Finance expert Mohamed El-Erian predicts a smaller currency

Is the euro breaking up, getting smaller before its 12th birthday?


It used to be only English Tory backbenchers you'd hear ranting on the BBC and ITN news bulletins about the failings in the architecture of the euro. But the debt burden is so great and the reaction of the guardians of the euro – the euro group 16, the European Central Bank and ultimately Berlin and Paris – has been so inept that questions have been raised about the political will of German, French, Dutch and Austrian citizens to guarantee the debts of the 12 other euro states. The steps announced by the Frankfurt central bank officials last Thursday will need huge good fortune to keep at least four states within the euro. So forget the Tory back-benchers – it is heavyweights such as Mohamed El-Erian, the boss of the huge global investment firm Pimco, who are predicting a shrinking of the eurozone. El-Erian is a heavyweight because he could be the next boss of the IMF when Dominique Strauss Khan steps down. (See El-Erian's CNBC interview last week below.)


How did this crisis unfold?


Bluntly, Greece, Ireland, Portugal, Spain and Belgium in the euro and Britain outside the euro have enjoyed living standards they could not afford. Looking across the sovereign debt piles, it is African countries, traditionally thought of as the world's most indebted, which carry debts of only 50% or 60% of the annual output of their economies. Now look across Europe and the debt piles of many states, whether in or outside the euro, will tower in the next few years at around 100% of their gross domestic product. The total pile of Irish sovereign debts, including the banking injections, could stretch as high as 115% of our shrinking GDP. In euros, that's a debt pile of €180bn that will have to be supported on a slender base of €32bn in taxes that the government collects each year. As a rough rule, many experts predict that if our debts peak in 2013 at over 120% of GDP or at €190bn to €200bn, then we will not be able to afford to pay back all the interest payments on our sovereign debt and we would have to default. Some believe a default here or elsewhere would lead to a new slimmer eurozone.


How come it is the mighty euro, anchored by Germany, the strongest economy in Europe, that's in the firing line?


It is a crisis for all of rich Europe. The strains are showing first across the euro 16 because individual member states, like our own, cannot use the traditional economic tools such as devaluing a currency to shrink the level of sovereign debt we owe foreigners. Britain's much vaunted devaluation and money printing with the fancy title of quantitative easing was mostly about devaluing the amount of money it would have to pay back to foreigners. For politicians, devaluations have the appeal of also hiding from their electorates that a country is getting relatively poorer. Many in the euro group are scratching their heads and wondering how Greece and Ireland can continue to be burdened by huge debts without seeking some sort of discount (defaulting) on their sovereign debts. Markets force countries into bailouts because they are expressing fears that creditors will not get repaid – they fear a default. That explains why Portugal and Spain need the additional supports from Frankfurt to keep out of the bailouts. The big question is whether defaulting on debts will lead to the break-up of the euro and the return of half a dozen currencies. How this could be done in an orderly way without plunging Europe into a new recession is not at all clear.


Bailouts are sticking plasters so?


Yes. Greece was bailed out in May to buy time and keep it in the euro until someone could think up a better plan. Athens received funds of up to €110bn from most of the European Union and the US, which is the main paymaster of the Washington-based IMF. Greece was told to pay a huge annual interest bill of 5.2% for the money over the next three years. The euro group also set up more stabilisers for other euro states – pledging as much as €440bn into Klaus Regling's euro facility in Luxembourg. The alliance was extended last spring when all EU 27 states – including Europe's most eurosceptic states, Britain, Sweden and Denmark – pledged €60bn. That raised the euro fighting fund to €500bn. With the IMF guaranteeing to match half the amount all-Europe had pledged, the maximum in the euro defence fund rose to €750bn. Unfortunately, when you set up a facility, no matter if it is described as a safety net or a contingency fund, it is always likely be used. Ireland last weekend became the first to tap the new facilities – borrowing at an average penal interest rate of 5.8% for all the European loans of €45bn stretching up to nine years (because we could not afford to pay the loans off earlier). We will also pay a remarkably low rate of 3.1% for the €22.5bn the IMF is providing, but only if these loans are paid back within three years. The cost of the IMF loans rises to a still reasonable 4% if we take longer. But a sure sign of the depth of the crisis here is that the Washington cash has been made available to Ireland for the next decade. Evidently, Europe set the high price for its €45bn to discourage Portugal and Spain from throwing in the towel. Irish citizens are, remarkably, taking a bullet to keep our insolvent banks from wrecking the euro by Christmas.


More strains are showing?


We have heard a lot about the newly indebted euro states, whose state finances spectacularly folded either under the weight of banking or budget burdens – that includes Greece, ourselves, Portugal and Spain. Then whisper it, there is the big euro state of Italy, which has done a great job in juggling its huge old sovereign debts for so long. But the fact remains that Italy, after Japan, is one of the most indebted states in the world. Last Tuesday, it even looked possible the euro would not get to the end of the year. But a note to smug Tory bankbenchers who might not have noticed that the debt crisis not only involves a handful of euro states that have been living beyond their means: it is a crisis of all European states. After Greece and Ireland, Britain outside the euro has the largest annual budget deficit in Europe.


