Hamish McRae: We will survive a eurozone collapse

Economic View

On it goes. The Group of Twenty economic summit in Los Cabos,
Mexico, tomorrow takes place against a suitably apocalyptic
backcloth. If, we are told, the Greeks do the wrong thing at the
polls, the euro will collapse and the world will be plunged into
another recession.

Click here to view the graphic

But this is inherently improbable: Greek GDP is some $300bn, roughly the same size as Argentina or Thailand. If Argentina or Thailand were to face economic disaster – and both have had bumpy rides over the past 20 years – we would be concerned for humane reasons, for no one should play down the cost of economic hardship on ordinary people. But we would not pretend that difficulties in those two countries could threaten the rest of the world. Only if Greece were to become a Lehman Brothers – where a relatively small incident sets off a chain reaction, undermining other and more important institutions – could the votes of the Greek electorate determine the direction of the world economy.

So, is Greece another Lehman or, my preferred analogy, is the eurozone akin to the Bretton Woods system of fixed exchange rates?

There are certainly Lehman-like elements to the Greek situation, for were it to leave the eurozone, there would be a knock-on effect from financial and commercial contracts not being honoured. Leave aside the speculation that this would provoke a run on Spanish and Italian assets, based on fears they might do likewise, for in the short term at least it should be possible to maintain a firewall between Greece and the other weaker eurozone members.

No, the point is that thanks to the eurozone's design, any exit will lead to disruption, just as the international banking system's design did not make allowance for a large bank being unable to meet its obligations.

But there is one crucial difference. The Lehman collapse was a sudden shock. There was no preparation for it. By contrast, the possibility that Greece might leave the euro has been around for at least a couple of years. Common sense has said so, even if politicians haven't. So while it might be a shock, it would not be a surprise. That is the most important single reason why it could be managed.

Now, take the other possible parallel: the end of the Bretton Woods fixed exchange rate system. This was set up after the Second World War to avoid the competitive devaluations and trade restrictions that had wrecked international trade in the 1930s. Countries had to maintain their currencies within 2 per cent of a central rate and they intervened on the markets to do so.

If they needed additional firepower to maintain a rate they could borrow short-term from the International Monetary Fund – they could, if a rate became unsustainable, devalue or revalue. Liquidity for the whole system was provided by the two reserve currencies, the dollar and sterling, both of which were convertible into gold at a fixed price.

In the early post-war years the system worked well enough, though devaluations of sterling in 1949 and 1967 undermined the pound as a reserve currency. The franc, the lira and the peseta were also devalued. There were occasional revaluations too, most notably of the deutschemark. But the system did provide a discipline of sorts, enabling rapid growth of international trade. What went wrong was a lack of faith in the dollar, for while the US was the dominant world economy it could underwrite the entire system. As that dominance faded, the pressures mounted and eventually, in 1973, the world moved to floating rates.

But – and this is the key point – there was huge resistance to the idea that Bretton Woods might break up. There were attempts to patch it up, culminating in the 1971 Smithsonian Agreement, which allowed the dollar to devalue against gold. This was hailed by Nixon as "the greatest monetary agreement in the history of the world". Britain left in 1972 and the system lasted less than 18 months.

Now apply this experience to the euro. Like the Bretton Woods system there are fundamental flaws in its design. There is also huge political commitment to keep it going. And the euro, despite its flaws, has worked reasonably well for a while. But it is even more rigid than Bretton Woods and it has not prevented a sharp divergence of trade balances.

As you can see from the main graph, there has been a substantial divergence of current accounts of the major eurozone members, with Germany moving from deficit to surplus, France and Italy moving the other way, and Spain reaching a deficit of more than 10 per cent of GDP before hauling that back somewhat. (The UK also moved from near balance to sizeable deficit, but we have exchange rate flexibility.)

What I find fascinating is that were we all in the Bretton Woods system, Germany would have been under pressure to revalue, and France, Italy, Spain and the UK to devalue – as the UK has done. So, we are all behaving exactly as we did in the 1950s and 1960s: Germany behaves like a strong currency country and the rest of us are, shall we say, somewhat less rigorous in our financial discipline.

The puzzle, I suppose, is why financial markets bought the idea that there would be financial convergence when there was already economic divergence. Back in the 1980s, Italy, Spain, France (and the UK) had much higher bond yields than Germany. Then, thanks to the euro, yields converged. Now, as you can see from the small graph, over the past year Italian and Spanish 10-year yields have risen from a gap of 2 per cent over Germany to around 5 per cent. For the bond markets it is as though the euro never existed.

I find this long view of financial relations comforting. We do face another Lehman moment, but this time we are more prepared. We may get some indication of the plans after the G20 summit, but business is well advanced in its contingency planning. And, if the Bretton Woods parallel is valid, the world economy could, even at some cost, still cope with the break-up of the eurozone too.

Will Huawei be the Chinese Tata of the mobile handset world?

Will it be Microsoft or Huawei that takes over Nokia? Yes, I appreciate that the question is a little premature but the investment community now seems to feel the only future for what was once the world’s largest mobile handset maker, and Europe’s most valuable company, will be for it to be taken over.

After a sharp fall in its share price last week it is valued at a 38 per cent discount to its net assets, the sort of level that might tempt a predator to step in.

But who? The obvious potential partner is Microsoft, its partner in smart-phone technology, with Nokia having dumped its own operating system for a version of Windows. That would be a defensive move on Microsoft’s part and might make sense for both. There was a rumour that Samsung might buy, but that was denied and it is hard to see why it should do so.

The most intriguing possibility, however, is that the buyer might be Chinese, in which case Huawei, the tech giant would be a prime candidate. The buyer would gain global access, manufacturing capacity, a great if somewhat battered brand, and some important patents. There are huge risks because the company has to be turned round, but to have a solid home market, the largest market for mobile phones in the world, would enable a Chinese buyer to offset those inevitable risks.

What I find fascinating is the way the unthinkable suddenly becomes the obvious. Ten years ago it would been unthinkable that Nokia would be so vulnerable. But, 10 years ago it would have been unthinkable that it would be Tata of India that would rescue Jaguar Land Rover – and be so hugely successful where others had failed.  

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