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Italy Exits Before Greece in BofA Game Theory: Cutting Research

July 12, 2012

Italy Exits Before Greece in BofA Game Theory

Italy, the euro area’s third-largest economy , would enjoy a higher chance of achieving an orderly exit than others and would stand to benefit from improvements in competitiveness, economic growth and balance sheets, they said. Photographer: Alessia Pierdomenico/Bloomberg

Italy and Ireland have more incentive to quit the euro than Greece, while Germany may have limited room to prevent departures from the currency union, according to Bank of America Merrill Lynch.

Using cost-benefit analysis and game theory, BofA Merrill Lynch foreign exchange strategists David Woo and Athanasios Vamvakidis concluded in a July 10 report that investors “may be underpricing the voluntary exit of one or more countries” from the bloc.

“Our analysis produces a few surprising results that even readers who may disagree with our conclusion are likely to find interesting,” the strategists wrote.

Italy, the euro area’s third-largest economy, would enjoy a higher chance of achieving an orderly exit than others and would stand to benefit from improvements in competitiveness, economic growth and balance sheets, they said.

While Germany is the nation deemed able to leave the euro zone most easily, it has the least incentive of any country to quit because it would face weaker growth, possibly higher borrowing costs and a negative hit to its balance sheets, the strategists said. Austria, Finland and Belgium also have little reason to quit, they said, while Spain has the weakest case for leaving among economies most directly affected by the crisis.

The analysis is based on a framework which ranks eleven of the 17 euro-area nations on criteria such as how orderly their exit from the bloc would be and how it would affect economic growth, interest rates and balance sheets. Ireland and Italy received an average ranking of 3.5, while Greece was at 5.3 and Germany had the highest score at 8.5. The lower the number, the more there would be to gain from leaving.

Woo and Vamvakidis employ game theory to suggest that while Germany could “bribe” Italy to remain in the bloc and avoid the fallout from an exit, its ability to do so is limited. That’s because Italy has more reasons than Greece to leave so any compensation could become too expensive for Germany and Italians may be even more reluctant than the Greeks to accept the conditions for staying.

“If our inference turns out to be correct, this could have negative implications for markets in the months ahead,” they said.

* * *

The scarcity of water means countries that have it enjoy a trade advantage over those that don’t. That’s the conclusion of University of Virginia professor Peter Debaere in a paper published by the Centre for Economic Policy Research.

“Water systematically affects countries’ trade patterns in a manner consistent with international trade theory,” said Debaere.

Those with less try to protect their scarce resources by exporting fewer water-intensive goods. That means those with a lot of it enjoy a comparative advantage.

Because water is necessary for life, Debaere found prices are often distorted and regulated by governments. Still, it contributes less to exports than factors such as labor, so climate change and changing precipitation patterns may only cause moderate disturbances to future trade, he said.

* * *

Millions of jobs are being lost in the U.S. and Europe because countries from China to Switzerland are manipulating their exchange rates, according to Joseph Gagnon, an economist the Peterson Institute for International Economics.

By restraining their currencies, governments are distorting capital flows by about $1.5 trillion a year, Gagnon estimated in a study this month. That drains demand from economies that allow exchange rates to float freely.

“In other words, millions more Americans would be employed if other countries did not manipulate their currencies and instead achieved sustainable growth through higher domestic demand,” said Gagnon, a former Federal Reserve economist.

Gagnon identifies Japan, Switzerland, Israel, Singapore, China and Russia as among the countries massaging currency values. To force a change, he suggested those countries face taxes on their purchases of U.S. and euro area financial assets.

* * *

Even as forces such as Europe’s (SXXP) debt crisis and global monetary easing appear to affect currency values, Marc Chandler of Brown Brothers Harriman & Co. suggests U.S. stock markets may still hold sway.

Over 30 days, returns on the euro follow those of the Standard & Poor’s 500 Index (SPX) 59 percent of the time, Chandler, global head of currency strategy at Brown Brothers in New York, said in a July 10 report.

“The general take away is that despite a number of other drivers and influences, the correlation between most of the currencies we looked at and the S&P 500 has increased in the recent period,” he said.

Chandler links the closer correlation to investors shifting between favoring risk and avoiding it. That explains why the Australian dollar is among the most correlated currencies with the S&P 500 Index. Its 30-day correlation suggests it tracks U.S. stocks about 90 percent of the time.

“It’s really risk-off, risk-on with the S&P a proxy of risk,” said Chandler.

* * *

Two-thirds of cash-strapped euro area governments are falling behind their own projections for cutting budget deficits in 2012, according to JPMorgan Chase & Co.

In a sign the region’s debt crisis may continue to smolder, JPMorgan’s Malcolm Barr and Raphael Brun-Aguerre in a July 6 report cited skepticism that Italy, Spain, Ireland, Portugal and Spain can reach their goals, and predict “widespread target overshoot.”

As a group, the governments are forecasting their budget deficits will fall an average 2.7 percent of gross domestic product this year from 2011.

The data suggest Italy will fall short of its goal even as its fiscal position improves this year, the economists said. Greece’s primary deficit will narrow while its overall gap won’t, and Ireland will deliver less this year than in 2011, they said. Portugal and Spain are running wider imbalances.

* * *

Money matters when it comes to securing success in some Olympic sports.

A study by Goldman Sachs Group Inc. (GS:US) economists found an increase in gross domestic product per capita tends to boost a country’s chances of winning Olympic medals in cycling, judo, rowing and swimming. Weaker income effects apply to archery, canoeing, sailing and Taekwondo, the economists said in a report published July 11.

The London Olympics begins July 27 and the U.K. may benefit from playing host because doing so tends to have a positive effect on local athletes competing in cycling, gymnastics, rowing, sailing, swimming and wrestling. The hosts would be expected to see 1.5 to 3 more medals in each of these sports, the economists said.

To contact the reporter on this story: Simon Kennedy in London at skennedy4@bloomberg.net

To contact the editor responsible for this story: Craig Stirling at cstirling1@bloomberg.net


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