The Eurozone crisis continues to fester. We are hardly closer to its resolution now than we were three months ago; in the interim, the outlook instead took a turn for the worse. In my last report, I sketched a risk matrix that matched various types of crises with the resulting risks, both microeconomic (to a company’s operations) and macroeconomic (to the economy). This time around, I map out the impact that a shock—such as a major European bank failure, a political crisis, or a stand-alone sovereign default—would likely have on various sectors of the U.S. economy.
The EU summit held in late June produced two breakthroughs. First, the European Financial Stability Facility (EFSF) and its successor, the European Stability Mechanism (ESM), are to directly fund shaky banks. Second, requirements were relaxed for EFSF/ESM to engage in bond purchases of troubled sovereigns. These steps are significant in that they address immediate needs (a liquidity provision, support for banks) as opposed to long-term solutions (fiscal adjustment, institutional change).
Yet questions remain. The ESM’s banking role is conditional on the European Central Bank becoming a Eurozone bank supervisor. Such a shift in regulation is fraught with political uncertainty, could take time, and may yet unravel. Also, bond purchases may deplete the ESM kitty of €500 billion without making much of a dent in yields.
Meanwhile, Greece, Portugal, and Spain all posted below-forecast annual gross domestic product rates in the first quarter; GDP declined 6.5 percent, 2.2 percent, and 0.4 percent, respectively. This will put the Greek and Portuguese IMF-mandated 2012 deficit and debt ratios in doubt. Greece will struggle to meet conditions for the program’s second review based on end of June data. Failure to receive the €1.6 billion third tranche would put the government’s finances in a tight position by August, if not earlier. Meanwhile, Spain has applied for EU assistance to shore up its banks. Compared to these predicaments, Cyprus’s request to draw funds from the EFSF looked like a footnote.
There are plenty of risks to go around. Global companies with exposure to Europe should prepare for a turbulent ride in the third quarter.
A sudden crisis would cause the dollar to gain in value and European interest rates to creep up. European banks’ dollar financing might come under pressure as well. Generally, higher interest rates and lower liquidity in Europe would spill over into the American financial system through counterparty risk. Some U.S. institutions would suffer losses.
A persistently higher dollar will depress international tourism receipts in the United States. An expensive greenback will also dampen domestic purchases of durable investment and consumption goods, that is, the most elastic segment of demand.
A stronger dollar will generally squeeze exports by making them more expensive. But a shock might also impact trade indirectly. Strikes and political gridlock could stymie transportation and logistics. In fact, a political stalemate, combined with a banking crisis, could temporarily paralyze large swaths of an economy. In this case, all types of manufactured goods sectors and transportation services would be affected, although the severity of impact is hard to pin down.
Finally, a major crisis would sap consumer and investor expectations. Sagging confidence would generally weigh on all sectors except those that operate locally, such as media/entertainment or healthcare. The impact would be moderate.
This short analysis paints a picture that is perhaps more benign than expected. Few sectors outside of financial services and domestic capital goods would suffer greatly from a localized shock coming out of Europe. Obviously, a major meltdown of continental financial architecture or a collapse of the common currency would subject the American economy to far greater stress. While such a scenario cannot be completely excluded, I do not consider it likely in the next several months.
Scenario Planning of the Eurozone Crisis: A Risk Template Approach, E-651, March 2012.
 This brief does not deal with a major crisis, such as the European Monetary Union (EMU) unraveling completely. Such an upheaval would have major consequences for the American economy, including a very likely renewed recession.