Germany can't save Europe

Germany does not have the financial resources and strength to rescue the peripheral nations of the eurozone.

Germany is indirectly exposed through its support of various official institutions such as the European Union (EU), the European Central Bank (ECB), the International Monetary Fund (IMF) and especially bailout funds. The exposure of the ECB to Greece, Portugal, Ireland, Spain and Italy is 918 billion euros as of April of this year.

Germany's guarantees supporting the European Financial Stability Fund (EFSF) are 211 billion euros and will increase if Spain and Italy require assistance and cannot act as a guarantor.

The European Stability Mechanism, the replacement to the EFSF which is planned to commence in July 2012, will require a capital contribution from Germany that will push its budget deficit to 35 billion euros from 26 billion euros. If the ESM lends its full commitment of 500 billion euros and the recipients default, Germany's liability could be as high as 280 billion euros.

The largest single direct German exposure is the Bundesbank's more than 700-billion-euro current exposure under the TARGET2 (Trans-European Automated Real-time Gross settlement Express Transfer system) to other central banks in the eurozone. Designed as a payment system to settle cross-border funds' flows, surplus countries, such as Germany, have been forced to use TARGET2 to finance the funding needs of peripheral countries without access to money markets to fund trade deficits and the capital flight out of their countries. Germany is by far the largest creditor in TARGET2.

Irrespective of events, Germany will suffer significant losses on its exposure.

Greater monetary and fiscal integration would require mutualization of debt through the issue of eurozone bonds backed jointly or severally by all member states. As the largest, most creditworthy nation in the eurozone, Germany would bear the largest financial burden.

Germany's TARGET2 exposure would also continue to increase, at a rate of 80 billion to 160 billion euros a year, to finance expected trade deficits in the rest of Europe. The increase in exposure may be higher if needed to finance budget deficits of weaker eurozone members and the weak banking sector. Germany's TARGET2 exposure has increased by around 237 billion euros, or around 34 per cent, in the last eight months alone.

If Europe relies on its current policy of partial solutions -- austerity and monetary accommodation by the ECB -- then the debt of peripheral nations will shift to official institutions as the troubled economies are unlikely to regain access to commercial funding in the near future. Germany's financial liability will also increase in this case via bailouts, funding arrangements and the TARGET2 system.

In the peripheral economies, continued withdrawal of deposits from national banks (a rational choice given currency and confiscation risk) may necessitate either a Europe-wide deposit guarantee system or further funding of banks. A credible deposit-insurance scheme would need to cover around 1.3 trillion euros of deposits in the peripheral countries. Any Europe-wide deposit guarantee system, provision of capital or further funding of banks increases Germany's financial liability. Despite agreement of a single European banking regulator, there has been no progress on any deposit insurance scheme.

If integration is not undertaken or the partial solutions fail, then some European countries will need to restructure their debt and potentially leave the common currency. Germany would suffer immediate losses. A Greek default would result in losses to Germany of up to around 90 billion euros. Germany's potential losses increase rapidly as more countries default or leave the eurozone.

There are also real economy effects. Austerity or default will force many European economies into recession for a prolonged period. German exports will be affected, given Europe is around 60 per cent of its market, including around 40 per cent within the eurozone. Germany's problems are likely to be compounded by a slowdown in emerging markets.

In the absence of a Lazarus-like recovery in the peripheral economies, Germany's current exposures are not recoverable.

Hans-Werner Sinn, president of Germany's IFO Institute, estimates if Greece, Ireland, Italy, Portugal and Spain went bankrupt and repaid nothing, but the euro survived, Germany would lose $899 billion.

If the euro also failed, Germany would lose more than $1.35 trillion, more than 40 per cent of its GDP, or 30 per cent of all German household assets (4.7 trillion euros).

Germany's attempt to balance the benefits of the single currency and the advantages of preserving the eurozone against its traditional preference for fiscal and monetary conservatism has failed, leaving the nation with severe financial problems.

Faith in Germany's ability to rescue Europe is misplaced. But as Norman Cousins noted: "Hope is independent of the apparatus of logic."

Satyajit Das is author of Traders Guns & Money and Extreme Money and a consultant to Jory Capital.

July 14: The eurozone's chronic disease

Today: Germany can't save the eurozone

Republished from the Winnipeg Free Press print edition July 21, 2012 B17