In the second of two special reports on the European debt crisis, we examine the implications of potential sovereign default and exit from European Monetary Union (EMU) by Spain and Italy, which are the largest of the so-called peripheral European countries that have been adversely affected by the debt crisis. Although foreign banks have reduced their exposure to these countries over the past few years, banks in Spain and Italy have increased their holdings of domestic government debt over that period. In a worst-case scenario, expectations of sovereign default and EMU exit by Spain or Italy could become self-fulfilling. In that event, the banking system of the affected economy probably would collapse due to the significant holdings of domestic government debt that default would make worthless. Due to substantial amounts of cross-border lending, banks in other European countries, especially in France and Germany, would likely suffer large losses as well. The indirect effects on the American banking system and economy could also be significant.
The worst-case scenario of EMU disintegration is not our base-case view, although its probability is not insignificant either. What seems more likely—in our view the probability is somewhat above 50 percent—is that European leaders will do enough to prevent a disintegration of the EMU. However, they probably will not do enough in the short term to completely “solve” the European debt crisis. Reforms that would “fix” EMU would include further fiscal integration, government financing via so-called eurobonds, bank recapitalization, bank regulation, supervision and deposit insurance at the supra-national level, and economic and labor market liberalization in highly indebted countries. In our view, however, domestic political constraints will make it difficult for EU leaders to entirely embrace this complete menu of reforms, at least for the foreseeable future. Consequently, the European debt crisis, which has been waxing and waning for more than two years, will probably continue to fester for some time.
Default by Spain or Italy Would Be Devastating
In a recent report, we wrote about the implications to Greece if it decides to pull out of EMU and abandon the euro.1 As we indicated in that report, abandonment of the euro, which would go hand-in-hand with default by the Greek government, would impose significant costs on different sectors of the Greek economy. A disorderly default by Greece would be messy, but it need not be inherently destabilizing for the global financial system as long as the Hellenic Republic could be completely “ring fenced.” However, we think it is unlikely that Greece can be completely “ring fenced.” As we argued in 0ur first report, “a roadmap for exit would have then been established, and investors would wonder whether other countries would be tempted to leave as well.” Exit from EMU by Greece would significantly raise the probability that other countries, especially Ireland, Italy, Portugal or Spain, would eventually follow suit.