Europe Has Three Choices, Including Collapse: El-Erian

Investors need to prepare for three possible outcomes to the European debt crisis, including the worst-case scenario in which the monetary union is left in tatters, Pimco's Mohamed El-Erian told CNBC.

Mohamed El-Erian, chief executive officer and co-chief investment officer of PIMCO
T.J. Kirkpatrick | Bloomberg | Getty Images
Mohamed El-Erian, chief executive officer and co-chief investment officer of PIMCO

While Wall Street this week grew more optimistic that a longer-term solution is possible for debt-laden European Union nations, the co-CEO of the the world's largest bond fund manager warned that much needs to be done.

"This hope has to turn into reality. For that we need design and execution," he said. "We need to stabilize the banks there and, critically and importantly, we need to find a way both to contain debt and promote economic growth."

Signs this week that investors are still willing to buy the debt of troubled nations such as Italy — even though they demanded record-high interest rates— helped improve investor sentiment.

"They're making progress," El-Erian said. "The market is hoping they make even further progress. But the jury is still out as to whether that is going to materialize."

As such, investors need to brace for some difficult outcomes.

According to El-Erian's analysis, there are three potential scenarios:

1) "Fragmentation of the euro zone," in which the 17 member nations would go their own way, which he said would be "incredibly disruptive not just for Europe but also for the global economy."

2) "Full fiscal union," in which the nations adopt uniform financial reforms that would be more political in nature.

3) A "middle ground" in which a "smaller but stronger euro zone" emerges where as many as three countries default on their debt and exit the EU.

"We are no longer looking at what we call a traditional bell curve where there is one dominant outcome," he said. "We're looking at a curve that is much flatter and has much fatter tails. Investors have to test different exposures to that new distribution. That's what happens when you put sovereign risk at play."

The key to a positive outcome, he said, is negotiating a majority agreement among EU nations and then getting the European Central Bank to go "all in" in terms of committing the requisite amount to backstop the bad sovereign debt.

That all needs to happen in advance of the ECB's Dec. 9 summit to address the debt issue.

"That will absolutely turn the market and that's the key issue right now," El-Erian said. "I will tell you (the chance of an agreement happening) is less than 50 percent. A lot more has to happen in the next few days."