European Debt Crisis: Good vs. Bad Alternatives

• In this scenario the European debt crisis goes from bad to worse. The escalation is caused by a failure to find a lasting solution to Greece’s debt problem and a worsening of the outlook for Italy and Spain.

• The Greek government eventually gives up and defaults – possibly as soon as 20 March when a EUR14.4bn bond matures.

• This event and the increasing likelihood of more sovereign defaults causes a sell-off in risky assets, credit tightening and a severe recession in the euro area. The rest of the world continues to grow, albeit slowly.

The resolution of the Greek debt problem has dragged on. In the meantime, the Greek economy has fallen off a cliff, which has caused the debt to GDP ratio to increase towards 160%.

In the bad scenario the austerity measures and structural reforms that are being implemented fail to revive growth and reduce the government deficit at a satisfactory speed. The planned voluntary private sector involvement proves insufficient to stabilise debt dynamics and politicians openly discuss whether to go ahead with a sovereign default that would wipe out most of the privately held debt. The Greek government then decides not to repay investors – possibly as soon as 20 March when a large (EUR14.4bn) government bond issue matures.

The default would cause havoc in the Greek banking sector due to its large holdings of Greek government bonds and would trigger payment on CDSs on
Greece. However, the market for CDS on Greece is assessed to be relatively
small, so this is in itself a manageable problem although some losses could
show up in unexpected places.

More importantly, a default would take away any confidence that investors might still have in European politicians and cause a rapid sell-off in risky assets. Intensified contagion to Italy and Spain and fears that these countries also risk defaulting would send yields higher and trigger another vicious cycle that would weigh down on growth. A sharp increase in non-performing loans and losses in the banking sector (in particular in Spain) would add to the problem.

In this scenario, the sell-off in risky assets would fuel a financial crisis where many financial institutions would have to get public support or be nationalised (primarily in Europe). Credit tightening and a sharp drop in private demand would cause a severe recession in Europe and dampen growth in the rest of the world. In many countries there is little or no room left for fiscal response and the ECB cannot cut rates much further. Although the ECB would probably apply ever more massive non-standard measures, a prolonged recession with a drop in GDP in the euro area above 3% cannot be ruled out. European stock prices could decline 20-30% and EUR/USD could fall below 1.15.

Headwinds fade fast

• The global economy was held back by a number of headwinds in 2011. If these fade faster than expected – or we underestimate the positive effect of the milder winds – then global growth could turn out to be stronger than expected.

Although we have mostly been surprised on the downside in the past couple of years, we believe a more positive scenario for the global economy could materialise. The following factors could trigger such a scenario.

Euro crisis eases: The euro crisis eases as market sentiment improves when
the global economy recovers. A positive feedback loop is started whereby investors gain confidence that the euro will survive and start investing in the high-yielding peripheral euro countries. Yields in the periphery come down to sustainable levels (around 5%). Budget consolidation continues and follows outlined plans in most countries. Eurobonds may be issued and/or the ECB could step up its ex ante commitment to buy bonds in the event of market stress.

Stronger rebound on fading headwinds: The effects of the headwinds from
oil and food prices were generally underestimated and the negative impact was stronger than expected. Similarly, there is a chance that the positive effects of the reversal in oil and food prices have been underestimated and we could get a stronger recovery in the global economy. The underestimation of the swings is often because the rebound effect from the inventory cycle is sometimes stronger than expected. This was the case at the end of 2010 when the global economy recovered more strongly from the ‘double dip’ recession fears over the summer of 2010. Also in early 2009 when PMI and ISM rebounded more strongly and earlier than generally expected.

The Chinese engine runs faster than expected: If inflation comes down faster than expected in China, the government and central bank might choose to stimulate the economy and push up growth rates more than we expect. This would have positive spill-over effects on the rest of the world – not least the euro area, where exports are the main driver of the recovery and Asia has
become the most important trading partner.

US job growth beats expectations again and strengthens the recovery:
Another candidate for a positive surprise is the US labour market. Employment growth has picked up faster than expected. This also happened in early 2011 but was halted by the oil shock. There is a chance that the positive surprises will continue and employment growth will become even stronger in the coming quarters than the 150,000-200,000 we expect. If so, it would have a positive impact on income growth and on sentiment as fears of a global recession would ease further. A positive spill-over on the global economy should therefore materialise.

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