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Should Germany Lead or Leave Eurozone?

Posted in Finance Articles, Total Reads: 2490 , Published on January 20, 2013

For the past 18 months or so, as and when depressing data come from Europe, talks get louder of breaking the euro or throwing countries like Greece out of Eurozone to protect it or about the role of Germany in the Eurozone. Instead of throwing the troubled nations out of the union, would it be better if Germany leaves the Eurozone. Or does Germany has the caliber to pull the Eurozone nations out of their debt-pit? We have tried to weigh the pros and cons of a German exit versus a German leadership in the current scenario.

Germany's exit would mean that Germany's credit rating improves as Germany has greater chance to switch to its own currency which would get better valuations than the troubled Euro. On the other side, the exit of Germany may break the Eurozone all together which could then mean a default on their debts by the troubled countries mainly the PIIGS. Germany and France have a lot at stake here. Germany, itself, is having a debt-to-GDP ratio exceeding 80% and any such default from the eurozone countries would lead to a serious balance of payment issue wherein Germany's balance sheet would have to account a substantial part of its accounts receivable to bad debts and thus would further strain its national balance sheet. Germany's total exposure currently accounts to over Euro 700 Billion, or about one-third of Germany's total public debt of around Euro 2.09 Trillion. As and when the losses are realized, the debt to GDP ratio may reach the behemoth levels of 114% according to Eurostat.

To gauge the risk associated with a German exit and a Eurozone breakup, one can refer the recent TARGET2 credit data which has increased from about Euro 40 Billion in June 2007 to Euro 576 Billion in February 2012 i.e. 20% of German GDP. This has exposed the German taxpayer, in case of a Euro breakup, to a high risk. In case of a breakup, 'Germany will have to provide the Bundesbank with a fiscal transfer of 20% of GDP to ensure its solvency'! Even if Germany avoids the transfer by following the fiat-currency system, the appreciation in its currency would make the weaker-currency denominated assets incapable of covering its liabilities by a large extent which could expose the country to further risks.

This would also affect the Current Account Surplus for the country as Eurozone is one of its major sources of export. With the breakup of the Eurozone and default of highly leveraged countries, the demand would hit all time low. Even in the current situation, the export to the Eurozone countries has declined by around 3.1% due to several austerity measures implemented by the respective governments as per the data released for August 2012. Germany's overall exports, however, jumped 2.4% month-on-month owing to an increased export to Asia and Non-Eurozone Europe. Analysts say that it’s a one-off effect and the broad trend points towards a decrease in overall exports. Breakup of the euro would lead to a domino effect of several countries defaulting and leading to a severe bank-run which, in turn, would affect the economies outside Europe too. The demand in the Asian countries will also take a beating and thus the chain would come back to hit, the export-oriented, Germany very hard.

However, sticking with the Eurozone would lead to further bleeding of the German economy for the time being where the people of the land are getting restless with the prolonged economic downturn and the regular sop cuts taken by their government to fund the bailout packages of the troubled Eurozone countries. Another point to be noted here is that during 1998 to 2011, Germany saw one of the lowest growth rates of 1.4% while Eurozone as whole grew at a rate of 1.6%. Economists argue that monetary union has served many of the countries but for Germany and with Germany involved in bailing out the PIIGS off their extravagancy, the trend would only get stronger. German people are not happy with the way Germany is draining its resources on the Euro issue and unrest is brewing in its own mainland too apart from the anger in the citizens of the troubled nations for imposing more and more austerity measures on them. Political voices from the country itself are hinting it to quit. George Soros also said "A German exit would be a disruptive but manageable one-time event, instead of the chaotic and protracted domino effect of one debtor country after another being forced out of the euro by speculation and capital flight,"

Accepted. Germany would rise back after the initial pain even if several other Eurozone countries go down. But, what does Germany stands to gain if it stays in the league as a 'benevolent hegemon'?

To begin with, the status of a leader in a power-potent Eurozone. With the attention of the whole world, including Fed, on Europe, Germany could look for channeling more funds to support the troubled nations from other parts of the world too, without losing the leadership status.

The current strategy of budget cuts and austerity measures would certainly bring down growth and the cost of living standards of the Europeans in the short run. At present, they are protesting this. However, given a longer duration, people would get used to it and accept the stark reality of their economies. Going forward, as and when the countries begin to recover from the debt burden, the reins of fiscal discipline can be loosened a bit to spur consumption and growth. Meanwhile, Germany can focus on gaining more impetus in decision making of the nations to make sure that Eurozone emerges as a fiscal union and not just a monetary union which it is now.

A stronger Eurozone would give it an edge over several other super-powers including US, UK and China. With Mario Draghi's announcement of 'Unlimited Bond Buying' from the troubled states, one thing is very clear that Germany is not giving up on the Eurozone as yet and rightly so.

This article has been authored by SIVA KUMAR NANDIPATI from IIM Indore.

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