Talk of euro wreckage is back say Morgan Stanley.

In its latest ‘Central-Bank watch’ note the bank reminds it warned five years ago euro wreckage was a distinct possibility. But, while MS believes its arguments are still valid, the more likely scenario is actually that the financial crisis will make a euro break-up much less likely.

Sovereign yield spreads within the euro area, as a result, may have overshot, it says. From the note:

Some themes are like U-boats. They linger beneath the surface most of time, but when they emerge occasionally, they provoke much fear and can cause serious damage. One such theme is the potential break-up of the euro, which has become popular again recently with the deepening of the financial crisis.

Reasons why the euro will survive:

• Without the euro, Europe would have been harder hit. This is evident from the pressure being felt by independent currencies like the Danish krone. MS says the costs of being outside the euro when a major crisis hits are therefore even higher than previously thought.
• The current crisis makes it more likely that euro membership will grow rather than shrink – look at Poland and Hungary which are now eyeing 2012 and 2013 membership respectively, a year earlier than previously expected.
• The interconnected nature of the financial system has been proven and euro secession by any member would lead to major currency mismatches, with major systemic consequences.
• The ECB has been tested. It’s reacted to the crisis with aggressive and unconventional responses showing its determination and ability to deal with adverse circumstance.

All that said, the closing thought is:

Don’t get us wrong. We are not arguing that a euro break-up is impossible. In fact, we warned about this possibility already four years ago, when hardly anybody was willing to entertain the idea. However, the experience of the current financial crisis should make it, at least for the foreseeable future, less palatable for any member country to venture secession.

Related link:
Bonds that go bump – FT Alphaville

This entry was posted by Izabella Kaminska on Thursday, November 6th, 2008 at 11:38 and is filed under Capital markets. Tagged with euro. Edit this entry.