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Planning for an orderly break-up of the European Monetary Union
Jens Nordvig (Lead Author)
Head of Fixed Income Research Americas & Global Head of G10 FX Strategy Nomura Securities
Dr Nick Firoozye
Head, European Rates Strategy Nomura Securities
Submission to Wolfson Economics Prize 2012: The opinions expressed in this paper reflect the personal viewpoints of the authors, not an official view of their employer.
30 January 2012
Table of Contents
Summary.............................................................................................................. 4 Section 1: Possible break-up scenarios ........................................................... 6 We see a real risk of break-up .......................................................................... 6 A very limited eurozone break-up: possible ...................................................... 7 A big-bang eurozone break-up: possible .......................................................... 7 A sequential „onion peeling‟ break-up process: unlikely ................................... 8 Section 2: Legal aspects of redenomination ................................................. 10 Redenomination risk: Which Euros will stay Euros? ....................................... 10 The importance of legal jurisdiction ................................................................ 10 The need for an ECU-2 and EU directives in a break-up ............................... 12 Risk premia and legal jurisdiction.................................................................... 14 More detail on legal jurisdiction ....................................................................... 14 The judicial process ........................................................................................ 16 Enforcement .................................................................................................... 17 Legal aspects of redenomination and contingency planning .......................... 17 Section 3: Size of Euro assets by legal jurisdiction ..................................... 18 Euro denominated bond markets by legal jurisdiction .................................... 18 Euro denominated derivatives by legal jurisdiction ......................................... 20 Euro denominated loans assets by legal jurisdiction ...................................... 21 Information gaps and redenomination complexity .......................................... 21 Section 4: Cost-benefit aspects of planning ahead ...................................... 23 Uncertainty about the eurozone is affecting investor behavior ....................... 23 The private sector is making contingency plans in any case .......................... 23 Uncertainty makes risk-management difficult ................................................. 25 Section 5: Key steps in planning for a break-up ........................................... 26 Aiming to avoid unnecessary disruption ......................................................... 26 Four steps in an plan for and orderly break-up ............................................... 27 Section 6: Guiding principles for redenomination ........................................ 28 Guiding principles for redenomination of local law assets .............................. 28 Guiding principles for redenomination of foreign law assets .......................... 28 Section 7: The new European Currency Unit (ECU-2) .................................. 30 The advantage of the basket currency redenomination .................................. 30 Potential weights of the new ECU ................................................................... 31 A brief history of the original ECU ................................................................... 33 A few technical considerations around the ECU-2.......................................... 34 Section 8: A hedging market for intra-EMU FX risk ...................................... 35 The need for a hedging market for intra-EMU exposure ................................ 35 Creating instruments for hedging intra-EMU currency risk ............................. 36 Creating instruments for hedging ECU-2 exposure ........................................ 36 Ensuring efficiency of intra-eurozone NDF markets ....................................... 36 Section 9: New regulatory frameworks .......................................................... 38 The need for quantification of intra-eurozone currency risk ............................ 38 Risk limits for systemically important institutions ............................................ 39
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Section 10: Concluding remarks ..................................................................... 40 Appendix I: Illustrative bank loss calculations in debt restructuring scenarios 41 Appendix II: BIS data on international bond issues by Eurozone issuers ...... 44 Appendix III: Valuing new national currencies ................................................ 45 Currency risk in a eurozone break-up ............................................................. 45 A framework for valuing new national eurozone currencies ........................... 46 Quantifying current real exchange rate misalignment .................................... 46 Quantifying future inflation differentials ........................................................... 48 Valuation of new national currencies: A two-factor approach ......................... 50 The countries not in our story… ...................................................................... 51 How to interpret the results ............................................................................. 52 Appendix IV: Eurozone assets by legal jurisdiction – further detail ................ 54 Appendix V: How to value the new ECU ......................................................... 55 References ...................................................................................................... 57
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Two types of break-up scenarios for the Eurozone are possible, from a practical perspective: A very limited break-up scenario, involving the exit of one or a few smaller countries, and „big bang‟ break-up scenario, which would see the Euro cease to exist. A sequential „onion peeling‟ type of break-up process, which would see only stronger core countries remain in the eurozone, is highly unlikely to be possible as the process would become uncontrollable around the exit of a larger Eurozone country. Policy makers should therefore plan primarily for the very limited break-up as well as the full-blown break-up scenario. The latter could be highly disruptive from a macroeconomic standpoint in the absence of any detailed and thoughtful advance planning. Eurozone break-up risk has clearly risen notably during the second half of 2011 as European policy makers have failed to put in place a convincing and credible backstop for the larger eurozone sovereign bond markets. Given this increased risk, investors and policy makers should think carefully about dynamics associated with redenomination of Euro denominated assets and obligations in a break-up scenario. There are important legal dimensions to this analysis, including the legal jurisdiction of the Euro denominated assets and obligation in question. In order to determine which contingency plans would be helpful to facilitate and orderly break-up process, it is important to understand certain legal aspects of a redenomination process, including the differences between domestic and foreign law instruments. In making contingency plans for a Eurozone break-up, it is important to think about the size of exposures involved, including new currency risks which would ensure from a redenomination process. Since Euro adoption was supposed to be irrevocable, very little attention has been paid to legal jurisdiction of assets and obligations up to this point, and the related differences in redenomination risk. But our preliminary analysis highlights the very large contingent open currency exposure. In particular, the importance of the size of Euro obligations under English and New York law, in the form of FX swap and forward contracts, as well as interest rate derivatives, should not be underestimated. The huge size of these markets illustrates that complications related to the redenomination process around such assets and obligations have potential to cause very significant disruptions, with dramatic macro economic implications. There is a general perception that any attempt to make contingency plans for a euro-zone break-up would lead to increased investor anxiety. But investor concerns about the risk of a eurozone break-up are already present. Moreover, the new uncertainties around breakup risk and related legal and political uncertainties around a possible redenomination process makes it hard for investors to manage risk related to their eurozone exposures. At this point in the crisis, communicating contingency plans for a break-up would reduce uncertainty, rather than add to it, and potentially even improve the current capital flow situation. In preparing for an orderly Eurozone break-up, we propose four key step in a contingency plan for orderly currency redenomination. European policy makers should: 1) Offer forward-looking guidance on the redenomination process for local and foreign law assets; 2) Specify the role of a new European Currency Unit (ECU-2) in the redenomination of foreign law assets and obligations in a full-blown break-up scenario; 3) Create a hedging market for intra-EMU currency risk, allowing risk reduction ahead of a break-up event; and 4) Adopt regulation which over time is aimed at reducing intra-EMU currency risk for systemically important institutions. Communicating guiding principles for redenomination of Euro denominated assets and obligations under local and foreign law ahead of a break-up would be a crucial first step in an orderly redenomination process. Communication ahead of the event would allow market participants to prepare efficiently, helping to avoid triggering bankruptcies and other disruptions as a function of losses on new currency exposures. Clear communication on guiding principles for the redenomination process ahead of time would help resolve uncertainty in the planning process, and reduce delays associated with legal disputes following an actual break-up.
