The Euro Is Already Disintegrating

To the naked eye, the euro is still alive. From a financial perspective, on the other hand, it is already pretty much kaput.

In just the same way as the currency union was preceded by an invisible rise in financial integration across the euro area, its demise is already being prefigured by financial disintegration throughout the eurozone.

Up until relatively recently, the banks and investors responsible for the financial plumbing throughout Europe would tend to treat euros as euros. So, if you lent money to a Greek business it was entirely sensible to balance that out with a deposit from Germany or France. There really was a single market for finance – and this was one of the most important component parts of the monetary area.

What’s happening at present – silently but swiftly – is that banks have realised that some euros are more equal than others. A German euro is not a Greek euro, and so on. Not only have they started to carry out “war games” to work out how their balance sheet would be affected if, suddenly, all those Greek assets were redenominated in drachmas, and were thus worth only half their previous value, they are also taking action.

Banks from around the world are attempting to ensure that any assets they have in Greece are matched against liabilities in Greece. The same goes for all of the embattled periphery countries, and even for other euro members.

You can get a sense of this from the following chart (source: Jefferies), which shows you the proportion of sovereign debt owned by foreign investors in certain eurozone countries.

Note that in Germany, France and Austria the proportion has remained the same (or has increased) between 2009 and 2011, but in other countries it has fallen – in other words foreign investors have pulled out to be replaced by domestic investors (the Netherlands is the outlier here, since it is generally regarded as a stronger euro member).

Another pretty striking illustration of this financial disintegration can be seen in the chart below, which charts the yields on benchmark Spanish government bonds (the yellow line) and compares them with the yields on German bonds.

Note that in 2005 and 2006, investors were charging the two governments precisely the same interest rate to lend them money. But a gap started to open up from mid 2007 onwards, as they started to realise that a euro of Spanish debt carried a significantly greater risk than the German stuff.

If you ‘re a bank or insurance company and think that the euro could split up, it’s only sensible to try to make sure your assets and liabilities are in the same country – so that if Greece left the euro, then at least your (30% reduced value) assets are matched against Greek (30% reduced value) liabilities. Otherwise a euro exit could leave you insolvent overnight.

The problem is that this makes the plight of those troubled euro members even tougher, as they get starved of cash from overseas lenders. They face a credit crunch of even greater proportions which makes their recessions deeper and longer, and lessen their chances of recovering, thus increasing the likelihood that they leave the currency.

It’s this dynamic, alongside the analogous phenomenon of the invisible Greek/Spanish bank runs, that mean the euro’s demise could be something which happens in spite of, rather than because of, politicians’ actions.