The Euro effect – what does the future hold?

Though Hong Kong’s banking sector had limited exposure to the EU debt crisis, what risks should we be prepared for?

While the general consensus is that the current Euro debt crisis poses no direct threat to our banking sector in Hong Kong, due to the relatively low exposure it has to countries with severe sovereign debt issues, there are still other risks that present potential causes for concern.

There’s no denying that Hong Kong’s economy is extremely robust, supported by our close links to China and strong domestic consumption, but like other Asia Pacific countries, we still have a dependence on the health of the global economy, which in part is influenced by Western businesses.

Consequently, while Hong Kong’s banks do not have a significant level of exposure to the debts present in individual European countries, there is a clear possibility that fiscal tightening and other debt reduction measure taken in Europe could lead to an increased aversion to risk. This fact has
already been recognised by Secretary for Financial Services & the Treasury, Professor KC Chan, who indicated that this risk aversion might trigger capital outflows and a squeeze on interbank liquidity.

Even though most Asian economies emerged from the global credit crisis earlier than other markets, the financial, commercial and political effects of that event are still causing ‘aftershocks’ across Europe, which are now sharply focused on the Eurozone sovereign debt crisis.

So what does the future hold for Europe and how will it affect us?

The end result of the current turmoil in Europe is still some way from being fully resolved, so any definitive predictions on the impact on Hong Kong and other Asian markets is likely to incorporate a potentially large degree of inaccuracy. In addition, there are already two different scenarios being considered as to which path the crisis might follow as we move further into 2012.

While one option is for the Eurozone to ‘stick together’ and manage the crisis through minimising further escalation, the other alternative of a ‘Eurozone breakup’ might seem a simple solution, yet the impact of any country leaving the European monetary union is burdened with further financial problems as well as legal issues.

Given the rapid escalation and stress in the Eurozone, breakup scenarios have been explored and analysed in depth. Yet detailed research undertaken by Atradius economists in a new report on ‘Sticking
together : the future of the Eurozone’, suggests that the consequences of a breakup would be highly amaging not only for any country that leaves the Euro but also those that remain within the currency union.

Initially it might appear simple for a country to leave the monetary union as it is a matter of passing a law through parliament to introduce a new currency and subsequently, contracts would be redenominated in the new currency, including demand deposits and accounts held with banks. In theory, this approach is a mechanical operation, but in practice, there are at least two difficulties.

Firstly, the operation would require meticulous preparation. Dismantling the Eurozone would be a completely new experience for policy makers, increasing the likelihood of policy mistakes.

Secondly, a new currency could only be introduced into the highly integrated Eurozone if the operation was made without prior publicity – essentially as a ‘big bang’ - otherwise the disintegration process would be disorderly. Even if a country could overcome these issues, there is actually no way that a country can leave the Eurozone legally and there is intentionally no ‘opt out’ clause in the Maastricht Treaty.

So, by default, there is really only one viable option, however challenging, left for policy makers, decision makers and the European Central Bank (ECB), which is to stay united and address the crisis by minimizing its escalation and begin to exert control over the debt levels in the peripheral member states of Portugal, Greece, Spain, Italy and Ireland.

Since September, the ECB’s balance sheet has already expanded by more than EUR 300 billion, or 14% and it is expected the ECB will continue to support the banking system via this channel. However ECB intervention, can only offer a long-lasting solution if bonds are bought from countries that are temporarily illiquid but fundamentally solvent, yet it can also offer relief to distressed countries for a limited amount of time until investor sentiment improves.

Whichever scenario prevails, there will inevitably be unrest and volatility within European markets for some time, although any stabilisation and improvement has to be welcomed. We know that Hong Kong is not immune from the effects of global misfortune, which is why it would be wise to maintain a cautionary interest in development in Europe.

A full copy of the comprehensive Atradius report on ‘Sticking together : the future of the Eurozone’ is available for free download from our website, www.atradius.com.hk and if you are interested in finding out more about credit insurance and how it can help protect your business, please contact me on +852-3657 0700.

Matthew Cockerill, Country Manager, Atradius