Tuesday, August 14, 2012
...Eurxit and beyond...
The Euro as currently configured is not sustainable, from both an economic and from a political perspective. Spain cannot possibly deflate its way back to balance, and 20% overall unemployment and 50% youth unemployment is not politically tolerable. The only way out – forcing German banks to write off their Spanish debt now, matched by stimulus sufficient to turn Germany into a net importer – is not on the policy horizon, though in due course German banks will in fact have to write down debt.
If Spain falls, so will other parts of the Euro zone. Greece of course, and Portugal, and Ireland but not Italy? – I'm not euro-centric and don't know enough to create my own list. I assume France, Spain, Benelux, Austria and Finland will remain. To highlight issues, however, it is sufficient to focus on Spain.
The Euro exit process – I've seen the term "Grexit" used for the likely initial case – is not clear-cut. I would hope that central bankers and pan-European financial institutions are (quietly) working on possible scenarios. If so, in our leak-prone world, they really have been quiet. At the moment, a sensible assumption might be a three years of chaos in those exiting, since there seems to be no planning to support a quick and clean break (cf. the 1997 Asian Financial Crisis). In the interim, those remaining on the Euro would face a corresponding period of deep recession. Then would come two years of recovery that would leave economies below peak, followed by an era of more gradual reconstruction. The total: five lean years, less than what drove Israel to Egypt, but potentially just as devastating to the European heartland.
Not all auto firms are equal. For several – Fiat, Peugeot and Renault – Europe dominates their operations. So far VW appears exceptional, because its German sales base has escaped the current crisis and it is larger outside Europe. Then there are BMW and Mercedes, in the upper segment of the market, about which I know little, and so will hazard no guesses.
Other firms have a footprint in Europe, but are not dominated by what happens there: Fordwerke and Opel are but one part of the global operations of Ford and GM. Europe is peripheral for Toyota, Nissan, Honda and Hyundai. Their parent companies may or may not decide to tough things out – GM will have the hardest time –but unlike Euro-centric firms they have the option of exiting. That would matter if both Ford and Opel/GM leave the market, but otherwise would not remove enough capacity to change the equation.
Then there are automotive suppliers, the larger of which have substantial bases in the Americas and Asia, but still have their core in the Euro zone. My sense from visiting suppliers on a regular basis is that they've done a good job of geographic rebalance, to the benefit of firms headquartered in Europe and the detriment of those headquartered in the US. Asian suppliers are on average relatively weaker in Europe, and so will be less affected. Catastrophic failure of any of the large European suppliers would be catastrophic to the industry, the equivalent of Lehman Brothers in the financial world. Renault would (quietly) cheer the failure of PSA or Opel. All would lose in a meltdown of the supplier base.
Shifting gears from firms to geography, Eurxit (pardon the neologism) would bring a large devaluation to Spain. That is most obvious relative to the Euro; imports from Germany and France [Grance? Framany? – the new Europe will need new jargon] would be much more expensive. However, I would also expect the (new) peso to depreciate relative to currencies in peripheral Europe, since Hungary, the UK, Russia and Turkey already reflect a more sustainable level relative to the Euro.
If it could avoid collapse during the transition, Seat as a local firm (albeit also a VW subsidiary) would benefit from a large shift in relative prices that would improve its strategic position. It could become a true value brand in Europe, with increased exports and (due to the higher cost of imports) would have a near-unassailable position in its home market. Seat might still be Skoda's poorer brother, but its place in the VW family would be more secure. Now the labor cost component of local [Spanish] assembly is modest, and many parts and components are imported, muting the initial benefit. Over the space of a few years, however, local content would rise and with it the peso component of the cost base.
In contrast, firms remaining in the Euro cost base would see their export markets shrink, and the burden of the zone's excess capacity is already heavy. Who has deep pockets? VW, yes, but (potentially) Ford, Opel, Toyota, Nissan, Honda and Hyundai. Chrysler isn't big enough to fully balance Fiat, nor Nissan to balance Renault. Absent government intervention, it is hard to imagine all of these small firms surviving five lean years. In addition, GM's pockets aren't deep; Ford is still rebuilding its balance sheet. Eurxit won't help the US economy and it won't help China, so won't help either firm. So it is conceivable that one of them would exit. It is almost inevitable that the European market would witness multiple bailouts, given a greater political sensitivity to unemployment than in the US. This would be to the detriment of VW, and to any of the branch operations of US and Asian-based firms that remain.
This is my first pass at the implications of Eurxit. Additional differentiation would come from breaking down market shares of individual firms between Eurxit and Euro countries; who is strong in the Mediterranean periphery, and hence more vulnerable? Who has the weakest balance sheet among OEMs and among suppliers? On which side of the divide will Italy lie? Who has a stronger base in the non-euro periphery (Turkey, Hungary, Poland, Russia) and so may be better positioned to pick up pieces of the market via exports?
We can always hope for a miracle European unity, that France and Germany can act as one. So far the fear factor is failing to force fraternity. The initial Eurxit – Grexit? – may change that, but my hunch is that by the time it will be too late.
Finally, this places a fundamental strategic choice in front of firms not irrevocably committed to Europe: do you marshal resources for a long and expensive slog there, or do you prepare to retreat and instead concentrate on the Western Hemisphere and Asia? Even with a reconfigured "euro" divide Europe will remain on average prosperous, and with a population larger than the US will remain potentially profitable. But is every current participant willing to wait until 2018 to realize that potential?