Exit Of The Periphery From The Eurozone Is Inevitable

Includes: EIRL, EWP, FXE
by: Sailesh Radha

As the euro crisis muddles along with no end in sight, let's analyze the journey of the eurozone so far since the great financial crisis of 2008, and the subsequent downward spiral of the eurozone periphery set in motion by the Greek socialist government's revelation in December 2009 that the Greek budget deficits were twice what were previously estimated.

The Greek crisis, on the heels of the Irish economic crisis, spread like a wild-fire across Europe and has left in its wake Portugal, Italy, and Spain, in a state of financial and economic panic. Albeit the panic assumed different proportions in those countries called the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) or the periphery as a group, its gust had the potency to draw the eurozone's core - Germany, France, Netherlands - in to the center of the storm. The fiscal crisis in Greece set off alarm bells across the eurozone, especially the periphery, on the fiscal front. They then triggered a series of backlashes from the bond vigilantes, who forced sovereign governments of the peripheral nations to pay up more to hold their debt, triggering a crisis of confidence that percolated through their banking and financial systems. Of course, I haven't said anything that you did not know, but what has been lost in the current turmoil is the root cause of the crisis.

All the discourse amongst the policy makers and the perquisites imposed by the troika of ECB, IMF and EU on the countries in the periphery to tackle the turmoil have solely focused on austerity measures to put the fiscal balances in order, and largely to preserve the monetary union. The irony is that none of the recommendations have emphasized reforming the flawed macro-economic fundamentals of the periphery, which have been asymmetric to that of the core ever since the establishment of the eurozone. The asymmetric macro-economic fundamentals of the periphery, which have been put to test by the recent crisis, are threatening to rupture the eurozone as the one-size-fits-all coordinated monetary policy has been ineffective so far, as it has failed to manage the persistent current account imbalances of the countries in the periphery

Lending by eurozone core to the periphery

As you can see in figure 1, German banks have retrenched their lending to the PIIGS from a peak of €917 billion ($1,218.63) in Q2 2008 to a €383 billion ($ 508.956) in Q2 2012. The German exposure was about 37% of its GDP at the peak in Q1 2008 compared with the 15% at the end of Q2 2012. Similar has been the case with French as well as the Dutch banks too (see figure 2 and figure 3). In the case of the French banks, the exposure dwindled from 52% of the GDP at the peak to 22% at the end of Q2 2012, while the Dutch banks' exposure dwindled from 63% of the GDP to 19%. With the year-over-year declines in the banking exposure to the PIIGS hovering between 25% and 35% in these countries, the periphery has been experiencing the classic case of "sudden stop" with inter-bank lending virtually coming to a halt. As a result of the "sudden stop," the slack in private lending has been picked up by ECB, the lender of last resort, the sovereign governments in the periphery, the duo of European Commission and IMF, and the bloated TARGET2 balances. The total exposure of banks from core eurozone countries Germany, France, Netherlands, Austria and Belgium to PIIGS dropped from €2.6 trillion in Q1 2008 to €1.0 trillion in Q2 2012 (see figure 4).

Figure 1

Figure 2

Figure 3

Figure 4

ECB Lending

The global recession of 2008 morphed into a crisis of confidence as well as a banking and debt crisis for the countries in the periphery, pushing Europe into another round of recession. In order to prevent the banking and debt crisis from spreading from the periphery to other peripheral and core nations of the European Union, the ECB stepped in to fill the liquidity gap left behind by the sudden withdrawal of private capital - as cross-border private lending as well as inter-bank lending had dried up. In January 2008, ECB lending to the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) in the form of Main Refinancing Operations and Longer-Term Refinancing Operations amounted to about €100 billion. As of end of October this year, ECB lending to the periphery has ballooned to around €1 trillion including lending by the individual National Central Banks via Emergency Liquidity Assistance (ELA). The lending also includes the 36-month Longer-Term Refinancing Operations conducted by the ECB in two installments - one at the end of December, 2011, and the other at the end of February, 2012. ECB allotted €489 billion to 523 banks in eurozone in the first installment and about €530 billion to 800 banks in the second installment. Figure 5 summarizes the ECB lending to the peripheral nations. In the figure, the numbers for Greece include the ELA lending of €122 billion by Bank of Greece, backed by inferior collateral than that accepted by ECB in general. The size of the entire ELA facility today stands about 234 billion (see figure 6), and factoring that into the total number from figure 4, and as said earlier, the total lending by ESCB (European System of Central Banks) should undeniably be more than €1 trillion. Figures 7 through 11 will reveal the size of the ECB lending to various peripheral countries.

Figure 5

Figure 6

Figure 7

Figure 8

Figure 9

Figure 10

Figure 11

Flight of Deposits and collapsed lending

Of the peripheral countries, Greece, Ireland, and Spain, have seen a massive exodus of deposits (see figures 12 and 13), partly from German, English, and French banks reducing their exposure to them, and in large part from the flight of investors pursuing safety. Spain has seen its deposits dwindle from €1.7 trillion in June 2011 to €1.5 trillion, at the end of October 2011, a decline of €237 billion. On the other hand, Greece has seen its deposits erode by €83 billion euros since the current crisis raised its ugly head in December 2009. Likewise, Ireland has seen its deposits erode by €23 billion euros since August 2009. However, as you can see from figure 12, core countries like Germany, France, and Netherlands are experiencing steady growth of bank deposits in spite of the crisis. The flight of deposits from the periphery coincides with the growth of deposits in the core countries, creating a fragmented credit system and a dualistic banking system in the eurozone, and thus, dampening the ECB's current ultra-slack monetary stance. With the flight of deposits, the cost of credit in the peripheral countries is rising, crippling the already strained credit system there. As you can see figures 14 & 15, lending has collapsed in Spain, Ireland, and Greece.

