A strategically-placed relative has left Neil Record with the lowdown on how the euro crisis is perceived at the top table of European politics. Here's what he learned

My niece Emily is sitting excitedly in front of me choosing her starter. She is over for a couple of days from her job as an interpreter at the European Commission, and has just started reporting to me (in the strictest confidence, of course) her most exciting day so far - translating a lunch-time meeting between Angela Merkel and Nicolas Sarkozy in Brussels.

Angela:
Nicolas, it is very important that we review now, in some detail, the various options open to us vis-à-vis the euro crisis, and understand fully some of the more unpleasant outcomes which the market may inflict on us, whatever our decisions. So far, I have had to give the German electorate a series of increasingly bad news, and both they and I feel that we have been caught somewhat unawares by the increasing gravity of the situation.

Nicolas:
I have just completed an all-day briefing with the best brains in France on this topic (the ‘Enarques'), in which I asked them to brief me on all possible future paths the crisis could take - not just the politically attractive ones. I think you will find what they told me very interesting and somewhat unsettling.

Angela:
Go on.

Nicolas:
In summary, the Enarques see four basic possible outcomes. The first, and of course our preferred solution, is no default and no exit of any state from the euro-zone - but frankly most of the Enarques thought it was becoming increasingly unlikely. Every time new information emerges, the position worsens. While many of them thought that it might be possible in theory to maintain the political will for a comprehensive support regime, the economic damage that would be wrought on the fringe states might be too severe for their governments, (or, Chancellor, in the case of Greece, democracy) to survive such a sustained depression. Oh, and they also thought your own position, Chancellor, would be, comment dire, un peu fragile, given your electorate's evident shortening fuse on this topic.

Angela:
Hmmm. What is the next option they considered?

Nicolas:
The second one is the one the market is really fearful of - default of one or more of the most indebted states. Frankly, few investors in the non-bank market have much Greek debt, but they know that several of our largest banks have built up large holdings - too large, I now discover - and what is really worrying them is the implications of a default on the banking system.

Angela:
Sorry to interrupt, Nicolas, but why do they have so much fringe euro-zone sovereign debt? From what my advisers have always told me, for sovereign debt financing to be non-inflationary, isn't it supposed to go into non-bank hands, like pension funds and insurance companies - in other words, long-term savers?

Nicolas: You're absolutely right, Chancellor, we were shocked when we discovered this, but it was, by then, too late. Banks normally stay away from long-term sovereign debt because it does not give them two characteristics they need - return (ie, a credit premium) and short-term interest rate exposure. It is pension funds and insurance companies that normally want long-dated and low-risk debt like sovereign bonds, to match against their liabilities. The bit we didn't spot was that the euro-zone bank regulation framework had insisted that all euro-denominated sovereign risk had a zero-risk capital weight on bank balance sheets! So when euro-zone banks realised that they could buy higher-yielding sovereign bonds and book the extra yield as additional ‘risk-free' profit, they piled in without further thought.

Angela:
So just talk me through what your advisers said about the effect on the banking system of sovereign defaults.

Nicolas:
You really want to hear?

Angela:
Nicolas, we can't deal with this unless we open our eyes fully. Tell me.

Nicolas:
The Enarques have calculated that if Greece defaults with a 40% recovery rate, euro-zone banks would suffer a €50bn pre-tax loss. While this might be manageable, given the resources available to the EFSF, it assumes that the support is forthcoming and, therefore, that systemic contagion is contained. Now, if, additionally, Portugal and Ireland default with a 50% recovery rate and Spain defaults with a 60% recovery rate, European bank losses would be in the order of €180bn. Given that total core tier 1 capital of euro-zone banks stands at €160bn, this represents a significant capital shortfall.

If Italy defaults with a 60% recovery rate, I don't think the combined fiscal power of our two countries could prevent a full-blown domino effect on the European, and, therefore, the world's banking system. A few Canadian, Australian and Far Eastern banks might survive without state help - everyone else would be in for help in one way or another. Oh, and the Enarques think there are only six or seven sovereigns (our two countries included) who can and/or will be prepared to materially contribute to that bail-out. They also think that the scale of the required fiscal transfer will sorely test the debt-raising powers of several of those.

Angela:
I see. What are the other two outcomes?

