The good news is that there is a difference in 2012 compared to earlier stages of the crisis, due to two main improvements:
- European Central Bank engaged in long-term repo operations (LTROs), reducing the risk of a systemic collapse of the banking system by increasing liquidity.
- Many countries have reduced their sovereign budgets and agreed to austerity measures. However, implementation has been slow in many cases and weak economic growth is making budget cuts difficult.
If the ECB were to commit to buy bonds on the primary market or take a step toward a closer fiscal union by providing euro bonds, it would be much more comforting for investorsābut it would be against the current law. Overall, to prevent contagion to other countries, Europe needs to provide more financial firepower to lower interest rates and boost confidence in the other peripheral European markets.
Source: Bloomberg
Global impact of a Greek exit
The direct economic impact on global growth would probably be relatively small if there is an orderly Greek exit and if contagion to other financially weak countries is limited. (Those are big "ifs," however.) Greece constitutes less than 2% of the total euro area economy and accounted for a bit more than 0.3% of global GDP in 2011, according to the World Bank.
If the exit led to rising bond yields in other European countries and further problems in the banking sector in other European countries, it could force the weaker countries out of the euro against their will. The exit of other smaller countries such as Portugal and Ireland would probably be feasible and not hamper global growth too much. However, if larger countries such as Spain or Italy were forced to leave the euro, it could endanger the survival of the whole currency union and could lead to significant disruptions in the global financial markets and probably a global recession.
Contagion risk
Contagion is already happening to a certain degree in Europe, as illustrated by the rising Spanish and Italian sovereign bond yields compared to the falling German sovereign bond yield. The wide spreads between the highest quality sovereign and the financially weaker Italy and Spain indicate a rising risk premium on their sovereign debt. Investors are increasingly concerned about the risk of default in these countries as well. Another way to gauge contagion risk is to look at European and US bank claims on the banks of Portugal, Ireland, Italy, Greece, and Spain (PIIGS).
Source: Bank for International Settlements
A look at the exposure of European banks to the PIIGS shows that their claims have been markedly reduced since their peak in the first half of 2008. Overall, European banks have reduced their claims to Italy, Spain and Ireland by about 50% since the peak exposure in 2008. Exposure to Irish and especially Greek banks was also reduced. This shows that risk of contagion through banks has eased somewhat since 2008.
Source: Bank for International Settlements
US banks' exposure to the PIIGS banks are a fraction of the European banks' claims, on average. Collectively, they had much lower exposure to the PIIGS banks to begin with and reduced exposure in the past few years, especially on Italian and Greek banks. In our view, the risk for US banks to be directly "infected" with the European virus through bank-related losses is relatively small, while the danger for European banks is much higher. This suggests that the US would be relatively better off should the smaller countries (Greece, Portugal and/or Ireland) need to default and leave the euro.