Figure 12

Figure 13

Figure 14

Figure 15

ECB's monetary policy

By applying Taylor's rule to the countries in the periphery and the core, and despite the deluge of liquidity pumped by the ECB, we can gather that the current ECB target rate is too tight for the periphery, while being lax for the core group. As you can see in figure 16, Taylor's rule suggests that the ECB target rates historically have been incongruent to the macroeconomic conditions of the two individual clusters considered separately. In other words, one size policy does not fit the economic circumstances of the disparate countries in a monetary union. Considering the fact that the current crisis in the eurozone has created a divergence between the core and the periphery, it raises the question - how long can the ECB be accommodative toward the periphery, without harming the economic interests of the core of the eurozone.

Figure 16

Incongruity of fiscal policy as well as monetary policy with macroeconomic conditions in the periphery

The bond vigilantes have forced the sovereigns in the periphery to undertake austerity measures, and with the ECB's current monetary stance, despite infusion of abundant liquidity, being tight for the conditions there, both the fiscal policy as well as the monetary policy as a result are running counter to the macroeconomic conditions in the periphery. The conditions set forth by the troika as part of bailout programs are grounded on principles of austerity, whereas the order of the day should have been comprehensive macroeconomic reforms supplemented by austerity measures. Ever since the existence of the European Union, the nations on the periphery have been running current account deficits with the core nations. And therefore all the prescriptions provided by the troika, in addition to austerity measures, should have been centered on labor reforms emphasizing productivity and wage reduction in the periphery. To be added to the list of prescriptions should have been the depreciation of the currency, which is impossible in the current scenario, considering the coordinated monetary policy that is threading through the peripheral nations as a result of being in a monetary union. Unless efforts are not made to restore balance to the current account, the periphery will never see resurgence again and will continue to muddle along in the quagmire as we have seen in the last few years, and that too only with the aid of boundless ECB liquidity. The ECB liquidity programs have given an opportunity for the core countries to set their financial books in order by reducing their financial exposure to the periphery and thereby setting the stage for transformation of the eurozone with minimum disruptions. The economic and financial divergence between the core and the periphery has reached a critical stage now. The policy makers in the EU and ECB now should be emphasizing through the current liquidity programs, maybe, an orderly bifurcation of the eurozone into two groups - one containing the core nations and the second containing the periphery including Portugal, Ireland, Greece, and Spain (Italy for all purpose would remain in the core). So far when the circumstance were good, the core nations were reaping the benefits from the union to some extent at the expense of the periphery, but since the crisis, the core led by Germany have not been happy campers for having to undertake the burden of bailing out the economically downtrodden brethren from the periphery. The divergence on the economic front has spilled over in to the political realm widening the breach even further. An orderly bifurcation rather than that forced by the markets would be the best long-term solution to the crisis in the periphery

For each of the countries in the periphery, the only way out of the current quagmire is through economic reforms aided by independent fiscal and monetary policy. The fiscal belt tightening going on in these peripheral nations is not helping alleviate the macroeconomic problems in these countries at all. As discussed earlier the underpinnings of austerity measures solely promote fiscal balance, and restoration of normalcy to the eurozone at the earliest, and not rectifying the macroeconomic flaws in the periphery. Since the coordinated monetary policy is not conducive for comprehensive macroeconomic reforms, independent monetary policy should be the way forward, but for that to happen the periphery will have to exit the monetary union. Labor reforms are the first that should be undertaken in order to promote productivity in the economy by removing labor market rigidities and welfare programs that thwart job creation and limiting cross-border labor migration. The wage structure in these countries needs to be rationalized to the national standards rather than the EU standards, thus promoting job growth. The peripheral nations have to depart from the euro currency, so that their new currency would operate at an optimum efficiency, which would eliminate current account imbalances and reduce the growth rate of sovereign debt. With the population growth rate at below replacement levels, the classical Solow's growth model would reveal that the long-term growth rate of the countries in the periphery would be governed purely by the rate of growth of productivity and human capital growth.


The rupture of the eurozone is inevitable due to the economic imbalance between the periphery and the core, but the rupture can be managed in an orderly fashion with the help of ECB. Doing so in an orderly manner will eliminate all uncertainties and minimize financial and economic losses. The ECB's quantitative easing has helped the core countries to manage their exposure to the periphery, and the policy makers should use this as an opportunity to stage the reformation of the eurozone rather than it being forced on them by the markets. Irrespective of how the rupture transpires, for long-term investors, exposure to country ETFs like EWP (iShares Spain Country ETF), having an exposure to financials of 50%, and EIRL (iShares Ireland Country ETF), should be kept at bare minimum

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.