30 January 2012
A new European Currency Unit (ECU-2) could play an important role in facilitating an orderly redenomination process for the myriad contracts and obligations under foreign law without a clear country specific nexus. Specifying the role of a new European Currency Unit in the redenomination process would be an important second step in planning an orderly redenomination process. The ECU-2 would be a basket currency, and would be mechanically linked to the performance of new national currencies of current eurozone member countries in accordance with a pre-determined weighting scheme. The ECU-2 would play a crucially important role in facilitating efficient redenomination of foreign law contracts, which would otherwise be hard to settle in a fair and efficient manner. The ECU-2 would thereby serve to minimize unnecessary insolvencies due to protracted legal battles about redenomination issues and due to losses on new currency exposure associated with a redenomination scenario. To facilitate an orderly break-up process, market participants would need instruments to reduce intra-EMU currency risk ahead of an actual break-up taking place. A third step in the planning process would involve the creation of non-deliverable currency forward markets for potential new national currencies of eurozone member countries. This step would be an important component in facilitating risk reduction in relation to contingent intra-EMU currency exposures. The availability of an efficient hedging market for intraEMU currency risk ahead of a bread-up would serve to minimize redenomination related disruptions in an actual break-up. The fourth and final step in preparation for an orderly eurozone break-up would be to implement new regulatory frameworks. The purpose of such a framework would be to monitor and over time reduce intra-Eurozone currency exposure for systemically important institutions, including by taking advantage of newly created hedging instrument for this purpose. Given the prevalence of Euro denominated assets and obligations under foreign jurisdiction, such a process should have a global component in order to shield the global banking system from shocks emanating from a eurozone break-up. The four-step plan outlined here offers a framework for orderly currency redenomination in a break-up scenario, including a full-blown break-up scenario where the Euro ceases to exist. To be clear, this would be just one aspect of an overall plan for an orderly break-up of the European Monetary Union. But this specific aspect is likely to be a crucial one given the very large contingent open intra-EMU currency exposures which have been accumulated since 1999. Any plan for a break-up, which does not include a framework to ensure an orderly currency redenomination process, is an incomplete one, and one which significantly underestimates the large disruptive force associated with an uncontrolled and unmanaged redenomination process.
In December 2011. 2: Italian CDS and default probability EUR will remain in 10 yrs EUR is preferred currency 600 500 bp Over 30% probability of default 70% 65% 60% 400 300 200 55% 50% 100 0 Jan. “Do you think the euro will remain your nation‟s currency in 10 years?” Red bars represent respondents who answered “Yes” to the question. new ECB President Draghi even commented on the consequences of a break-up in a Financial Times interview. 1: Opinion poll measuring support for the euro 85% 80% 75% Fig. which would see only stronger core countries remain in the eurozone. Policy makers should therefore plan primarily for the very limited break-up as well as the full-blown break-up scenario. such as Greece. But the eurozone debt crisis has changed matters. When the euro was created.08 Note: Grey bars represent respondents who answered “Yes” to the question.30 January 2012 Section 1: Possible break-up scenarios Two types of break-up scenarios for the Eurozone are possible. “Do you prefer the euro to your past national currency?” Source: Nomura. which also define the rules of the monetary union. But the genie is out of the bottle. a key question is what form a potential break-up the eurozone could take. in our view: A very limited break-up scenario. policymakers wanted euro adoption to be irrevocable. where weaker peripheral countries gradually peel off. key European policymakers.10 Jan. Wall Street Journal Jan. The turmoil around the suggested Greek referendum on the bailout package in November 2011 illustrated that a break-up is no longer inconceivable. including French President Sarkozy and eurogroup head Juncker. involving the exit of one or a few smaller countries. like 6 .09 Jan. Bloomberg In this context. There are various theoretical possibilities: a one-off departure of a single country.11 Jan. do not contain any specific procedure for a eurozone breakup. is highly unlikely in our view. Fig. and various break-up scenarios are now being discussed more openly. Following then-Prime Minister Papandreou‟s proposal for a referendum. We see a real risk of break-up The treaties of the European Union. talked openly about a potential Greek exit from the eurozone. a sequential process. and they did not want to spell out a route to exit. which would see the Euro cease to exist. which could be highly disruptive in the absence of any advance planning. A sequential ‘onion peeling’ type of break-up process. European policymakers continue to argue that they will do „what is needed‟ to save the euro.12 Source: Nomura. and ‘big bang’ break-up scenario.
but as a very significant tail risk. A big-bang eurozone break-up: possible A big bang break-up could result from a default in a major eurozone country. Such a scenario would render the bulk of eurozone banks insolvent and leave the ECB incapable of providing liquidity to banks in an orderly fashion. Irish Finance Minister Noonan declared before Christmas 2011 that a referendum for an EU treaty change would be a referendum for euro membership.30 January 2012 layers of an onion. Moreover. where the eurozone collapses in one go and the euro ceases to exist. opinion polls suggest that support for the euro remains relatively high in the periphery (see Figure 1). highlighting once again how political developments can serve as catalysts for a break-up. 2011). For example. This determination should also help guide policy makers. and this implied default probability reached substantially higher levels during the most intense days of market turmoil in November 2011. which resembles peeling an onion. But that does not mean that a break-up is impossible. given the very large economic cost involved and the very significant political capital already invested. using standard recovery rate assumptions (see Figure 2). The market is pricing an Italian default not as the central case. Meanwhile. Recent deposit and capital flow dynamics in the eurozone suggest that destabilizing cross-border capital flows are starting to take place. which would translate into unwillingness to satisfy EU demands and the breakdown of bailout programs (see Nomura Europe Special Report: Event risk in Greece – December 1. A further deterioration in these dynamics could destabilize the banking system to a degree where concerns about a break-up could start to have a self-fulfilling element. even those which are not the central case outcome. Moreover. It will influence how various eurozone assets trade and the euro‟s behavior during the transition process to the final outcome. Hence. mirroring the type of capital flight dynamics typically seen in emerging market currency crises. in our view. this scenario would likely involve a full-blown collapse of the eurozone. a sequential and prolonged break-up process. A very limited eurozone break-up: possible A very limited break-up involving one or a few smaller peripheral countries is a possibility. But this view does not seem to be fully consistent with the default risk implied by Italian sovereign bonds and CDS contracts. 7 . We think only two main types of break-up scenarios (the very limited break-up and the „big bang‟ break-up) are realistically possible. in their efforts to make contingency plans for possible scenarios. This is especially the case if capital flows start to leak out of the eurozone. Distinguishing which of these break-up scenarios is possible (even if the probability is relatively low) and which is highly improbable (close to zero probability) is important. such as Italy. and it is doubtful whether the eurozone monetary system can withstand an Italian default. the possibility of an Irish referendum has become a real risk. accidents can happen in terms of economic and market developments too. is highly unlikely in our view. A break-up is unlikely to happen by explicit choice. More recently. The turmoil around the suggested Greek referendum in November illustrates how a „political accident‟ can suddenly put a break-up on the agenda. The current spread of 400bp on the 5yr CDS contract (as of end-January 2012) can be translated into implied default probability of just below 30% (over a five-year period). This scenario could happen in the face of a political setback in Greece and/or Portugal. The consensus among institutional investors we speak to globally is that this is a very low probability scenario. and a „big bang‟ break-up.
