth Rogoff – that sovereign debt levels become unsustainable when they rise above 60-90 per cent of a country’s gross domestic product.
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But, as government or corporate debt rarely ever gets repaid, the real question is whether that debt can be serviced and investor confidence maintained to allow it to be refinanced. In reality, the level of tolerable sovereign debt depends on a multitude of factors ranging from the currency of the debt to the level of interest rates and the debt maturity profile and structure of the country’s economy.

But perhaps the most important determinant is the level of current and expected economic growth. A dynamic economy capable of high levels of growth, with the attendant ability to generate additional tax revenues and attract investment, can maintain a higher level of debt than one with lower growth prospects.

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While not exact, the sustainable level of debt can be approximated by another formulation commonly used by economists and analysts, which links the existing level of public debt, the current budget position, interest rates and growth.

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Using this formula, eurozone economies need to achieve strong growth merely to stabilise their debt burdens.
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Assuming borrowing costs of 4 per cent and a debt-to-GDP ratio of 120 per cent, Italy needs to grow at 4.8 per cent just to avoid increasing its debt burden where its budget is balanced. At current market borrowing costs of 7 per cent, Italy has to grow at an unlikely 8.4 per cent just to avoid increases in its debt levels.
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Given low projected growth rates and elevated borrowing costs, Italy must reduce its debt levels significantly to avoid the risk of insolvency. Assuming interest costs of 4 per cent and growth of 2 per cent, Italy would have to run a budget surplus of 5 per cent per annum for 10 years to reduce its debt to 90 per cent of GDP. Alternatively, it must sell state assets to reduce its debt.
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The toxic cocktail of high levels of existing debt, large and seemingly irreversible structural budget deficits, low growth rates and high borrowing costs makes the position of many European countries unsustainable. Beleaguered economies have to run budget surpluses (through spending cuts and tax increases), grow at very high rates, decrease their borrowing costs or achieve a combination of these merely to stabilise their debt.
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The vulnerability of wealthy nations, financing the bail-out of weaker neighbours, is also evident. Assuming borrowing costs of 3 per cent and a debt-to-GDP ratio of 81 per cent, Germany needs to grow at about 2.4 per cent to avoid increasing debt levels. France needs to grow at even higher levels. If growth is low and additional liabilities are incurred to support Greece, Ireland, Portugal, Italy and Spain, then the problems are exacerbated.
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Within this framework, Germany’s reluctance to allow a restructuring of the euro is explicable. Appreciation in the value of a restructured euro would make German exporters less competitive, slowing growth. This would trigger increased concern about the sustainability of German debt levels.
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The reluctance of stronger countries to countenance significant debt writedowns is also explainable. Losses on sovereign debt holdings would trigger the need for states to increase their own borrowing to recapitalise national banks and support their funding operations. The simultaneous slowdown in growth as credit supply slows, combined with higher state liabilities, might trigger sovereign debt concerns, as they did in Ireland.
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Events show that the combination of a large stock of debt, intractable, corrosive budget deficits, low growth rates and increasing borrowing costs can result in a rapid slide into a sovereign debt crisis. As interest rates increase as a result of rising investor concern about creditworthiness, attempts to cut the budget deficit merely reduce growth, exacerbating the problem. Without a significant reduction in the amount owed to creditors, the country is locked into a self-defeating cycle of austerity, continuing budget deficits and increasing public debt.
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Following the global financial crisis, governments expanded their borrowings, replacing private sector, especially consumer debt, in a heroic bet to engineer a recovery. The increase in government debt will prove unsustainable if growth does not return quickly to high levels, driving a new phase of the global financial crisis.
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It is really not a problem of debt; it is one of growth. But the economic growth of recent years was debt-fuelled. When asked for directions, the old joke is that some wise guy pipes up: “If you want to go there, then I wouldn’t start from here.” The same could be said about dealing with the problems of an over-indebted world.
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Satyajit Das is the author of ‘Extreme Money: The Masters of the Universe and the Cult of Risk’ (2011)
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Copyright The Financial Times Limited 2011

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November 29, 2011 9:32 pm

Businesses plan for possible end of euro

By Tony Barber in London and Daniel Dombey in Istanbul
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Activists of the Occupy Frankfurt movement have set up a fire place near the Euro sculpture in front of the European Central Bank

International companies are preparing contingency plans for a possible break-up of the eurozone, according to interviews with dozens of multinational executives.
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Concerned that Europe’s political leaders are failing to control the spreading sovereign debt crisis, business executives say they feel compelled to protect their companies against a crash that can no longer be wished away. When German chancellor Angela Merkel and French president Nicolas Sarkozy raised the prospect of a Greek exit from the eurozone earlier this month, it marked the first time that senior European officials had dared to question the permanence of their 13-year-old experiment with monetary union.

“We’ve started thinking what [a break-up] might look like,” Andrew Morgan, president of Diageo Europe, said on Tuesday. “If you get some much bigger kind of ... change around the euro, then we are into a different situation altogether. With countries coming out of the euro, you’ve got massive devaluation that makes imported brands very, very expensive.”

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Executives’ concerns are emerging as eurozone finance ministers weigh ever more radical options to tackle the sovereign debt crisis, including the possibility of funnelling European Central Bank loans to struggling countries via the International Monetary Fund.
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Some are examining expert advice on the legal consequences of a eurozone split for cross-border commercial contracts and loan agreements. By contrast, most small and medium-sized firms have made few, if any financial and legal preparations.
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Market participants and, increasingly, real businesses are pricing in a break-up scenario,” said Jean Pisani-Ferry, director of the Brussels-based Bruegel think-tank. “It is still hard to think the unthinkable, let alone to work out the details of it, but any rational player has to consider the possibility of it.”
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Some businesses with global reach say a euro break-up would be grim but manageable. “We have made a first rough analysis about the consequences of the discontinuation of the euro as the Portuguese currency,” said Jürgen Dieter Hoffmann, finance director at Volkswagen Autoeuropa, the German carmaker’s Portuguese arm. “The conclusion is that overall the impact would not be so negative to our company, as we are mainly an exporter and belong to a worldwide group.”
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Some French, Italian and Spanish executives say they have plans in place for severe financial and economic turbulence, but not specifically for a euro break-up. The risk, in their eyes, is that the region’s stability might come under even greater threat if it became known that companies were contemplating the worst.
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Traders prepare for endgame
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Urgent action has long been the mantra of investors in the eurozone crisis. But for them, policymakers have seemed more interested in buying time, writes Richard Milne in London.
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That some politicians now appear to be coming round to markets’ sense of timing coincides with heightened chatter on trading floors not just of foreign investors shunning eurozone assets but also of the prospect of a break-up of the euro.
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Many market participants are convinced the ultimate play – “the one minute to midnightscenario for some – is of the European Central Bank buying government bonds in huge quantities. “I don’t know how close we are to midnight, but it’s awfully dark outside,” one says.
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Additional reporting by Peter Wise in Lisbon, James Wilson in Frankfurt and Alex Barker in Brussels
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Copyright The Financial Times Limited 2011.