Nicolas:
The third outcome is that no euro-zone government formally defaults, but that some states leave the euro-zone. Behind closed doors, we all acknowledge that there is no prospect of Greece servicing, let alone repaying, her euro-denominated sovereign debt. We agree that her membership of the euro is no longer tenable, and that she will announce her departure from the euro-zone on, say, 31 March 2012. Full Council agrees that she should remain a full EU member, but take on a status similar to Denmark and the UK from the currency point of view. The 31 March 2012 happens to be a Saturday. Until that day, we will maintain the fiction that Greece is remaining a full euro-zone member, and we will act to shore up confidence and provide short-term financing as far as possible.

If sentiment and fundamentals continue to move against us, this will be a difficult period, and much of the preparations will have to happen in the strictest secrecy. But on the day of announcement, Greece says that the new legal tender is the drachma (not the new drachma), and that all contracts, debts and assets of Greek domicile will from that date be denominated in drachma and all sovereign debt will be honoured in full in drachma. The conversion rate will be the same as the entry rate (which was 340.75 drachma to the euro).

Our advisers think that the market will open on Monday morning between about 700 and 1,500 GRD/EUR, or about a 70% discount to the entry value. This will immediately devalue the international (ie, euro) value of Greek sovereign debt by this amount, although the Enarques tell me that Greek bonds will not fall by this much (or indeed at all), as the default risk premium will collapse, to be replaced by a (somewhat lower) currency risk premium. Greece will undoubtedly import inflation and by that mechanism, over time, render its sovereign debt affordable. The UK did it after the war, so we know it is possible.

Angela: And under this scenario, Nicolas, what will happen to the banks?

Nicolas:
Sadly, much the same as the default scenario, but with a more complicated outcome.

Angela: More complicated? And by the way, what does ‘Greek domicile' mean, Nicholas?

Nicolas: That's the key complication, and the one question I hoped you would not ask, Chancellor. The Enarques were heavily divided on this, and so will the lawyers be. There is some precedent for re-denomination (the latest being the arrival of the euro), but with the amount of money at stake, we will probably need to rush through new laws at European level to make a clear determination so that our financial institutions are not embroiled in ruinous litigation on this topic. A small point - euro notes are supposed to be ‘equal', but actually are all officially issued by a National Central Bank. Greece's note issues have a Y prefix to the serial number, and so presumably these will become drachma at the entry rate - ie, be devalued by at least 50%. German issues have an X prefix; French U.

Angela: [Searching in her purse, turns to a member of her entourage] Could you exchange this for me, please; look for the X prefix on the serial number. Thank you. So, Nicolas, why would Greece choose this route rather than default?

Nicolas: Because it will get them back to work by making them internationally competitive, and, with luck, keep them a democratic and governable nation.

Angela: And the fourth outcome?

Nicolas: In my opinion, the worst of both worlds - default and re-denomination. Under this scenario, Greece will fare materially no better in the outside world, and will be excluded from the debt markets for years. I really think they should avoid this outcome at all costs.

Angela: And do we have any handle on how likely any of these scenarios are, assuming that we have not yet made any political determination?

Nicolas: Well, Chancellor, of course we are an integral part of the decision-making process, but the Enarques have used German and French (and other states') political decision-making records, together with their best assessment of the current ‘fundamentals' to develop a game-theoretical decision model, which is pre-programmed with what they call ‘end-states' - each one of the four options we have considered.

Angela: I see - and what does this tell us?

Nicolas: The probability of no default, euro-zone intact is 18%; some sovereign default, euro-zone intact is 60%; no default, some states' euro-zone exit is 5%; some sovereign default, some states' euro-zone exit is 17%. These inputs were as at 30 September, and by ‘some' they mean between 1 and 17 countries' exit.

Angela:
And does this accord with what markets are pricing in?
Nicolas: Broadly, yes. We need to start to make serious choices, Angela, but I am not going to start doing that without a drink. Mosel or Sancerre?

Alas, Emily was not invited to continue the translation into the break. She was not, therefore, privy to the next stage of the conversation.

Neil Record is founder and chairman of Record Currency Management. A former Bank of England economist, a trustee of the Institute of Economic Affairs and a Visiting Fellow of Nuffield College, Oxford, none of his relatives works as an interpreter at the European Commission