similar to the level in Italy currently.30 January 2012 A sequential „onion peeling‟ break-up process: unlikely We think a sequential break-up where the eurozone over time is reduced to a core of strong eurozone countries is highly unlikely to be feasible in practice.9 Italy 106.9 9. Italy is a part of Europe‟s core: Italy was one of only six founding members of the EU more than 50 years ago.2 13.0 100. at which point the euro project would be obsolete. Fig. Such an „onion peeling process‟. Hence.7 Note: See Appendix I. including the core countries. But after his resignation. There may have been some doubt about Italy‟s position and role under Prime Minister Berlusconi. At this point. Fig. But an Italian default and eurozone exit is a completely different matter. this additional contingent liability and a related drop in the level of French GDP could see the debt to GDP ratio jump to levels in the region 120%. 1 for further detail on exposure to eurozone periphery. such as Italy or Spain. Third. 3: French exposure to eurozone periphery countries French exposure to eurozone periphery ($ bn) Type of Exposure Greece Public sector Banks Non-bank private Total Source: Nomura. European policymakers have already articulated that an Italian default would spell the end of the European Monetary Union: When Chancellor Merkel and President Sarkozy meet with Mario Monti at the end of November 2011. the founding treaty of the EU was signed in Rome in 1957.5 38.8 44.8 680. Second. This is at least the conclusion if the time frame is just a few years. is likely to come to a halt when the process reaches one of the larger eurozone countries. The losses for French banks in a situation of Italian exit/restructuring could generate losses in excess of 20% of French GDP. Mr Monti‟s office released a statement saying that Ms Merkel and Mr Sarkozy were aware that the collapse 8 . Figure 3 shows the exposures of French banks to Italian assets based on BIS statistics. an Italian default and exit would likely bring down large parts of the eurozone banking system: An exit by Greece or Portugal may be manageable given that those countries are small.3 25. and an Italian debt restructuring may indeed be too much for the French banking system to handle.8 19. we think the process would likely become uncontrollable and lead to a big bang collapse. In fact.7 10.6 81. and Appendix 1 contains some illustrative calculations of potential losses for French banks. It is no coincidence that the ECB president is an Italian and that the previous ECB presidents were also from original founding member countries (Duisenberg from the Netherlands. and given that preparations for potential debt restructuring have already been under way for some time. Trichet from France).8 150.7 1.0 6. Given that the French debt to GDP ratio is already set to reach around 90% during 2012. BIS Ireland Portugal 2.7 Spain 30.2 6.0 416. There are three main reasons why we think an Italian exit and default scenario is unlikely to be manageable and would translate into a big bang collapse of the eurozone: First.3 32. Germany and France have strongly endorsed Mario Monti‟s technocratic government and Italy is clearly back in the core. during which weaker eurozone countries gradually exit.6 43.9 422.4 Total 157.5 55. The size of Italy‟s debt burden has precluded an explicit sufficient official sector backstop up to this point. an Italian default and exit scenario would likely make core eurozone banking systems so unstable that capital controls would be a distinct possibility.7 265.
which would minimize the disruptions associated with a very limited break-up and a full-blown breakup. policymakers already recognize that failure to limit contagion to Italy would likely lead to a breakdown of the monetary union altogether. in which the Euro ceases to exist.30 January 2012 of Italy would inevitably be the end of the euro. The conclusion is that policy makers should focus on contingency plans. Those are the two main adverse scenarios to plan for. 9 . We therefore believe that even if a break-up begins to unfold in an „onion peeling‟ fashion. As such. it will eventually spin out of control and turn into a „big bang‟ break-up of the eurozone.
then it may be up to the courts to determine the implicit nexus of contract. including the legal jurisdiction of the assets and obligation in question. Leaving the Euro zone: a user's guide. although we note that the Commission has specifically said exit was not possible. during its recent national congress the German CDU party approved a resolution that would allow euro states to quit the monetary union without having to also exit the EU. Similarly. 1 See P Athanasiou. the recent political reality has demonstrated that the lack of legal framework for an exit/break-up is unlikely to preclude the possibility. Given this increased risk. (see link). However. ECB Legal Working paper series no 10. there is some debate about the specifics of Article 50 of the Treaty on the Functioning of the European 1 Union (TFEU) and the immediacy of its applicability . There are important legal dimensions to this. Malta and Romania are not signatories to the Vienna Convention and this may complicate the international acceptance of Vienna-based methods of exit. If the currency is not explicit to the foreign contract. 10 . Since the risk of some form of break-up is now material. 2011-ECO-06. it shows the direction in which politics are moving. link.. If the obligation is governed by foreign law. Withdrawal and expulsion from the EU and EMU: Some reflections.g. investors and policy makers should think carefully about dynamics associated with redenomination of Euro denominated assets and obligations in a break-up scenario . e. Argentina moved away from an effectively dollar-based economy in 2002. currency unions have seen break-downs in the past. Redenomination risk: Which Euros will stay Euros? Countries do change their currency from time to time. then the country which is exiting the eurozone cannot by its domestic statute change a foreign law. We note that this decision would need to be approved by the national parliament before having any legal power. investors and policy makers 2 should be thinking about “redenomination risk ”: Which Euro denominated assets (and liabilities) will stay in Euro. In the context of the eurozone. it is important to understand certain legal aspects of a redenomination process. In order to determine which contingency plans would be helpful to facilitate and orderly break-up process. Moreover. 2 See. towards a flexible peso based currency system. If the obligation is governed by the local law of the country which is exiting the eurozone. Oct 2011. IESEG School of Management working paper series. etc). Eric Dor. We note that France. the issue of redenomination is complex because there is no well-defined legal path towards eurozone and EU exit.30 January 2012 Section 2: Legal aspects of redenomination Eurozone break-up risk has risen notably during the second half of 2011 as European policy makers have failed to put in place a convincing and credible backstop for the larger eurozone sovereign bond markets. which from a legal perspective should determine the risk of redenomination of financial instruments (bonds. Nevertheless. and which will potentially be redenominated into new local currencies in a break-up scenario? The importance of legal jurisdiction There are a number of important parameters. The first parameter to consider is the legal jurisdiction of an obligation. loans. then that sovereign state is likely to be able to convert the currency of the obligation from EUR to the new local currency (through some form of currency law). The break-up of the Czechoslovakian currency union in 1993 and the break-up of the Rouble currency area between 1992 and 1995 are key examples from the relatively recent history. In addition. Dec 2009.
such as Greece and perhaps Portugal. and full blown break-up scenario). would not easily be redenominated into a new local currency. if the specific contracts in question have a very clear link to the exiting country. the ECB would be dissolved. Treaties are merely contracts between sovereign nations and can be broken under some circumstances. end up exiting and adopt their own new national currencies. issued under local Greek law. We will go into detail later. Full-blown break-up: In this scenario. Similarly. This leaves four basic scenarios to consider. The second legal parameter to consider is the method for breakup. For example. and it may prove far more expedient to undergo a unilateral withdrawal rather than to wait for the vast array of agreements needed for consensual withdrawal. As discussed in section 1. depending on whether obligations in question are issued under local or foreign jurisdiction and depending on the nature of the break-up. This scenario materializes if a few smaller countries. This is the case regardless of the nature of the break-up (unilateral. it implies that Greek government bonds issued under Greek law (which account for 94% of the outstanding debt).30 January 2012 Applying this principle to a scenario of Greek exit from the Eurozone. then this would accord more international jurisprudential acceptance. but they can be grouped into two main possible categories: Limited break-up: Exit of one or more smaller eurozone countries. But before we do that. the situation around redenomination is more complex. or if there is an EU directive specifying certain agreed criteria for redenomination. and what it means for the existence of the Euro as a functioning currency going forward. For obligations issued under foreign law. perhaps precipitated by an Italian default. can be redenominated into a new Greek drachma. multilaterally agreed. there are many possible permutations. the Euro would cease to exist. However. foreign law contracts are highly likely to remain denominated in Euro. it is highly likely that redenomination into new local currency would happen through a mandatory statute/currency law. For example. expulsion could also be unlawful in theory. (which are issued under English law) or their USD-denominated bonds (under NY Law). There may be other methods for “opting out” in the use of Vienna convention on the Law of Treaties3 if there is no agreement on the usage of Article 50. Lawful and Consensual Withdrawal. this is one of the underlying reasons why the current Greece restructuring is contemplating swapping old Greek bonds under local law into new Greek bonds issued under English law. there may be certain foreign law contracts and obligations which could be redenominated into new local currency using the socalled Lex-Monetae principle. and all existing eurozone countries would convert to new national currencies or form new currency unions with new currencies. Greek bonds. 11 . the large majority of contracts and obligations are likely to stay denominated in Euro. There is debate about legal methods for exiting the Euro but there is some consensus around the use of Article 50 in the Lisbon Treaty. However. the Euro will likely remain in existence. In fact. Unlawful and Unilateral Withdrawal. Is the method a legal or multilateral framework or is it done illegally and unilaterally? The method for breakup has vastly different consequences for the international recognition. it is helpful to highlight the big picture: Unilateral withdrawal and no multilaterally agreed framework for exit. and may indeed stay denominated in Euros. Greek Eurobonds. In this scenario. Exit is multilaterally agreed. Greek Eurobonds issued under UK law should remain denominated in Euros. and new central banks. The third parameter to consider is the nature of the break-up. For obligations issued under local law. are highly likely to be redenominated into a new Greek currency if Greece exits the eurozone.
