Euro break-up could be cure

After a lengthy period of delay, confusion and behind-the-scenes bargaining, the 17 members of the euro zone appear no closer to resolving their most pressing issue: what to do with their currency.

It may turn out, as many seem to hope, that given enough time, the problems will simply go away, and short-term fixes will eventually right the ship.

But as Professor Bruno Solnik, of Hong Kong University of Science and Technology's (HKUST) Finance Department, spelled out in the latest HKUST/NYU Stern - Global Finance Seminar Series, inaction or limited measures would only prolong the pain.

In his view, more drastic surgery was needed. The sooner Europe's politicians and central bankers realised this, the easier it would be to restore growth, stability and economic sense.

Solnik, who teaches the MSc in global finance programme offered jointly by HKUST Business School and the NYU Stern School of Business, spoke under the topic "Financial Markets and the Eurozone Crisis: Some Provocative Views". He said he had little time for an approach that ignored root causes and, in doing so, pumped more money into propping up a crumbling structure.

He saw the euro-zone break-up as the way forward, with the economically weaker countries leaving and the rest better able to align their interests.

"A short-lived crisis in which you address the fundamentals is better than being 'on Prozac' while the problem gets worse," Solnik said. "At the moment, people are paying hundreds of billions of euros or dollars to buy time, which is only making things more difficult. I think, though, the euro will implode - and the sooner, the better."

His reasoning stemmed from a belief that the initial concept of the euro was seriously flawed. Having economic powers such as France and Germany in a fixed exchange-rate system with smaller developing countries such as Slovenia and Malta was always going to be asymmetric.

Coupled with huge subsidies for Greece, Spain and others, plus the chance for such nations to increase borrowing capacity by issuing sovereign bonds in "risk-free" euros, and the seeds of disaster were sown long ago.

"The speculative tensions and moral hazards built into the system are too much," Solnik said. "Rather than seeing this as a chance for structural reform, the politicians just started spending wildly. This was aggravated by the credit liquidity crisis of 2007 and 2008 when you saw, for example, a dozen new airports being built in Spain because each city wanted its own."

In Solnik's view, the problems went right back to the calculation of purchasing-power parity and the "legacy rate" for each country entering the euro. It was assumed at the time that Greece, for instance, would reform, become more competitive and, within five years, resemble the idealised euro economic model. That didn't happen and, as things now stand, isn't going to.

There was too much disparity between the stronger and weaker euro-zone countries, which shows in the current account balance, Solnik said. The "southern" nations now have a significant competitive disadvantage - compared with, say, Germany - with higher unit labour costs and punitive borrowing costs.

Since the advent of the fixed euro in 1999, labour costs in most southern countries have increased by 30 per cent or more relative to Germany. Without the option of devaluation through an adjustable exchange rate, they're caught in a trap where things just get worse.

Disguising the realities or papering over the cracks simply won't work. No country can hope to hold its own if it is borrowing at 6 per cent versus 1.5 per cent for others - or if, like Spain, it has an overall debt level above 100 per cent of GDP. Countries such as Spain or Italy, where government debt is at such a significant level versus GDP, need to grow their GDP at 6 per cent annually just to offset what is burned in interest charges. Others, such as Germany, only need to grow at 1.5 per cent. For the euro zone to flourish, this growth differential needs to become smaller, but instead it is getting bigger.

Solnik advocates quick, decisive and drastic action. He believes that countries for which the euro is obviously a burden - and which continue to drag down the rest of the euro zone - should be shown the door. A core group of "northern" countries could remain. In due course, all could find their true level of competitiveness in the global economy, implement the necessary structural reforms, and bring runaway debt back under control.

There would inevitably be knock-on effects for the rest of the world, with bond yields initially rising in most markets. But overall, Solnik thinks many assets will retain their real value.

"A divorce is usually very messy, but you have to ask whether it is better to do so or suffer through an unhappy marriage," he said. "I think a euro-zone break-up is the best solution, but politicians are politicians. They are not necessarily very smart and, if elections are coming up, they won't do anything unpopular."HKUST-NYU Stern Master of Science in Global Finance Program - Phone: 2358 5028 - www.globalfinancemaster.com