The 5 Most Likely EMU Scenarios

by: Cullen Roche

Analysts at RBS recently released the 5 potential scenarios they see unfolding in Europe. Their highest probability event involves a Greek default, recapitalization, increased ECB bond buying and no defections. I think they basically have this one dead right. The EMU can’t avoid some form of restructuring in Greece. What they can avoid is a massive banking melt-down and contagion. But their response will have to be massive on the recapitalization side. What they won’t allow is a Greek default and defection which spirals into mass contagion and a worst case scenario.

European banks have $121B in Greek exposure so a Greek default/restructuring isn’t exactly a disaster if it’s accompanied by a substantial recapitalization. The risks rise exponentially if they should allow a Greek default to spread fears into other regions or through the rest of the banking system. The European banks have total exposure of ~$700B to PIG’s (Portugal, Ireland and Greece) debt. Italy alone amounts to ~$750B in European banking system exposure and Spain at ~$580B. So you can see that the game changes entirely if contagion occurs. Greece HAS to be contained and the potential for Portuguese default has to be prepared for. For this reason, any recapitalization has to get out ahead of this issue and it has to be substantial. We’re talking about some sort of bailout amounting to the trillions. A bazooka for the banks.

The disaster in this inevitable bailout is that, just like in the USA, it will not resolve the crisis although it will take the worst case scenario off the table. This entire crisis is due to an inherent flaw in the currency union itself and the only true resolution is the creation of an autonomous EMU with a central Treasury. Either that or a break-up. I think we can rule that scenario out. In the end, Europe will bailout their banks, impose austerity on the periphery and the end result will be slow growth and more of the same that we saw in the USA in 2009. The big difference is that Europe isn’t going to supplement their TARP with a ARRA. So, this bank bailout is even worse than the ineffective one in the USA. Main Street gets nothing and Wall Street gets everything. If the taxpayers in Europe catch on to this there is a very serious risk that the Greek riots of last year begin to look rather benign….This is a risk that cannot be overlooked. The taxpayers in Europe have every reason to be very very angry if Europe bails out their banks and imposes austerity on the periphery without resolving the flawed currency crisis…..

The 5 scenarios (via RBS):

“Scenario 1 (35%): Greece defaults by December, Portugal and Ireland suffer renewed contagion, Spain, Italy and France suffer from contagion. EFSF is upscaledto Eur1tr. ECB buys more bonds including covered bonds to support banking system. EFSF injects capital into banks and lends to ailing sovereigns. Crisis drags on with bouts of volatility but no country exits.

Scenario 2 (20%): Greece gets through its PSI and does not default despite missing targets as Europe gathers together once again to show solidarity. Portugal and Ireland get additional funding, Italy regains market confidence through austerity measures while avoiding a recession. Euro area muddles through in a low growth scenario.

Scenario 3 (5%): Shock and awe policy response. Banking sector is TARPed, periphery is haircut by 50%, ECB goes full QE to mitigate negative impact.

Scenario 4 (30%): Greece defaults by December, Portugal and Ireland suffer renewed contagion, Spain, Italy and France suffer from contagion. EFSF is not upscaled as AAAs are under threat. ECB goes on a buying strike leading to major political crisis and heightened risks of dismantlement of the Union.

Scenario 5 (10%): Greece defaults by December, Portugal and Ireland suffer renewed contagion, Spain, Italy and France suffer from contagion. EFSF is not upscaled as AAAs are under threat. ECB goes on a buying strike leading to major political crisis and heightened risks of dismantlement of the Union. European Commission saves the day by introducing a common bond that meets legal and political constraints.”

Source: RBS