reversing the process observed for ECU denominated obligations when the Euro came into existence in January 1999. For example. such as GBP or USD. For now. as per terms implicit in English and NY Law contracts. Euro-Fragmentation. it is likely that a great many ambiguous cases result in arbitrary awards.30 January 2012 Full blown eurozone break-up: In a scenario where the eurozone breaks up in its entirety and the EUR ceases to exist. 4: Redenomination risk on eurozone assets Small Break-Up scenario: EUR remains the currency of core Eurozone countries Unilateral withdrawal Multilaterally agreed exit Full-blown Break-up Scenario: Euro ceases to exist Securities/Loans etc governed by international law No general redenomination: EUR remains currency of payment. While this has certain advantages given the overall flexibility of the Lex Monetae principle (see Box 3: Lex Monetae) for attempting inference as to the originally intended (and likely more equitable) currency of the contract. (2) where there is no specific nexus established to a country which previously used the EUR. Without some overriding statutory prescription. if English courts decided on redenomination into British pounds. see Procter. (and thus the Lex Monetae principle cannot be used). an EU directive could be implemented ensuring that existing EUR obligations are converted into a new European Currency Unit (ECU-2). We will address those issues in detail in Section 7 (“Do you remember the ECU?”). (1) obligations are redenominated into new national currencies by application of the Lex Monetae principle or there is significant rationale of the legal basis for the 3 argument of Impracticability or Commercial Impossibility . the Courts are left having to decide the currency of each contract. as case 3 The more common Frustration of Contract is unlikely to apply. In this case. with exchange rates as determined by directive. there are three basic solutions. or by Courts Fig. we simply want to highlight the introduction of the ECU-2 as a attractive option for settling payment on EUR obligations and contracts in the full-blown break-up scenario. 12 . legislation. contracts cannot for practical purposes continue to be settled in Euros. (3) Euro denominated obligations could in theory be settled in an international foreign currency. although certain EUR Redenomination happens either No redenomination: EUR remains contracts/obligations could be to new local currencies by the currency of payment (except redenominated using lex applying lex monetae principle or in cases of insolvency where local monetae principle (if there are by converting coart may decide awards) special attributes of contracts) contacts/obligations to ECU-2 and/or an EU directive setting criteria for redenomination Securities/Loans etc governed by local law Redenomination to new local currency (through change in local currency law. unless not in the interest of the specific sovereign) Source: Nomura The need for an ECU-2 and EU directives in a break-up There are a number of practical difficulties associated with creating a new European Currency Unit (ECU-2) to provide a means of payment on EUR denominated contracts and obligations. in the event of complete split-up.
it is highly likely that there is insufficient evidence to determine the link to the <Exiting Country> and the contract or obligation is likely to kept in EUR. it is altogether likely that national courts would only apply this directive in the case where the governing law is that of an EU country. It is generally established that sovereign nations have the internationally recognised right to determine their legal currency. Mann on the Legal Aspect of Money. Reliance on this principal was actually key to the establishment of the EUR itself (see W Duisenberg. most likely some last official EUR-GBP exchange rate before trading halted). the following parameters are likely to be crucial in order to establish the legal territorial nexus of contract/obligation: 1. As Governing Law is one of several determinants of the nexus of a given contract. As we will discuss in more detail later. 6th Ed. Sweden. Implicit Nexus of contract if a. essentially to the effect of: Where the EUR was previously the currency of denomination of any contract that is not so determined to have a nexus to any one particular country which had previously used the EUR. Cap Markets Law J (2011) 6(1) (see link) or The Greek Crisis and the Euro – A Tipping Point.. England. i. Denmark and the CEE.g. the lack of an economically fair unit for settling purposes would likely lead to a large number of redenomination related bankruptcies.. c. If one or more of the implicit tests fails. Was EUR meant to be EUR or the currency of the <Exiting Country>? If all of the factors mentioned tie the contract to the <Exiting country>. 13 . While courts themselves will be unable to apply a conversion to a new ECU-2 without some overriding legislation. see C Proctor. Explicit Nexus of contract can be established via a (re)denomination clause: The EUR or in any event the legal currency of <Exiting Country> from time to time.e.. This is the key attraction of a new European Currency Unit. Furthermore this directive could only apply where there was no means for the courts to infer a nexus of the contract under the other typically usual terms of Lex Monetae as highlighted in the grey box below. and would depend crucially on conversion rates decided upon by courts. not in the Eurozone. see link). The Euro-fragmentation and the financial markets. 2005 (see link). b. d. the vast majority of English Law contracts originally denominated in EUR will remain in EUR (if it exists). Oxford UP. C Proctor. there is a rebuttable presumption that the parties to the contract had intended to contract on the currency of the <Exiting Country>. it would be necessary for the EU Council to adopt a directive. Box 1: Lex Monetae Lex Monetae or “the law of money” is a well determined principle with a great deal of case law. For a brief overview of the principle. The Past and Future of European Integration: A Central Banker‟ s Perspective. Northern Ireland. Scotland. place of payment) is <Exiting Country> Place of payment is <Exiting Country> 2. Wales. (i. clearly the redenomination process would involve currency risk that would seem rather arbitrary. When thinking about the likely redenomination process. it will henceforth be redenominated into the ECU. If no denomination clause exists. IMF 1999 Per Jacobsson Lecture. We expect that under this principle. it is up to the courts to determine the Implicit Nexus of the contract.30 January 2012 law gives precedence to (as highlighted by Charles Proctor). June 2011 (see link) and for a more in-depth exposition as well as the history of case law. Contract is governed by the Laws of <Exiting Country> Location of Obligor (debtor) is <Exiting Country> Location which action must be undertaken (e.e.
These include the various swap agreements from ISDA (under NY or English law) to those under French. Ireland. This is an extremely complex issue to think about in totality. as well as the various Repo and Securities Lending master agreements and MTN platforms for issuing bonds. Covered Bond law for Pfandbriefe. This conclusion is based on the implicit assumption that a new national currency would trade at a discount to the Euro. Spain and Italy. If hair-cuts on foreign law bonds are higher than local law bonds. there are some countries which have issued international bonds (i. Hence. Obviously the validity of this assumption will depend on the specific country in question. Company Law for Equities) which governs each security. but most would agree that this assumption is likely to be correct for countries such as Greece. The table below highlights the legal jurisdiction of a number of key eurozone assets. as foreign law is only used as a means of contracting outside of a local jurisdiction. and there is a less clear-cut case for differing risk premia based on different jurisdictions. for international investors) under local law. In any case. This distinction is especially relevant in scenarios where the break-up is limited. foreign law obligations may remain denominated in Euro (in a limited breakup scenario). While we cannot claim completeness. Banking Law for deposits. and our analysis in Appendix III substantiates this. in an insolvency. making the outcome of a redenomination far less certain given the ambiguity of the nexus of the governing law. In the case of insolvency. Moreover some master agreements such as MTNs may be flexible enough as to allow the issuance of bonds to be under various different governing laws.e. English or NY and the body of law (e. we have attempted to highlight the appropriate governing principals.. the only relevant body of law likely will be contract law. But there could still be a material hair-cut on foreign law obligations. whether Local. German or Spanish law. whether local law obligations should trade at a discount to similar foreign law obligations will then depend on an evaluation of the higher redenomination risk relative to the size of likely haircuts on local law vs foreign bonds. 14 . In the alternative scenario of a full-blown break-up. while BTPs and GGBs are governed by local statute and local contract law and for the most part international bonds (Rep of Greece Eurobonds.g. In the case of English or NY law. individual swap and bond transactions can be documented quickly and efficiently. For instance. given the greater redenomination risk for local law instruments. redenomination into new local currency or ECU-2 is possible even for foreign law bonds. The caveat to this argument is that insolvency may alter the conclusion. and no specific foreign statute could have an impact. What is obvious as well about this table is the vast number of master agreements which underpin most financial transactions. policy makers would need to understand issues around the redenomination process in detail. and it would require significant leg work by key European institutions to aggregate issued at the micro level to a full macro perspective. Portugal. the immediate conclusion from an investor perspective should be that assets issued under local law should trade at a discount to foreign law obligations. and Rep of Italy Eurobonds) are governed by English law or NY law. and this type of differentiation based on redenomination risk is already starting to impact investor behavior. that could negate the redenomination effect. We give examples of the various financial instruments which trade. and foreign law bonds should no longer trade at a premium in this scenario. Each master agreement involves far more paperwork than a single standalone swap contract or bond. But the setup costs ensure that once the master agreement is finished. and where the EUR remains a functioning currency. contract or interest.30 January 2012 Risk premia and legal jurisdiction The overall conclusion from our perspective is that the risk of redenomination of EUR obligations into new local currency is higher for local law obligations than for obligations issued under foreign law. More detail on legal jurisdiction In making contingency plans for various break-up scenarios.
