Eurozone Break-Up

Will Italy be forced to break up the Euro currency? Its bonds yield 32% above German bunds...

TWO YEARS AGO, I expressed the doubt that the Euro could survive a major shock, such as had repeatedly occurred in Europe during the 20th century, writes William Rees-Mogg for The Daily Reckoning.

I mentioned the two World Wars, the Russian Revolution and the Great Depression as three events which would probably have led to a break up of a single European currency, if one had existed at the time.

The First World War did, in fact, cause the Gold Standard to break up after 1914, and no-one found a satisfactory way of restarting it. The Great Depression knocked what remained of the Gold Standard on the head, when Britain terminated convertibility in 1931.

There are a few of us – I know Ambrose Evans-Pritchard at The Daily Telegraph is one of our group – who do watch the Euro from day to day. There are some hedge fund managers who share this habit, because they believe that the Euro will eventually break up, as the economics of the sixteen Eurozone countries move further and further apart.

The table that is most useful is to be found on the Market Data page of the Financial Times. It is the table of 10-year government bond spreads. Not everyone is aware that the European Governments of the Eurozone are separately responsible for their Euro-debt, although the Euro itself is a single currency. For that reason, the different national denominations of euro debt have different yields. It offers a telling signal of how investors view the underlying premise of the experiment.

The basic yield is the yield on a German ten-year bond. All the other Eurozone countries provide higher yields than Germany, reflecting the fact that Germany has the strongest economy. The gap between the German ten-year bond yield and other national ten-year yields is called the "Spread versus Bund".

For instance, on November 3rd, the annual yield on the German 10-year was 3.84% if the bund was then held to maturity. The yield on the French bond, also denominated in Euros, was 4.24%, a premium of 40 points. The market is valuing the risk of France defaulting on the Euro, as compared with the German risk, at around 10% of the yield of the Bund.

These premiums vary from country to country, as one would expect. One would also expect them to rise in a period of financial distress, and they have in fact done so. But there are four Eurozone countries in which the premium has risen to a disturbing level.

Greece now has a spread of 1.59% over Bunds, Italy 1.15%, Ireland 1.13% and Portugal 0.90%. The other Eurozone countries have lower spreads over the Bund, and stand somewhere between Portugal and France.

Convert these spreads into percentage premiums over the yield of the Bund, and you'll see that Greece offers a 41% premium, Italy and Ireland 32%, and Portugal 23%. Three of these are small countries, but Italy is one of the four largest economies of the Eurozone (with Germany, France and Spain).

If Greece, Ireland or Portugal were to come under extreme pressure to leave the Eurozone, it would be possible for the larger countries to bail them out, on the principle that they are too small to be allowed to break up the single European currency. The Germans might or might not be willing to finance a weak partner in such a way. But in 1992, Germany let both Britain and Italy fall out of the European exchange rate mechanism rather than reduce German interest rates. So one cannot assume that Germany will always fight to maintain the unity of the European monetary system.

Historically, the German decision at the Bath summit of September 1992 was hugely important and now looks to have been a great mistake which liberated Britain and limited Germany. (Italy reverted to the ERM in due course, joining the Euro at its launch in 1999.) However, the table of Bund Spreads shows that there are now three groups of Eurozone countries, a strong Northern tier of Germany, France and the Netherlands, a weak Southern tier of Greece, Italy and Portugal, with a weak Ireland on the West and a middle group which includes Austria, Belgium and Spain.

Italy is the real problem, a large economy with a relatively low credit rating, with a much lower rate of growth of productivity than Germany. There must be serious doubts about Italy as a Eurozone power, with a 32% higher yield than Germany on the ten-year bond. That is a measure of serious risk. It is not clear that the Southern tier of the Eurozone could hold together if the recession becomes a depression.