One of the main issues driving financial market volatility is the risk of default facing some eurozone economies, and the impact for the world economy. Concerns are growing that the crisis threatens not just Greece, Portugal and Ireland but also Spain, Italy and even France.

What could precipitate a euro break-up?

The main catalyst is likely to be a failed effort to rescue the highly indebted economies of Greece, Ireland and Portugal.

The EFSF (European Financial Stability Facility) was released as the definitive solution to the debt crisis. By providing the finance for Greece to reduce its risk of disorderly default, it was hoped it would ring-fence other economies from contagion effects. However, the recent widening of spreads amongst Eurozone countries over Germany and rise in bond yields, even in Germany, indicates that financial market confidence in it has evaporated. Instead, there is a spread of contagion risk to core economies and a rising risk of a disorderly break-up.

Financial market volatility has reached the point that a decisive moment may be almost upon us. A default by Greece would greatly increase the risk that it leaves the euro. A disorderly default would likely lead to an even more profound market reaction. Bond yields could spike further, there would be a flight to gold and other commodities, and to currencies seen as safe, including the dollar and sterling. An orderly default is preferable, and could result in an improvement in market sentiment.

Sovereign debt defaults won’t automatically lead to a break-up. However, the economic, social and political consequences of default could lead the country to question its membership. The likely unwillingness of financially stronger countries to provide adequate fiscal support on ‘favourable’ terms could tip the balance in favour of exit.

Three ways a break-up could occur

1              A disorderly break¬up. This is where the markets ultimately force the dismantlement of the euro project. Through limited negotiation, each country recreates its own domestic currency. We give this scenario a 25% probability. The consequences would be very traumatic, with a major financial crisis and recession in some countries almost inevitable.

2              An orderly break-up. In this scenario, an exit mechanism (opt-out) is put in place for countries to exit. This will likely include the option to rejoin if key criteria are met in the future. The single currency remains, but with a reduced membership, increased economic integration and a significant support mechanism to transfer resources from the strongest members at times of financial and budgetary stress – with Germany agreeing on the basis of a balanced budget amendment being enshrined in law. For exiting countries, the initial adjustment could be devastating and significant official support would have to be provided for many years. This is likely to include continued access to ECB short-term financing, support for new currencies via links to the euro and provisions to minimise the associated mismatch of assets and liabilities for banks and corporates. Still, any decision to orderly exit the euro would require a tremendous amount of negotiation with measures on both sides that are perceived to be fair. We give this scenario a 60% probability.

3              Germany and a core group of countries leave the euro to create another currency, for example a Euro II or DM zone. Along with the massive political ramifications, the most likely result would be a very sharp revaluation of this new currency, with serious economic effects – most notably on exports and the banking sector. It would hit both internal and external competitiveness, leading to a sharp increase in unemployment. The ECB would need to be replaced. We believe it is unlikely that Germany would choose this option, especially given the massive political and financial capital gains it has made as a result of European integration, and the potentially ruinous consequences for its near neighbours. It would also end over 50 years of work to rebuild Europe and its clout in world affairs. Nevertheless, we assign this outcome a 15% probability.

Overall, we believe the authorities can resolve this crisis in an orderly way that leaves the euro largely intact. This carries the least political and potential economic disruption.

Which countries are most likely to exit?

We have calculated the relative risks of countries leaving the euro based on market data for two-year government bond yields. Our calculations, which abstract from differences in recovery rates, show that there has been a dramatic rise in the near-term risk of default, relative to that of Germany, over the last five years for many Eurozone economies. For example, while Greece and Germany carried essentially identical risks in 2006, Greece is now estimated to be over 60 times more likely to default.

Other peripheral markets, notably Portugal and Ireland, display less dramatic, but still significant, cause for concern. Moreover, given that ECB interventions in the market for government debt have pressed down on peripheral yields, these estimates are likely to understate the latent risk. Interestingly, France, which has attracted some concern over its fiscal position, has seen a negligible rise in its chance of default. Italy and Spain are also not as vulnerable as many presume. On the basis that a 10-fold increase in the odds of default since 2006 represents a greater than two-standard deviation rise – which corresponds to an over 70% default likelihood – then Greece, Portugal and Ireland are strongly threatened while both Italy and Spain are much better positioned. Therefore, we believe that the countries most likely to default and potentially leave the euro are, in order, Greece, Portugal and Ireland.

What depreciation is likely?

If Greece exits the euro, market perception that other countries could follow is likely to lead to additional pressure on the euro. This could see it weaken further against currencies like the dollar and the pound. However, it could strengthen as those countries that remain in it are deemed stronger without Greece. Meanwhile, the experience of countries that have left currency regimes, like Argentina and Iceland, suggest that Greece could initially see severe additional inflation pressure, rising bond yields, greater currency depreciation than expected – but eventual economic recovery.

Our analysis shows that a new Greek currency could be subject to a devaluation of up to 50%, with counterparts in Portugal and Ireland depreciating by less, at around 40% and 15%, respectively. The Greek drachma could fall by between 31% to 46% in 2012 relative to the euro entry rate, while the Portuguese escudo and Irish punt are estimated to fall by between 28%-43% and 9%-14%, respectively (see chart Figure 1). In the event of a break-up, foreign exchange rate markets could price in significantly greater depreciation into these rates to encompass the risk of further slip-page. In reality, therefore, actual trading levels are likely to be at the outer bounds of the levels implied by our estimates.

For the remaining constituent members of the euro, our analysis shows that Italy and Spain would face a devaluation of 8-10% if they were to exit, while at the other end of the spectrum, Germany and Austria would face appreciation of 12% and 5%, respectively. On the face of it, one implication of weaker countries leaving the euro area is an appreciation of the euro, of possibly 10% or so (see chart Figure 2).

What does it mean for exporters?

The UK’s balance of trade in goods with the world widened to a record £9.8 billion last month, worse than the consensus view of £8 billion. Exports rose marginally by 0.2%, but were outweighed by a 3.8% jump in imports. If a surplus of trade in services of £5.9 billion is included, the total UK’s trade deficit widened to £3.9 billion, the highest since December 2009. However, the volume of goods exports in the latest three months was up by 1.2%, more than offsetting a rise of 0.5% in import volumes. That said, in September and excluding erratic items, the volume of exports was lower, driven by a fall in exports to the EU of 3%.

These figures cast doubt over the economy’s performance near term in the face of turmoil in Europe and evidence from recent business surveys, including our own, that the outlook for exports is becoming more challenging. With the risks from Europe escalating, the worst may yet be to come for exporters.

Conclusions

The most likely scenario is that the euro will not exist in its current form, with potentially three of the current members – Greece, Portugal and Ireland – exiting. We believe that Spain and Italy have a much smaller chance of debt default, and of exiting. However, there will be significant changes in the way the euro operates. There are large structural distortions across the eurozone that must be addressed to secure its long-term stability. Stronger members will want greater fiscal discipline and structural reforms enshrined (at a minimum, a legal balanced budget rule) before agreeing to the fiscal transfers required to stabilise the debt ratios of weaker members.

For those that exit, a significant devaluation of their new exchange rates is inevitable and significant official support mechanisms will need to be put in place to aid transitions. We believe the current ‘muddle through’ approach to safeguarding the future of the euro in its current form is looking increasingly unlikely as a sovereign default in Greece draws ever closer.