from: BofA Merrill Lynch Global Research
Even though much of the market focus on exit risk has been on Greece, Italy and Ireland have the highest relative incentive to voluntarily exit the euro, by our analysis. In the case of Italy, it faces a relatively higher chance of achieving an orderly exit and it stands to benefit significantly from competitive gains, growth gains and even balance sheet gains. No wonder former Prime Minister Berlusconi has been recently quoted as saying that leaving the euro is not a “blasphemy.” Among the peripheral countries, Spain appears to have the lowest relative incentive to leave.
While Germany is the country most likely to achieve an orderly exit from the Euro, it also has the lowest incentive of any country to leave, in our view. It would suffer from lower growth, possibly higher borrowing costs, and negative balance sheet effect. Austria, Finland and Belgium don’t have strong incentive to leave, either.
Can Germany “bribe” Italy to stay?
What we have established in the previous section is that the incentive to leave the euro varies from country to country. Among the major economies, we believe Italy stands the most to gain from exiting, whereas Germany has the most to lose from exiting. We would argue for the same reason that Germany would also lose from the exit of other countries. (Say Italy leaves the euro but Germany stays. German holdings of Italian liabilities would fall in value, German exports to Italy would suffer and German companies would now face more competitive Italian manufacturing firms.) Does this mean that Germany would be willing to pay a price for Italy (as it has for Greece, Ireland, and Portugal) to stay in the euro? Yes, but we would argue that this strategy is not a stable Nash equilibrium. To illustrate this, think of the following game. In period 1, Italy decides whether or not to exit. If it does, the game is immediately over – Italy will get a payoff of -2 and Germany will get a payoff of -5 (outcome 1). If Italy decides to stay, Germany has the option in period 2 of choosing to pay Italy to stay or not. If it decides not to pay, Italy exits the euro in period 3 and the game is over. To the extent that there is a cost to Italy of delaying its exit, we assume the payoff to Italy is now -5 (an increase of 3); the payoff for Germany is still -5 (outcome 2).
What if Germany decides to pay Italy to stay?
Indeed, Germany might be willing to pay Italy 4 units so that if Italy does stay, Germany will still be better off than not paying and Italy leaving. After Italy receives the payment from Germany, it faces the option of exiting or staying in the euro in period 3. If it exits (outcome 3), it will collect a payoff of -1 (the 4 it gets from Germany minus the 2 fixed exit cost minus the 3 penalty for staying for an extra period), while Germany will get a payoff of -9 (-5 when Italy exits and the -4 it had paid Italy to stay). If Italy chooses to stay after receiving the “bribe” from Germany (outcome 4), Italy will end up with a payoff of -2 (the 4 it received from Germany and two periods of -3 for living with low growth, high borrowing costs and political instability) while Germany will receive a payoff of -4.
What is the Nash equilibrium of this game?
We can use backward induction to solve the game. In period 3, Italy is clearly better off exiting than staying (after Germany has already paid the “bribe”), as the payoff for Italy in outcome 4 is inferior to the payoff in outcome 3. If we can see this, so can Germany in period 2. Whether it pays or not, Italy will exit in the following period. Therefore, Germany is better off by not paying. Now in period 1, Italy can make the informed calculation that Germany will not pay. This means that Italy has an incentive to exit in period 1. The bottom line is that the only stable equilibrium of this game is that Italy exits the euro and, more importantly, it exits already in period 1.
Of course, this game is meant to be illustrative rather than predictive, as in real life things are much more complicated. Nevertheless, this game and the analysis in the previous section would suggest that we should not expect what has already happened between Germany and Greece during the eurozone crisis to play out Cause and Effect 10 July 2012 10 the same way for Italy if the crisis spreads.
Italy has more incentives than Greece to voluntarily exit the eurozone, in our view, while it will be more expensive for Germany to keep Italy in the eurozone. This means that Italy could be even more reluctant than Greece to accept tough conditionalities for staying.
If our inference turns out to be correct, this could have serious negative implications for markets in the months ahead. With Prime Minister Monti’s approval rating having fallen from 70% last November to barely above 30%, the domestic debate about the Italy’s future in the eurozone ahead of the general elections next March will be very important to watch.
from: BofA Merrill Lynch Global Research