IS THE EURO HEADED FOR A BREAKUP ? / THE WALL STREET JOURNAL OP EDITORIAL ( HIGHLY RECOMMENDED READING )

OPINION EUROPE

JANUARY 18, 2010.

Is the Euro Headed for a Breakup?

By MORITZ KRAEMER

The first leg of the financial crisis seems to be behind us and most European economies are reemerging from recession. Attention is now shifting towards the sustainability of public finances. The latest European Commission forecasts show the public debt-to-GDP ratio for euro-zone countries rising to 88% in 2011 from 69% as recently as 2008. Government borrowing is increasing sharply, fed by dwindling revenues and the cost of supporting the financial and other sectors.

Markets are taking a dim view of sovereign indebtedness and have begun to focus on what they think are the most vulnerable candidates. After years with no noticeable market differentiation between euro-zone countries, bond and credit default spreads widened in early 2009 to their highest levels since the euro was introduced. Market sentiment calmed midyear, but spreads have now widened again, especially for Greece, where the new government has overseen a substantial and adverse post-electoral revision of budgetary performance.

But divergence in creditworthiness is hardly a phenomenon created by the economic crisis: For example, euro-zone sovereign ratings assigned by Standard & Poor's had begun to move apart around five years ago, following downgrades of Italy, Portugal and Greece.

Today, investors and commentators appear to be asking more fundamental questions, going to the core of the euro project. Once the preserve of fringe political commentators, speculation about the possibility of a euro-zone break-up has now crept into mainstream economic and political debate.

But the possibility of such an event remains remote. Euro-zone membership remains a profoundly popular proposition, with countries from Iceland to Bulgaria seeking to join. Equally important, we believe that governments' incentives are skewed against a euro exit.

Assume, for example, the scenario of a highly indebted EMU government looking for a shortcut to regain economic competitiveness and reduce the burden of state debt. Exiting the euro zone and letting the newly adopted national currency depreciate initially could appear an attractive option. Assuming historical trends repeat themselves, one might expect that in this scenario exports and growth would likely jump, external imbalances shrink, employment would recover and with it tax revenue.

However, this strategy would likely undermine sovereign creditworthiness. An export-led recovery, in our view, would not be sustained, as a nominal depreciation would not address the underlying structural causes of a lack of competitiveness. Domestic price and wage inflation and higher domestic interest rates would be expected to soon erode the effects of any temporary benefit to the economy, potentially requiring further depreciation. This is all the more so if the country's export-oriented sectors are fairly small, as in the case of Spain and Greece.

This approach was tried, tested and found wanting by several southern European countries in the pre-EMU era. The lasting negative economic consequences of this strategy persuaded those economies to go to great lengths in the 1990s to qualify as euro-zone members.

Exiting the euro would be significantly more challenging a proposition than joining. In such an event we would expect that households' and companies' efforts to circumvent conversion of their assets (and wages) would likely to lead to a severe financial crisis similar to the Argentine experience, when that country's banks' assets were converted at a less favorable exchange rate than its deposits. The cost of enforcing contracts still denominated in Euros would also likely increase, raising the cost of doing business and adversely affecting the business environment for many years to come. In sum, sovereign creditworthiness would likely suffer for any country exiting the euro zone.

An even worse scenario could be one in which exiting governments redenominated their euro-debt and paid investors in a new form of currency. In such a case, access to future funding would likely be difficult and costly for a reneging government.

Euro-zone governments are aware of the risks associated with exiting the euro zone and the potential costs of such an action for their economies. They understand what is at stake and that the price to pay would be too high.

Mr. Kraemer is a managing director at Standard & Poor's Ratings Services.

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