In a new report, Fitch Ratings expands on its existing view that it expects the eurozone to ‘muddle through’ the crisis and to survive intact as economic adjustment proceeds combined with gradual steps towards closer fiscal and economic integration. However, the risk of alternative outcomes, although small, is growing and cannot be discounted until a broad-based economic recovery is underway and owing to political and other event risk.
As well as exploring the base case, therefore, the report sets out five stylised and purely illustrative alternative scenarios for the future of the eurozone, including preliminary guidance on their potential rating implications. It also looks at intra-eurozone balance sheet exposures to shed light on channels of contagion and the main financial implications of the scenarios, as well as the potential magnitudes of exchange rate adjustments. The scenarios in order of likelihood are: ‘Greek exit’, ‘quasi-fiscal union’, ‘euro-mark’ (Germany and a ‘core’ exit, leaving the remaining countries with the euro); ‘United States of Europe’ and ‘full break-up’.
Fitch believes the likelihood of a full break-up and demise of the euro remains very low given the huge financial, economic and political costs of such an outcome, as well as the still strong political commitment to Economic and Monetary Union (EMU). Even a partial ‘break-up’ involving the exit of one or more so-called peripheral nations would risk severe systemic damage, although cannot be discounted. The likelihood of a move to full fiscal union in the near term is also very small, as in Fitch’s view, the political will for it does not exist.
The crisis has shown that EMU is substantially flawed and fundamental reforms are needed to adapt it into a long-term viable structure. Some of these elements are being put into place, such as the fiscal compact, country fiscal austerity and structural reform programmes, and substantial financial assistance to peripheral countries from the European Financial Stability Fund (EFSF) and the European Central Bank (ECB).
Fitch believes additional measures will be needed to resolve the crisis. These are likely to include some dilution of national fiscal sovereignty, potentially some partial mutualisation of sovereign liabilities and resources, as well as measures to enhance pan-eurozone financial supervision and intervention, combined with further institutional reforms to strengthen eurozone economic governance.
Even in Fitch’s relatively benign ‘muddle through’ base case, some further eurozone sovereign rating downgrades are likely. The majority are on negative outlook, reflecting the economic cost of the crisis and downside risks, including rising political tensions that may hinder effective decision making. In the medium term, a reformed EMU and an eventual easing in the crisis would be positive for most sovereign ratings. Were the crisis to evolve towards one of the more adverse scenarios, Fitch would adjust its sovereign (and other) ratings accordingly and the breadth and severity of negative sovereign rating actions would likely be greater.
Of the alternative scenarios presented, Fitch believes that a Greek exit is the most likely. In that event, all eurozone sovereign ratings would be placed on rating watch negative (RWN), with those already on a negative outlook at most risk of a downgrade. Greece would very likely have to re-denominate its debt and default again. Initially, Fitch would likely downgrade Cyprus, Ireland, Italy, Portugal and Spain owing to the ‘exit precedent’ of Greece and risk of contagion to banks, bond markets and capital flight; with Cyprus particularly vulnerable owing to its banking system’s huge Greek loan book.
In an ‘orderly variation’, with an effective eurozone policy response and minimal contagion, most ratings would likely be subsequently removed from RWN and affirmed. However, in a ‘disorderly variation’, involving material contagion to the periphery and a significant increase in contingent liabilities facing the core, all countries would probably face downgrades and stay on RWN until the situation stabilised.
The report sets out further details for the Greek exit and other alternative scenarios. It also explains how Fitch would treat a redenomination of sovereign debt from euros into new currencies in accordance with its Distressed Debt Exchange (DDE) criteria. Redenomination into a markedly devalued currency would likely be viewed as a default, particularly as it would likely be required to avoid insolvency. However, this would not necessarily be the case for a sovereign with a revaluing currency, where a redenomination might not be economically disadvantageous to bondholders.
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