Kauri. Covered etc) Schuldscheine Schuldscheine (marketable loans) Cedulas. Maple. Bunds. Electricity Gold Swaps/Forwards. Irish CBs Cedulas. CDS.WBA ATX BEL20.e. Obligacions Foncieres. Dim Sum. etc English Contract.schuldscheine Banking schuldscheine Any EU Equity Any EU Equity Any EU Equity CDs CDs Greek CDs Euro-bonds.. Schatz. Bunds. Pfandbriefe. etc Pfandbriefe. etc Bulldogs. EIB MTN Programmes English Contract English Contract English Contract NY Contract NY Contract NY Contract English Contract English Contract English Contract English Contract English Contract English Contract NY Contract NY Contract NY Contract English or NY Contract English or NY Contract English or NY Contract Other Other Other Bond Futures (Eurex) Bond Futures (Eurex) Bond Futures (Eurex) IR Futures (Liffe) IR Futures (Liffe) IR Futures (Liffe) Equity Futures Equity Futures Equity Futures OTC Futures OTC Futures OTC Futures Clearing Houses (LCH. Bond options IR Swap/Fwd. Schatz. Electricity Gold Swaps/Forwards. Samurai. OATs GGBs. MIB. BEL20. Rep Italy. Kingdom of Spain. Kingdom Rep of Bunds. EIB MTN Programmes WB. etc Swaps/Fwds. CAC40. IDX. FX Swap/Fwd. Rep Italy Eurobonds. OF. Rep Italy Eurobonds. Italy. All cash sales prior to settlement (i. IBEX. etc Rep of Italy. etc with German Swaps and Repos Swaps and Repos with German Swaps and Repos with German counterparties counterparties counterparties Swaps with French counterparties and Swaps with French counterparties and Swaps with French counterparties and all local authorities all local authorities all localwith Spanish counterparties Swaps authorities Swaps with Spanish counterparties Swaps with Spanish counterparties Repo Agreements Repo Agreements Repo Agreements Standard NY Law Repo Agreements Standard NY Law Repo Agreements Standard NY Law Repo Agreements Repo with Euro-systems NCB/ECB Repo with Euro-systems NCB/ECB Repo with Euro-systems NCB/ECB Sec lending Sec lending Sec lending Sec lending Sec lending Sec lending WB. MIB.e. etc Yankees. etc) Clearing Houses (LCH. IR Swap/Fwd. Dim Sum. Kingdom of Belgium USDGreek Euro-bonds. Yankees.Bonds (Pfandbriefe. Bills Security Type International Bonds International Bonds Sovereign Bonds. Bills Sovereign Bonds. Dim Sum.WBA ATX BEL20. OF. ICE. OATs of Spain. Kingdom of Belgium USDdenominated bonds denominated bonds Euro-Loans Euro-Loans Euro-Loans Yankees. Banking Irish CBs Banking schuldscheine Cedulas. CAC40. IBEX. CDS. DAX. Kangaroos. Bobl. Corporate Bonds Cedulas. Kingdom of Spain. Irish CBs Pfandbriefe. CDS etc via clearing houses All cash sales prior to settlement (i. Kauri. Obligacions Foncieres. Kangaroos. Samurai. Electricity Swaps/Fwds. Bobl. PSI-20. SX5E. CDS etc via clearing houses Repo. Schatz.. Maple. Sukuk. DAX.. Covered Bonds (Pfandbriefe. IDX. etc) Cedulas. Sukuk. Kangaroos. PSI-20. Cedulas. DAX.e. Bulldogs. Bulldogs. FX Swap/Fwd. etc English Contract.30 January 2012 Fig. etc) Cash Sales Cash Sales Cash Sales German Contract German Contract German Contract English Contract English Contract English Contract Local Law/English Law Local Law/English Law Local Law/English Law English or NY Contract English or NY Contract English or NY Contract English Contract. BTP Futures on Exchange Exchange Exchange Euribor Contracts on Exchange Euribor Contracts on Exchange Euribor Contracts on Exchange SX5E. etc) Clearing Houses (LCH. MIB. etc English Law English Law English Law NY / Other Law NY / Other Law NY / Other Law Master Agreements Master Agreements Master Agreements Corporate Bonds (Euro-bonds) Corporate Bonds (Euro-bonds) Loans (Euro-Loans) Corporate Bonds (Euro-bonds) Loans (Euro-Loans) Commercial Contracts Loans (Euro-Loans) Commercial Contracts Sovereign Bonds Commercial Contracts Sovereign Bonds Sovereign Bonds Corporate Bonds Corporate Bonds Loans Corporate Bonds Loans Commercial Contracts Loans Commercial Contracts International Swap Dealers Commercial Contracts International Swap Dealers Association Swap International(ISDA) Dealers Association (ISDA) Commodity (ISDA) Association Master Agreements Commodity Master Agreements Commodity Master Agreements Rahmenvertrag für Rahmenvertrag für Rahmenvertrag für Finanztermingeschäfte (DRV) Finanztermingeschäfte (DRV) Finanztermingeschäfte (DRV) Fédération Bancaire Française Fédération Bancaire Française Fédération Bancaire Française (AFB/FBF) (AFB/FBF) (AFB/FBF) Contrato Marco de Operaciones Contrato Marco de Operaciones Contrato Marco de Operaciones Financieras (CMOF) Financieras (CMOF) Financieras (CMOF)Repurchase ICMA Global Master ICMA Global Master Repurchase ICMA Global Master Repurchase Agrement (GMRA) Agrement (GMRA) Agrement (GMRA) Agreement Master Repurchase Master Repurchase Agreement Master Repurchase Agreement (MRA) (MRA) (MRA) European Master Agreement (EMA) European Master Agreement (EMA) European Master Agreement (EMA) General Master Securities Loan General Master Securities Loan General Master Securities Loan Agreement (GMSLA) Agreement (GMSLA) Agreement (GMSLA) Agreement Master Securities Loan Master Securities Loan Agreement Master Securities Loan Agreement (MSLA) (MSLA) (MSLA)Medium Term Note (Euro) Medium Term Note (Euro) Medium Term Note (Euro) Programme (MTN/EMTN) Programme (MTN/EMTN) Programme (MTN/EMTN) Contract Contract Contract Contract Contract Contract Contract Contract Contract Contract Contract Contract Contract Contract Contract Contract English Contractor NY Contract English or NY Contract English or NY Contract Various for each commodity Various for each commodity Various for each commodity German Contract German Contract German Contract French Contract French Contract French Contract Spanish Contract Spanish Contract Spanish Contract IR Swap/Fwd. Bond options Gold options BondSwaps/Forwards. FX Swap/Fwd. 5: Governing law and standard financial securities and contracts Governing Law Governing Law Local Law Local Law Law Governing Local Law Security Type Security Type Sovereign Bonds. ICE. BTP Futures on Bund. CDS etc via clearing houses Repo. etc GGBs. CAC40. OF. Bobl. Kauri. EIB MTN Programmes WB. before T+3) before T+3) Source: Nomura 15 . CDS. Kingdom of Belgium USDdenominated bonds Eurobonds. IBEX.WBA ATX Client back-to-back futures with Client back-to-back futures with Client back-to-back futures with member firm member firm member firm Repo. All cash sales prior to settlement (i. Bills International Bonds Corporate Bonds Corporate Bonds Covered Bonds (Pfandbriefe. etc Sales or Transaction Sales or Transaction Sales or Transaction Bund. Rep Italy. etc Swaps/Fwds. Sukuk. Obligacions Foncieres. PSI-20. etc) (marketable loans) Loans Loans Schuldscheine (marketable loans) Equities Equities Loans Equities Commercial Contracts Commercial Contracts Deposits Commercial Contracts Deposits Sovereign Deposits Bonds Sovereign Bonds Sovereign Bonds Body of Law Body of Law Local Statute/Contract Local of Law Body Statute/Contract Local Contract Local Contract Local Statute/Contract Local Contract Contract Contract Covered Bond Law Covered Bond Law Contract (Pfandbriefe) (Pfandbriefe) Law Covered Bond Contract Contract (Pfandbriefe) Contract Contract Company Company Contract Company Contract Contract Banking Contract Law Banking Law Contract Banking Law Contract Contract Examples Examples GGBs. Maple. ICE. OATs Examples Rep of Italy. SX5E. Rep Italy. BTP Futures on Bund. IDX. Samurai. Rep Italy Greek Euro-bonds.
