A new uncertainty-factor on financial markets in the euro area

Recently a political party in the Netherlands, PVV, has announced that it will commission an inquiry into the advantages of leaving the euro and re-introducing the Dutch guilder as well as looking into the possibility for a currency union consisting of Northern European countries. It has just been announced that Lombard Street Research will conduct the research. Charles Dumas is the notoriously euro-sceptic Chief Economist of Lombard Street Research, making it highly likely that the report will be euro-sceptic as well and hence, that it will fuel the debate on the future of the euro in the months ahead.

Debates on re-introduction of national currencies and talk of a new monetary union in Europe will most likely  lead to a worsening of the crisis in the euro area in the short term. We will explain why in this short ECRXtra.

In recent weeks, European banks have offloaded Italian, Spanish, Portuguese and even French and Belgian government bonds as much as possible. Every time the European Central Bank (ECB) entered the market to buy government debt of those distressed countries, the supply was overwhelming.

One important reason for banks to sell their debt holdings of aforementioned countries is the increased chance of a default or application of haircuts like has been agreed with regard to the Greek debt.

Moreover, structuring those haircuts as voluntarily, meaning that technically speaking there is no default, Credit Default Swaps have become worthless. CDS is a product that protects the holder of for example sovereign debt in the case of default of the issuer. For example, an institution that holds Italian bonds  can buy CDS on those bonds, making sure than in the case of an Italian default, the issuer of the CDS compensates the institution for its losses. The damage of CDS contracts becoming in fact worthless mainly concentrates on institutions such pension funds and banks, with the side note that those banks that mainly have sold CDS contracts are actually profiting from this fact.

Together with the decreased likelihood of implementation of structural reforms in the weak euro area countries and countries that are on their way to become weak (i.e. France and Belgium), and hence decreased chances of economic growth returning to the countries that need it badly in order to be able to service their ever-larger debts, the de facto abolishment of protection via CDS contracts has sent the long term interest rates in a majority of the euro area member states sharply upwards.

Now, the talk of musings in France and Germany of a monetary union in Northern Europe and of the possibility of re-introducing the old national currencies, leads to yet another factor that is likely to stimulate the European banks to sell even more sovereign debt they hold on their books.
Were Europe to re-introduce the pre-euro era national currencies or to form a new monetary union without some of the current euro area member states, then there is a chance that European banks might get their money back from their Italian, Spanish or Portuguese debtors but not in euros but in liras, peseta’s or escudo’s. Given the fact that those currencies would sharply fall in value immediately after their re-introduction, the end result would again be a great loss for European banks.

This threatens to nullify any gains on the trust-front stemming from the fact that Greece and Italy have just gotten new governments with the sole aim of implementing structural reforms.

The likely worsening of the euro crisis in the months ahead, will have large consequences on the ECB. In our reports on European interest rates and EUR/USD we will go into more detail. Not only this week but in the weeks ahead as well.