FRANKFURT (Reuters) - Euro zone central bankers are looking at the possibility of a shock to the currency area that could trigger its partial break up and their priority in such a scenario would be to preserve the system’s survivors, central bank officials say.
The European Central Bank is pressing governments to adopt tougher fiscal rules and has signaled it is ready to take stronger action to fight Europe’s debt crisis if political leaders agree to tighter budget controls.
In private, euro zone central bank officials say a lot of the pieces in Europe’s policy puzzle need to fall into place to calm financial markets and see off the crisis.
An official at one of the bloc’s 17 national central banks identified a collapse in a peripheral euro zone country’s banking system as something that could trigger a break-up of the bloc in its existing form.
The ECB hosted a crisis communications exercise with officials from national euro zone central banks late last month that included a commercial bank collapse scenario.
In the event of such a banking collapse leading to a country defaulting and - in a worst case scenario - leaving the euro zone, the central bank official said policymakers’ priority would be to protect the rest of the bloc.
“In such a situation, we have to safeguard the rest of the system,” the official said, adding that this could involve reshaping the euro zone’s EFSF rescue fund and recapitalizing banks.
Another euro zone central bank official pointed to Franco-German group Dexia as an example of a euro zone bank that recently got into trouble, requiring a government rescue, although the wider impact was limited.
The likely burden of bailing out Dexia led ratings agency Moody’s to warn Belgium its Aa1 government bond ratings may fall. Standard & Poor’s subsequently downgraded Belgium, saying funding and market risk pressures were raising the chances its financial sector will need more support.
Euro zone central bank officials have privately cited market expectations for a 20-25 percent chance of a euro zone break-up, though they believe markets will turn more positive if governments deliver the tougher fiscal rules the ECB wants.
They are loathe to speak about a “Plan B” - or crisis contingency planning - with heavy ECB involvement for fear that this will reduce governments’ incentive to push ahead with “Plan A”: implementing economic reforms, kick-starting the euro zone’s EFSF rescue fund and adopting tighter fiscal rules.
“What I think is important at the moment is not showing politicians that there might be an alternative, because in their mind that might be less costly than the options they have,” the central bank official said.
The ECB wants euro zone governments to agree a new “fiscal compact” and a summit of European Union leaders in Brussels on Thursday and Friday is an opportunity to agree on treaty change to anchor coercive budget discipline in the bloc.
German Chancellor Angela Merkel has said, however, that the “marathon” crisis will take years to solve.
In Britain, top officials are not waiting to see if their euro zone peers can deal with what Merkel says could be Europe’s toughest hour since World War Two. Instead they are already discussing a potential euro zone break-up scenario.
“The government together with the FSA and the Bank of England are making contingency plans against a wide range of contingencies,” Bank of England Governor Mervyn King said last week, without detailing the nature of the plans.
“Maybe it (the euro zone) won’t break up, maybe it will continue in various forms but maybe there will still be questions of default,” he added, openly acknowledging the possibility of the bloc ceasing to exist in its current form.
A third euro zone central bank official, although he did not comment on central bank contingency planning within the currency bloc, said it made sense for the Bank of England to make contingency plans, even if the chances of a country leaving the bloc were tiny.
Berenberg Bank economist Holger Schmieding said King’s remarks showed that contingency planning for a euro zone break-up was prudent, even though he did not believe that scenario will come to pass.
“Hopefully this has served the purpose of driving home to the ECB how worried the world is,” Schmieding said. “We’ve learned during this crisis that you may have to plan for a few contingencies which initially did not look very likely.”
Additional reporting by David Milliken, editing by Mike Peacock