We thus expect that foreign law will insulate contracts from redenomination in the vast majority of cases. it is likely that local law sovereign bonds will immediately be redenominated. 4 The more common Frustration of Contract is unlikely to apply. and unless otherwise directed. Unlawful and Unilateral Withdrawal . a Legal tender law from an exiting country in flagrant violation of the treaties will be considered to be manifestly contrary to UK public policy and the Lex Monetae of the Exiting Country will likely not be upheld in UK Courts. because the UK was signatory to the treaties. the Euro will remain the currency of payments. The one overriding concern would be the introduction of legislation (NY or EU/English) which circumvents any court decision. 16 . will do so in all cases when the method of exit is unilateral and illegal. Alternatively. contracts cannot for practical purposes continue be settled in Euro‟ s. there will likely be some variance as to courts’ decisions based on both the method for introduction of the new currency and any legislation directly binding on the courts. it is unlikely that any such legislation would occur unless there were complete breakup.No redenomination -. We note that the difference between lawful and unlawful exit/breakup is crucial for UK courts. In this case. With specific mention of sovereign bonds. would likely remain in EUR.As UK is signatory to the Treaties. while the foreign-law bonds. This is. leave in euro. It is particularly likely that contractual terms will be changed to re-denominate all local law contracts. in particular.30 January 2012 The judicial process In terms of the judgment. NY/Other Courts: Lex Monetae principle: If legal nexus is to the exiting country then redenominate. EU Directive/UK Statute to redenominate and ensure continuity of contract: English Court must uphold UK statute and/or interpret UK Statute so as to be in agreement with EU directive and re-denominate. NY (or other) Statute to redenominate and ensure continuity of contract. see Protter. In a scenario where the eurozone breaks up in its entirety and the EUR ceases to exist. NY Courts must uphold NY State Legislation and redenominate contracts if so directed. existing EUR obligations are converted into a new European Currency Unit (ECU-2). The general criteria for decision is as follows: Local Courts Specific Legislation (a currency law) for Redenomination of Local Contracts into new currency can bind courts and overrule any contractual terms. unlawful withdrawal is manifestly contrary to UK public policy and no redenomination will likely allowed. Either obligations are redenominated into new national currencies by application of the Lex Monetae principle or there is significant rationale of the legal 4 basis for the argument of Impracticability or Commercial Impossibility . and in the UK in particular. English Courts: Lawful and Consensual Process implies application of Lex Monetae principle: if legal nexus is to the exiting country then redenomination can happen in some cases. although due to the politics of exit. Otherwise. there are two basic solutions. Otherwise. reversing the process observed for ECU denominated obligations when the Euro came into existence in January 1999. with obvious international distribution. Euro-Fragmentation. The legality of exit is of little consequence to NY and other non-EU courts and probably will not prejudice their judgments.
however.30 January 2012 Enforcement The court of judgment is of some matter. if the court is: Local Court: Courts will enforce only in the local currency (as per the new Currency law) and conversion will take place at the time of award or at some official rate (which may differ from the market rate (see Nomura’s Global Guide to Corporate Bankruptcy. 21 July 2010. There probably will be uncertainty over the timing of payment and the conversion rate may not be at market rates. In particular. This would be true. but exchange controls may further complicate repatriation of awards. but foreign law affords far greater protection. conversion is generally made at time of insolvency filing (irrespective of eventual award). but the court of enforcement is of paramount importance in determining payoffs.) Insolvency: If the entity is undergoing an insolvency governed by local law. appear to give little comfort to holders of either Greek or foreign law debt. for Greek bonds. Generally. In the next section. If there is an exit. The current PSI discussions underway. A detailed understanding of these conceptual issues is a prerequisite for adequate contingency planning in an orderly redenomination process for European policy makers. investors look to Greek Eurobonds for the extra protection afforded by English Law in an attempt to avoid some of the restructuring risk in GGBs. we will offer some preliminary estimates of the size of various Euro exposures. link. Insolvency: If English or other court is determined to be the appropriate jurisdiction for insolvency. If. foreign law instruments may similarly afford little protection. on the other hand. then delivery in appropriate foreign currency (see Global Guide to Corporate Bankruptcy. If on the other hand the exit also involves an insolvency. Proper planning for orderly redenomination should be guided both by the underlying conceptual legal aspects of redenomination as well as the economic importance of certain types of exposures currently in place across the broadest possible spectrum of relevant markets. link) The combination of the award and the enforcement risk highlight a number of interesting credit concerns. for instance. English NY/Other Court: Redenomination is unlikely to change the award and enforcement will likely be made in appropriate foreign currency. local law instruments will typically be redenominated and there will be little protection in them. Legal aspects of redenomination and contingency planning The purpose of this section has been to outline a number of important legal aspects of a currency redenomination process in a Eurozone break-up. broken down by legal jurisdiction. it would make more sense for the Greek government to continue to service their GGBs using seignorage revenue (or perhaps with support of the CB) and default on the overly expensive Eurobonds. 17 . we take exit into account.
