Kamala Aithal

European debt crisis, simply put, is the inability of the PIIGS countries (Portugal, Ireland, Italy, Greece and Spain) to pay back bondholders. A slowdown in global economy made it unsustainable for countries with a loose fiscal discipline.

Greece, for instance, (which historically ran high- budget deficit) was the first to go under with its growth and tax revenues falling. With increased sovereign risk, investors' expectation of returns has been going up pushing the bond yields of some of the countries in the region. This is a vicious cycle -- higher bond yields mean higher fiscal strain which prompts the investors to demand even higher yields and this could go on.  

The EU (along with IMF and EFSF) has been bailing out Greece, Portugal and Ireland. The European Central Bank announced a plan to purchase government bonds in order to contain the spiraling bond yields of countries like Spain and Italy. The central bank also made credit available to troubled European banks at very low rates through its LTRO (Long Term Refinancing Operation) plan.  While these help stabilise the financial markets in the short term, they have been "kicking the can down the road" and postponing a more decisive step to a later date. 

So where is the Eurozone and Euro headed?

Nouriel Roubini, the economist credited with having foreseen the credit crunch has warned that euro zone will collapse within this year; Nassim Taleb (author of Black Swan) also opines that the end of common currency is no big deal. Structural flaws that remain in the European Monetary Union need to be addressed; but does the measure have to be extreme?

There are a number of ways that this crisis could play itself out. Let’s discuss a few scenarios that could be a potential resolution to this -- almost three-year-old crisis.

Greek (Or peripheral) exit: Taxpayers of other nations (Germany, for instance) of the European Union may push for this. The short term impact for Greece may be quite severe; however in the long run they may be able to rebuild credibility through tighter fiscal measures and sustainable competitive advantage. Euro zone may not be significantly impacted by Greece exit per se, provided it works on preventing a contagion effect. 

New and improved European Union or a full break up: The existing union with its structural flaws seems unsustainable and may pave way to a new, core and better-regulated currency union. The resultant "new" euro (or its derivative) could be a far stronger currency. The weaker members who leave the union may have to devalue their currencies to remain competitive. But, will this be the preferred path for export-heavy Germany which is currently benefitting from a weak euro? Or will all this pressure of austerity lead to a full break-up of the union?  

Fiscal union or monetary expansion: Fiscal union in the real sense of the term, I mean. Will there be a political will to give up sovereignty and a willingness to issue what you may call, Euro bonds? Alternatively, the ECB injecting significant monetary expansion or liquidity to protect vulnerable banks and countries could be a potential resolution. But what this will do to inflation is anybody's guess!

The probability of Greek exit and/or use of monetary expansion as a preferred tool seems high, at least in the near term.  Break-up of the union? Nah, what with ECB President Mario Draghi claiming (this evening) that "Euro is irreversible" and that "Fears of Euro reversibility are unfounded"!

Kamala Aithal is the founder of a consulting firm that assists corporates develop Risk Management Framework and a regular contributor to Wisonomics column. The views and opinions expressed in this article are those of the author and does not reflect the views or position of IndiaNewsBulletin.com.