A man walks past a branch of the Unicredit bank in downtown Rome on February 09, 2017. / AFP / FILIPPO MONTEFORTE/Getty Images


While Trump’s tweets grab the headlines, Europe’s perils are becoming harder to ignore. Greece’s fiscal follies have surfaced once again, but that’s not the EU’s biggest threat at the moment. That award goes to Italy’s banks.

Currently, around 18% of Italian bank loans are nonperforming. For some context, nonperforming loans in the US only reached 7% at the height of the 2008 financial crisis. The same level of bad loans in the US banking system would equal $3.8 trillion.

Political will has forestalled these problems for the last seven years. However, with German Chancellor Angela Merkel the only member of the old guard left standing, 2017 could be the year the EU collapses under its own weight.

As George Friedman has stated, “The EU is merely a treaty between nations, not a federation. As such, there is nothing holding it together except the promise of prosperity. When that prosperity is no longer forthcoming, people will leave.”

So, what does an EU breakup mean for the future of the Continent’s economy?

De-Facto Defaults

As uncertainty about the EU’s future grows, European bonds will sell-off sharply. During the 2011 European debt crisis, yields on sovereign debt spiked to record highs. This effectively locked countries out of credit markets. Defaults were only averted because the IMF and ECB stepped in.

Europe’s problems are now much larger, and bailouts won’t hold the EU together during the next crisis. So, how might this mess play out? As history has proven, governments prefer soft defaults over hard ones. Therefore, re-denomination back into national currencies is the likeliest outcome.

To avoid a hard default, fiscally weak nations—like Italy and Spain—could markedly devalue newly issued currencies. While creditors will be paid, it won’t be to the value of what was agreed upon.

After new currencies are created, bank deposits would be automatically converted. With estimated devaluations of 60%+, the value of savings would be destroyed overnight. Capital controls would have to be enacted to halt bank runs. This would be akin to what happened in Argentina in 2001.

For fiscally strong countries like Germany, things may play out differently. If reinstated, the Deutschmark would likely appreciate. This would actually benefit Germany as it would lower the value of their liabilities. However, given their huge credit exposure to weaker nations, they wouldn’t escape unscathed.

There’s another major issue for the Germans—trade. Germany exports 47% of its GDP, and most of that is within the Schengen Area. This area has no border controls and stretches the length of Europe, covering some 420,000,000 people. As a member, Germany can export throughout the bloc without the added cost of tariffs and other trade restrictions.

As detailed above, there would be severe economic implications for European nations if the EU collapsed. In such an event, it’s likely that countries will take steps to protect domestic industries, like reinstating borders and tariffs. This would raise the cost of trade, thus lowering demand for exports. The fact that every 10% drop in Germany’s exports means its GDP would fall roughly 5% is cause for concern.

Having explored how a collapse may play out, can investors profit from this scenario?