What would a break-up look like?


Ourselves and Greece have already been put into quarantine. Greece is likely to default on its sovereign debts when it emerges from its three- year bailout at the end of 2013. Germany's Angela Merkel has since said that the euro would look at defaulting on sovereign debt but only after 2013 and then only for pricing of new debt, not existing debt. Some London economists believe Greece will default as early as next year. People are trying to figure out whether a default means devaluation.


How bad could it get?


The clearest thinking is coming out of America. Here's a transcript of the interview last week with Pimco boss Mohamed El-Erian, who many tip as a front runner to become the new IMF boss.


CNBC Interviewer: I am trying to remember the first time we decided that Greece wouldn't be the end [of the European debt crisis] and you have been intimating that all along… if we know it is going to happen it would be cheaper if we just dealt with it immediately. But if doesn't seem to be possible?


El-Erian: Yes, it is not possible because the first rule of crisis management has not been met by the Europeans and that is get ahead of the crisis and to be seen as proactive instead of reactive. As long as they are seen as reactive, the slow-motion wreck we are seeing in Europe, and then we are going to wake up and it is a new country we are talking about… it is about balance sheets.


Interviewer: How do you fix insolvency? Can you save up by kicking the can down the road? How do you deal immediately with insolvency?


El-Erian: You can grow yourself out of debt and time only helps if you can grow rapidly. People recognise that in peripheral Europe you do not have these conditions. So, time does not help in these conditions. Time ends up contaminating other peripheral countries and ultimately you contaminate the core. So, time is not your friend.


Interviewer: Tell me about Portugal and then take me to Spain and tell me what happens after that?


El-Erian: Portugal again is a balance sheet issue. It is slightly different than Ireland. Ireland has been an issue of the banks contaminating the government's balance sheet. Portugal is more like Greece, in terms in the fact that it is the budget. Spain – it is the private sector's balance sheet that is contaminating the government's balance sheet. It is all about the balance sheets being oversized. So, unless we see more than just liquidity support, unless we see something that deals with the balance sheet expect this crisis to go up. Remember, Greece is the most vulnerable – Ireland, then Portugal then Spain, then Belgium, then Italy. What you are going to see is the contamination migrate up until we deal with the balance-sheet issues.


Interviewer: So does Germany continue to double down or do they get to the point where they say enough is enough?


El-Erian: They started [last] weekend by trying to strike this very delicate balance between on the one hand supporting liquidity or rescue funds for Ireland and on the other hand saying that by 2013 we are going to have a mechanism dealing with solvency. The problem as you know is if you tell creditors that in 2013 something is going to happen, creditors are going to try to anticipate that. And that is what we are seeing today: we are seeing people exit European exposures because they are not going to hang around because they fear this timeline is going to change… It does not help the US to see Europe where it is today. In addition, what is happening in Europe is unambiguously deflationary. Whatever projections you had for growth rates in Europe, you are going to be revising them down now because of what has been happening in debt markets.


Interviewer: So when you think about say €100bn to Greece, and €85bn to Ireland and the cascading effect of all these other countries, what is the trade that you make?


El-Erian: The first thing is do not be sucked into peripheral exposure simply because money is being thrown at the problem. Money will not solve the issue. Secondly, be cautious toward the euro and be cautious toward German bonds because what we are seeing now is that the periphery is slowly contaminating the core. Thirdly, look for opportunities elsewhere.


Interviewer: What are the chances that there is no euro in five years?


El-Erian: I think small, I think that the bigger likelihood is that the bigger eurozone that consists of 16 countries is smaller.


Interviewer: As small as one, like Germany?


El-Erian: No, not as small as one. I think the euro brings benefits but it is important it brings benefits to countries that are similar in structure. Right now, the zone is so heterogeneous that you have the bad contaminating the good.


Interviewer: Who gets to stay?


El-Erian: I think you look at the core countries – Germany, France, Netherlands. These are pretty homogeneous countries. You extend it to Austria. So, there is a group of countries where the single currency makes a lot of sense. Now, they are going to have to revise a few things. The have learned that a single currency will have to be accompanied by more fiscal union than they have right now. But I do not see as a base line the euro disappearing in five years.


So, could it get much worse?


Gabriel Stein, the chief European economist at Lombard Street Research, has told the Sunday Tribune he refuses to hold some high value euro bank notes for fear of the break-up of the euro and devaluation. Euro issuers can be identified from the first letter in the serial numbers of euro bank notes.


It would be like the sterling notes issued in Belfast by the Bank of Ireland, First Trust, Ulster and Northern, which are sometimes not accepted by the London taxis and shops. Many believe that if it got to the point that many in the euro were checking the serial numbers then it would be long past the stage that the euro was sunk. From the ECB website, here's the list of national euro issuers and the letters that precede every euro bank note: Belgium Z; Germany X; Estonia D; Ireland T; Greece Y; Spain V; France U; Italy S; Cyprus G; Luxembourg (1); Malta F; Netherlands P; Austria N; Portugal M; Slovenia H; Slovakia E; Finland L.