Recession in Europe, Driving Risk of Breakup – FSG Analyst Insights

Eurozone

Interview with Matt Lasov, Head of EMEA Research for Frontier Strategy Group

“The risk of default and devaluation in Europe is still high. Bailout discussions focused on Spanish banks buy time and businesses should use this time to set plans in place to protect themselves against a Spanish exit from the euro.

So what’s changed in Europe since the last update? Not much. The crisis is playing out exactly as anticipated. The likely scenario remains deep recession. The risk of eurozone break up remains high and businesses should continue to plan for this. Greece is off the rails, waiting for elections in the middle of June to determine its fate inside or outside the eurozone. Meanwhile, Spain entered a full-fledged banking crisis that requires a coordinated European bailout.

The bailout for Spanish banks should buy time and avoid a run on banks in the immediate term. It will not fix the structural issues that will plague Spain in the medium term.

It is important to note that the bailout deal is not done. Spain will still have to accept the terms of the agreement, which will require harsh austerity and a transfer of fiscal sovereignty to Germany. Can the Spanish government force this on its people, especially when Prime Minister Rajoy ran on a platform guaranteeing that this would not happen? If Rajoy can push it through, how long will Spain be able to weather a cycle of harsh cuts to public services while unemployment remains at record highs?

Even if the bailout goes through, and we expect that it will, Spain will still require cost cutting of 30-40% to compete globally. This will be immensely painful whether it is done slowly over a decade, as every labor and government contract is renegotiated at competitive rates, or through a quick but highly disruptive devaluation. As cost cutting continues, the economy will shrink, and more debt will go bad because there are fewer available revenue streams that can be used to pay it off. Another bank bailout will be required to clean up the remainder of the debt overhang and the cycle will continue. Some estimates show an additional $300bn euro gap in the medium term. The current package amounts to $100bn euro.

We have seen this movie before. The cycle playing out in Spain is exactly what happened in Greece. Europe stepped in with bank bailout money to avoid imminent implosion of the member state. In exchange for funding, Greece accepted austerity measures which reduced the size of its economy. While the economy shrank, the debt burden with long term maturities stagnated. Debt to GDP ratios soared and Europe called for further austerity. The result for Greece is higher unemployment and extreme social pressures that are leading to an exit.”

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