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DB ResearchDeutsche Bank

The Future of the Euro

Dr. Thomas Mayer, CFAChief Economist of Deutsche Bank Grouptom.mayer@db.com

(+49) 69 910 30800

July 2011

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95

100

105

110

115

120

125

130

135

140

2000 2002 2004 2006 2008 2010

Germany France GIIPS

Real GDPIndex, Q1' 00= 100

1

The first 10 years of EMU were a big party forsome

Source: Haver

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95

100

105

110

115

120

125

130

135

140

2000 2002 2004 2006 2008 2010

Germany France GIIPS

Unit labour costsIndex, Q1' 00= 100

2

where cost discipline was lost

Source: Haver

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95

100

105

110

115

120

125

130

135

140

1999 2001 2003 2005 2007 2009 2011

Germany France GIIPS

CPIIndex, Q1' 99= 100

3

where price discipline was lost

Source: Haver

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-8

-6

-4

-2

0

2

4

6

8

10

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Germany

France

GIIPS

CA % of GDP

and where financing of external deficits was not(seen as) a problem

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4

Source: Haver

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Net borrowing surged

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Cumulated net borrowing by the public and private sector,

1999-2007

Source: Haver

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...debt reached worrisome levels...

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leading to dependence on foreign investors

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7

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Costly reliance on foreign borrowing

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8

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Sovereign debt crisis affecting banks

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9

0

500

1000

1500

2000

2500

0 500 1000 1500 2000 2500

CDS

5Y

-B

anks

CDS 5Y - Sovereign

2011 CDS: Gov't vs. bank spreadsin bp

Source: Bloomberg, DB Research

IE

GR

PT

ES

BE

IT

FI

NL

DEAT

FR

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Banks relying on ECB

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10

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ECB lending concentrating on GIP

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Eurosystem funding government debt

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Bank credit to governmentHoldings of bonds under the ECBssecurities markets purchaseprogramme

Source: ECB, National Central Banks

EUR bn

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and external imbalances

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Claims of the Bundesbank against the Eurosystem

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Intra-Eurosystem positionsEnd-2010

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Shifting exposures

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GIP: Public Debt by lender (EUR bn)2009 2010 2011E

Total public debt 531.1 623.5 678.3

Domestic banks 68.0 133.5 117.0

Foreign banks 137.0 106.5 95.5

National central banks 13.0 18.8 18.8

Other domesticinvestors

51.4 39.0 33.5

Other foreign investors 261.8 220.6 198.0

EU / IMF assistance 0.0 31.5 148.4

ECB SMP 0.0 73.5 66.8

Source: IFS, BIS, ECB, Bank of Greece, DB Research

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Bank exposures to risky countries

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GIP debt owed to foreign banks (EUR bn, end 2010)

Greece Ireland Portugal Total

German banks 19.2 2.5 6.0 27.7

French banks 14.5 4.8 11.8 31.0

Spanish banks 0.4 0.2 6.4 7.1

Italian banks 1.9 0.6 0.7 3.1

British banks 2.3 4.8 1.9 9.1

Japanese banks 0.4 1.1 0.9 2.4

US banks 1.3 1.1 1.2 3.6

Other EA banks 11.5 2.7 5.7 19.9

ROW 1.1 0.5 1.1 2.7

Total 52.6 18.3 35.6 106.5

Source: BIS, DB Research

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Who can role and who cant?

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Real GDPEUR bn, base year = 2000

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Source: DB Research

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Euroland forecast: Reversed growth divergence

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Who could succeed?

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Primary budget balance underdifferent assumptions

Greece Ireland Portugal

5% interest rate(stable debt ratio) 1.4 1.0 0.9

10% interest rate

(stable debt ratio) 8.1 6.1 5.1

80% debt ratio in2020, 5% rate 7.8 3.7 1.8

Memorandum:

2011 debt ratioNominal GDP gr. 1404%1054%

894%

Source: DB Global Markets Research

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Centrifugal forces within the EMU

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Over-borrowing during the decade of easy credit

has subjected EMU to a stress test

Creditor nations Debtor nations

Moretransfers

Less socialspending

Consolidation programmes

Nationalisticmovements

Majorityagainst

adjustment

Without clear assignment of responsibilities of

1. national governments for national debt and

2. ECB for price stability

a Eurozone break-up cannot be excluded.

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Hypothetic scenarios for an EMU-breakup

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Capital flight leads to

unsustainable Eurosystem

imbalances

Eurosystem creditor central

banks refuse payment to debtor

central banks

Locally held money in debtorcountries (deposits and cash)

depreciates against core euro

Adapted from Garber (1998, 2010)

Discontent in hard currency

countries leads to emergence of

privately issued parallel currency

Parallel currency crowds out euro

in hard currency countries

When credit is created in parallel

currency hard currency centralbank takes over

Adapted from All Saints Day Manifesto 1975

Gradual dissolutionBig bang

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The (optimistic) view of the future EMU: a big Italy

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Both holding together

Italy EMU

Strong north Strong centre (Germany, et al.)

Weak south Weak periphery (Greece, et al.)

Medium centre Medium middle circle (France et al.)Weakish government Weakish government (in Brussels)

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Copyright 2011. Deutsche Bank AG, DB Research, D-60262 Frankfurt am Main, Germany. All rights reserved. When quoting please cite Deutsche BankResearch.

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