and the aggregate currency risks potentially associated with a redenomination process. forward. it is instructive to break eurozone assets and obligations into their legal jurisdiction. One source which can be used to get a sense of the break-down of eurozone assets by legal jurisdiction is Bloomberg. good and detailed information about the legal jurisdiction of assets is generally not available. Slovakia. and we believe Bloomberg is likely to cover the majority of bond issues. But information about legal jurisdiction is now becoming relevant. But even for the bonds. But there are ways to estimate the importance of foreign law assets and obligations. this is much easier said than done. Against this background. at least the larger ones relating to eurozone issuers (Appendix II compares the figures derived from Bloomberg with BIS data. which we analyzed in detail. bond markets offers more transparency than loan. involving bonds. interest rate swaps. Estonia and Luxemburg). We argued in section 2 that the legal jurisdiction of a given asset or obligations would play a crucial role in a redenomination scenario. Slovenia. In practice. as well as a myriad of derivative contacts. of which EUR14. from the 11 larger Eurozone countries (excluding Malta. bond by bond. The overall sample covers around EUR16. to try to extract this information. Euro denominated bond markets by legal jurisdiction Generally. include: EUR224b of foreign law bonds in the sovereign category. as well as interest rate derivatives. and swap markets. which are dominated by over-the-counter (OTC) transactions and therefore harder to monitor from an outsider‟s perspective. But such an exercise would be relatively straightforward to run. it is instructive to think about the size of exposures involved. very little attention has been paid to legal jurisdiction of assets and obligations up to this point. To be specific. including from a macro perspective. deposits. however. Key figures to note. The universe of Euro denominated instruments is rather large. In total. which is derived from this source does not cover bonds in Euro issued by non-eurozone issuers. however.30 January 2012 Section 3: Size of Euro assets by legal jurisdiction In making contingency plans for a Eurozone break-up. Information about the legal jurisdiction of such instruments has generally been ignored by market participants. 18 . the sample covers in excess of four hundred thousand individual bonds. since there is no official data available. and the overall magnitudes are generally similar). except in situations involving insolvencies. These estimates highlights the very large size of Euro obligations under English and New York law in the form of FX swap and forward contracts. the sample of Euro denominated bonds includes 436998 bonds. We scanned all debt instruments by eurozone issuers which are listed on the Bloomberg system. We note that the database. Cyprus. as a parameter to evaluate in order to assess systemic risks. The huge size of these markets illustrates that complications related to a redenomination process have potential to have dramatic macro economic implications. The tables below show a general break-down of bonds issues by eurozone issuers broken down by legal jurisdiction. There are ways. loans. fx forwards. for allocated issues.2 trillion were Euro denomination.0 trillion of bonds issued by Eurozone issuers. Since Euro adoption was supposed to be irrevocable.
i. this seems a smaller problem. This highlights that the redenomination process could be extremely complex for corporate debt in general. But for non-financial issuers (corporations) the information about legal jurisdiction is unknown for the majority of issues. Figure 6 below has the detailed figures broken down by the eleven Eurozone countries which we have scanned (Noting that amounts listed under the sovereign header include subsovereigns. it suggests that EUR1. For sovereign issues. If we apply this percentage to the entire population of Euro denominated corporate debt. as most issues have this information. among the issued with known jurisdiction we find that EUR432bn or 60% is under foreign law.. We note that the available data does not have information about jurisdiction for every single issue.30 January 2012 - EUR684bn of foreign law bonds in the financial issuer category.e.3 trillion could be issued under foreign law. and agencies): 19 . regions and municipalities. However. EUR432bn of foreign law bonds in the non-financial (corporate) category.
and interest rate swaps.9 % 100% 75% 25% 28% 72% 57% 9% 33% 1% Total 4494. we note that a number of Eurozone issuers seem to use German law rather than their own domestic jurisdiction.4 669.1 German 1. these markets are very large in size.8 200. offers additional detail on the specific foreign jurisdiction which applies.1 115. potentially in the EUR15-25trillion range.8 83.3 Source: Nomura. Bloomberg The table below. These contracts are generally written with reference to English and New York law. which would add significant complexity to any redenomination process.7 31.0 Local 121. estimate average maturity of contracts. Bloomberg Financial % 100% 31% 69% 68% 32% 89% 4% 3% 4% Amount Outstanding (EUR bn) 2304. but one way to proxy it would be to look at daily turnover statics. German. For the non-financial (corporate) issuers.6 1442.9 Other 2. We are not aware of any official estimates of the notional size outstanding of FX forwards. Figure 7. and New York. the most relevant foreign jurisdictions are English.4 983. FX swaps.0 Foreign 58. Meanwhile.7 New York 2. the importance of foreign law jurisdiction grows further. and less than that for sovereign issues. 7: International EUR-denominated bond amounts outstanding (EUR bn) Sovereign Amount Outstanding (EUR bn) Total 258. including for basic markets such as FX forwards.5 454. As it turns out.2 42. rather than broken down by individual Eurozone countries.1 English 51.2 574.5 489.6 Allocated 179.0 138.4 159. The main message here is that English law accounts for the majority of all foreign law issues.2 Euro denominated derivatives by legal jurisdiction Turning to derivatives markets. Moreover.9 26.7 1060. especially for sovereign and financial issuers.9 33.9 2302.3 706.8 1634.9 % 100% 29% 71% 65% 35% 79% 9% 7% 5% Nonfinancial Amount Outstanding (EUR bn) 1931. New York law applies to just below 10% of financial and non-financial issuance under foreign law. The outstanding notional of FX forwards and FX swaps is potentially very large.7 Unallocated 79.4 50. 6: Euro-denominated bond amounts outstanding in the eurozone (EUR bn) Sovereign Local Law Austria Belgium Finland France Germany Greece Italy Ireland Netherlands Portugal Spain Total 176 309 69 1421 1530 256 1517 114 282 107 638 6420 Financial Nonfinancial Total 459 446 115 2466 3916 360 2673 579 1363 244 1608 14230 Foreign Foreign Foreign Unknown Local Law Unknown Local Law Unknown Law Law Law 2 1 151 58 30 11 19 9 16 5 2 7 1 10 9 86 1 0 9 14 10 3 8 1 19 12 422 139 125 139 89 100 1 23 2053 66 130 54 16 43 9 5 19 18 47 2 3 1 74 14 567 141 90 17 43 210 0 0 51 111 49 0 15 239 15 0 188 81 131 23 196 448 13 2 39 16 22 16 2 26 74 16 490 32 33 14 32 279 224 80 3990 684 670 288 432 1443 Source: Nomura. and supplement with information about the Euro‟s share in these transactions 20 .7 1319. Fig.7 2191. For simplicity.30 January 2012 Fig.2 350. the data is reported as aggregate figures.1 3.
But this sample is not covering the entire spectrum of bonds outstanding. - - Working with the assumption of 22 trading days in a month. should seek to quantify the exposures at the institutional level to instruments of different jurisdiction. in order to determine implicit open currency exposures. Even excluding the exposure through Euro denominated interest rate swaps. aggregate exposure to foreign law Euro denominated instruments could easily add up to a figure well in excess of EUR30 trillion. and determine the need for planning across various 21 . it would be very complicated to redenominate such contracts in an economically fair fashion in a break-up scenario. we simply note that the outstanding notional amounts of Euro based interest rate swaps is also very large. it would create major redenomination issues in a break-up scenario. The average tenor of contracts traded is estimated to be roughly around 1 month. it would be possible to have issued an ABS securitization of Spanish assets under English law. based on input from Nomura‟s Foreign Exchange Franchise.30 January 2012 - The latest Tri-annual BIS surveys states daily FX market turn-over of $2. but the underlying contracts have several jurisdictions. may involve outstanding notional amounts in the region EUR15-25 trillion. In addition to the relatively well-defined exposure in bond markets (in the region EUR2. A common example is members facing Eurex under German law. Since it is generally the case that these instruments are traded predominantly under English or New York law agreements. The Euro share of FX market turn-over is 40%. there is a general lack of information about the legal jurisdiction under which loans are extended. In addition. One added complexity is the fact that many such transactions involve laws of several countries. FX related derivates. this would give a proxy estimate of outstanding notional of Euro denominated FX forward. Regulators. It is our understanding that a large portion of these loans are governed by foreign laws. when excluding spot transactions). swap and other derivates of around USD22 trillion. Euro denominated loans assets by legal jurisdiction As with derivatives contracts.5trillion. there is almost no aggregate data available on the legal jurisdiction of derivatives and loan contracts. again according to BIS. particularly English law . shows that total cross-border loan exposure in Euro reported by global banks add up to USD11 trillion. where banks generally intermediate trades which are meant to be economically hedged. as they would have no clear nexus to a given country. Information gaps and redenomination complexity The bottom line from the examples presented here is that Euro denominated exposure in foreign law contracts is very large.5 trillion). which were released in January 2012. Without going into details. For instance. The analysis above of bond market information is based on a sample of more than four hundred thousand bonds. in preparation for a possible break-up. there may be around EUR10 trillion such exposure in the form of cross-border EUR denominated loans. And since the majority of these instruments are governed by foreign law. There are similar complexities involving so-called back-to-backs. Regulators would need to investigate the break-down of assets by legal jurisdiction more carefully to close the current information gap. More importantly. but facing non-member investors in a back-to-back contract under English law. although we are not aware of any publicly available database to quantify the split by legal jurisdiction more specifically. BIS data for the third quarter of 2011. or EUR17 trillion at the current EURUSD exchange rate.
including English. which will be the cause for far greater scrutiny by regulators and Courts seeking resolutions which are the least disruptive to the majority of counterparties involved. In particular. 22 . New York and other jurisdictions. these derivative transactions and back-to-backs where several legs could potentially be differently redenominated.30 January 2012 jurisdictions.
