Friday, May 4, 2012

4/5/2012: Fitch Bells: Ringing de Panic?

Yesterday, Fitch Ratings issued an interesting report, titled "The Future of the Eurozone: Alternative Scenarios". The report sounds alarm bells over what some markets participants have thought of as a 'past issue' - the risks of contagion from Greece to the Euro area periphery.

Fitch Ratings core view is that the eurozone will 'muddle through' the crisis, surviving in its current composition,  while taking 'gradual steps towards closer fiscal and economic integration'. 

The interesting bit comes in the discussion of possible alternatives and the associated probabilities of these alternatives. According to Fitch, there is rising (not falling, as we would expect were LTROs and Greek debt restructuring, plus the Fiscal Compact and the ESM working) risk of a protracted growth slowdown or political shock or some other shock triggering either a possible facilitated Greek exit from the Euro or a disorderly Greek exit from the common currency.

And, crucially, according to Fitch, this risk cannot be discounted. 

This bit is where Fitch's assessment is identical to mine and contradicts that of the majority of Irish 'green jersey' economists: the tail risk of a disorderly unwinding of the euro is non-zero and rising, while the disruption or cost associated with such a outcome is by far non-trivial. Prudent risk management policy would require us to start contingency planning and addressing the possible realisation of such a risk. Instead, we are preoccupied in navel gazing through the lens of the Fiscal Compact, and not even at our own 'navel', but at the European one.

Fitch view is that a full break-up and demise of the euro is probabilistically highly unlikely. This belief is based on Fitch foreseeing large financial, economic and political costs of a break-up. More interestingly, Fitch determines that a partial break-up of the euro zone - with one or more countries exiting the common currency -  would "risk severe systemic damage, although cannot be discounted". 

For those thinking we've done much to resolve the systemic euro crisis (by doing much we usually mean creation of EFSF and agreeing ESM, deploying LTROs and restructuring Greek debts, and putting in place the Fiscal Compact), Fitch has some nasty surprises. Basically, Fitch believes (and I agree with their assessment here), that "additional measures will be needed to resolve the crisis. These are likely to include some dilution of national fiscal sovereignty [beyond the current austerity programmes and Fiscal Compact], potentially some partial mutualisation of sovereign liabilities [basically - euro bonds of sorts] and resources [some transfers to peripheral states], as well as measures to enhance pan-eurozone financial supervision and intervention, combined with further institutional reforms to strengthen eurozone economic governance". Basically, you can read this as: little done, much much much more to do still...

It gets worse.

Of all the alternative scenarios presented, Fitch believes that the most likely scenario will involve a Greek exit, with Greece re-denominating its debt in a new currency and default on its bonds again. Per Fitch, the core danger will be to Cyprus, Ireland, Italy, Portugal and Spain based on:

  1. Greek exit creating an 'exit precedent' for the already distressed economies
  2. Greek default impacting adversely other peripheral countries banks (especially true for Cyprus)
  3. Greek default increasing the risk of capital flight from the countries
  4. Greek default triggering a run on peripheral bonds just around the time when the 2013 'return to markets' horizon is in the crosshair.
Just as I usually do in my presentations on the topic, Fitch distinguishes two potential paths to Greek 'exit' - a structured and unstructured or 
  • an "orderly variation with an effective eurozone policy response and minimal contagion" and 
  • a "disorderly variation", involving "material contagion to the periphery and a significant increase in contingent liabilities facing the core".
Ouch, I must say, for all the folks who lost their voice arguing that my views are 'unreasonable' and 'scaremongering'. Sorry to say it, risk management approach to dealing with reality requires taking a probabilistically-weighted expected costs scenarios of the downside into the account. Simply shouting "all is sustainable here, nothing to bother with" won't do.

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