Today. Since the Italian bond market came under pressure in mid-2011. the cost-benefit analysis is clearly different. and since policy makers are increasingly open about the possibility of various break-up scenarios. This is a departure from patterns observed up to November. policymakers made an effort not to spell out any procedures for an exit from the eurozone as euro adoption was supposed to be “irrevocable”. the cost-benefit analysis of planning ahead versus pretending that a break-up is not possible has shifted: Back in 1999. They have to. There is even evidence that some regulators outside the eurozone are asking banks to submit contingency plans for various eurozone break-up scenarios. But the genie is now out of the bottle. when euro weakness was concentrated versus the US dollar and the Japanese yen. rather than add to it. Euro weakness is now seen in the strength of currencies from both emerging markets and other European countries relative to the Euro. ranging from a very limited break-up (involving one or a few small countries). if it continues. In fact. and potentially even improve the current capital flow situation. But investor concerns about the risk of a eurozone break-up are already present. foreign investors have been looking to reduce their eurozone exposure across the board. the costbenefit analysis of announcing contingency plans for a break-up is very different to what it would have been in 1999. The types of market participants making such plans includes global central banks and major banking institutions. The world‟s biggest investors are already drawing up contingency plans. Uncertainty about the eurozone is affecting investor behavior There was no plan for a eurozone break-up when the European Monetary Union was created. As mentioned in Section 1. rather than add to it. as well as institutions within the EU are already trying to make contingency plans for a eurozone break-up. Moreover. various forms of eurozone disintegration are possible. 23 . The recent broadening of the euro weakness points to nascent capital flight out of the eurozone. Since fears about a break-up are already present and affecting investors‟ flows. In December 2011 and January 2012. The private sector is making contingency plans in any case Foreign investors around the world. both in the periphery and in the core. communicating contingency plans for a break-up would reduce uncertainty. This would be a disturbing development. to a full-blown break-up (which would see the euro cease to exist). we have also seen a shift in euro trading dynamics. At this juncture. The increasing risk of a break-up is already having an impact on investor behaviour. At this point in the crisis. ranging from the very limited break-up. it would have created unnecessary uncertainty to spell out procedures for and exit (although perhaps it could be argued that awareness of the exit possibility it would have avoided the seemingly irrational spread compression in Eurozone bond markets generally observed during 1999-2007). Against this background. since objective market based metrics are showing high default risk in the biggest eurozone bond markets. to the full-blown collapse of the monetary union. the elevated uncertainty about key legal and political aspects of a possible redenomination process makes it hard for investors to manage risk related to their eurozone exposures.30 January 2012 Section 4: Cost-benefit aspects of planning ahead There is a general perception that any mention of contingency plans for a euro-zone break-up would lead to increased investor anxiety. contingency plans would help to reduce uncertainty.
Fig. But in the second half of 2011. or EUR160bn annualized. This compares to an inflow of EUR270bn in H1. MOF. investors are no longer substituting from the periphery to the core. In the July to November period. there is now a certain type of stigma associated with European exposures. foreign investors purchased eurozone fixed income instruments to the tune of only EUR66bn. They were also selling out of core exposures. making it more difficult for US banks to hold such exposures. supports this notion. foreign sales appear to be broad-based. 8: Fixed income investment into eurozone (monthly by region of investors) (EUR bn) 80 US Japan Other area Total 60 40 20 0 -20 Net selling -40 2007 2008 2009 2010 2011 Note: 3 month moving average. But it could hint at a shift in preference for eurozone bonds within the official sector too. global central banks demand for Eurozone bond appear to have dropped too. Downgrades have hit Italian and Spanish bonds. private investors in Japan. including sales of core eurozone bond holdings. 24 . This was the case in 2010. Source: Nomura. For example. were large net-sellers of eurozone fixed income assets during August – November (see Figure 9). when weakness in the periphery tended to generate additional demand for German and French bonds. This is partly a function of slower global reserve accumulation than normal. More generally. for example. In addition. Only a small part of the eurozone bond market has consistently traded as a risk-free asset. and all major rating agencies have recently warned that France could see its AAA rating put in question. or EUR540bn annualized. Importantly. there has been no evidence of a substitution effect. and they were selling not only the three small peripheral countries. suggesting that concerns of a new type is driving investors away. US Treasury. which is less likely to be impacted by short-term changes in risk sentiment. But recent trends in Eurozone cross-border capital flows point to a new form of structural weakness. The fact that weakness in inflows into Eurozone debt instruments has persisted over the July-November period. and Spain/Italy. In fact. through ups and down moves in risk assets. and is a very large swing (see Figure 8).30 January 2012 There is no simple way to prove that these specific considerations are affecting investor investor behavior and flows. These factors point to a more structural form of weakness. Bloomberg.
Ironically. This specific scenario involves a host of very complex redenomination issues associated with the very large number of assets and obligations which are subject to English law (not the laws of the eurozone countries). foreign investors are leaving eurozone fixed-income markets. Spain/Italy. in which the euro would no longer exist as a currency. Source: Nomura. At the current time. A contingency plan for orderly asset redenomination in a break-up scenario could help alleviate investor worries about the tail-risk for eurozone assets. It is very difficult for investors to assess with confidence what would happen to certain assets and obligations in a break-up scenario: What is the redenomination risk for local law assets? How would the redenomination process work for the myriad of English and New York law assets? Against this background. November figure is Nomura estimate. spelling out guidelines for a eurozone breakup may – at this stage in the crisis – even help to reduce the risk of the break-up itself. there is now an opportunity to reduce ex ante uncertainty by offering a plan. This advantage comes in addition to the benefits such well thought out plans would have on market functioning in an actual break-up. 25 . Bloomberg.30 January 2012 Fig. 9: Japanese investment in eurozone fixed income (periphery. a suitable contingency plan will offer guidance on orderly redenomination of euro-denominated assets and obligations in a break-up scenario. The basic problem is that it is extremely difficult to predict with confidence how the redenomination process would work for such instruments. and may improve the current capital flow situation and funding costs for sovereigns. MOF. in part due to the uncertainty about break-up and redenomination risk. and core) (EUR bn) 8 Other countries Spain & Italy 3 peripheral countries Euro area total 6 4 2 0 -2 -4 -6 Net selling -8 2007 2008 2009 2010 2011 Note: Monthly figures calculated as 3-month moving average. As we will detail below. Uncertainty makes risk-management difficult Making contingency plans is currently very difficult given the huge legal uncertainty around the break-up process. Such guidance is crucial in connection with a full-blown break-up scenario.
this would raise the risk of more severe than necessary banking crisis. The huge size of Euro denominated assets and obligations (as illustrated in Section 3) would create new open currency exposures in a break-up scenario. with create a negative impact on actual and potential growth for a prolonged period of time. We will not try to directly quantify the negative effects associated with a disorderly and unmanaged redenomination process. the quality of the preparation will be crucial in determining the degree of disruption. 2) Specify the role of a new European Currency Unit (ECU-2) in the redenomination of foreign law assets and obligations. for which market participants would have had little chance to prepare.30 January 2012 Section 5: Key steps in planning for a break-up Having outlined the very complex legal aspects of redenomination of foreign law assets and illustrated the huge size of assets and obligations issued under foreign law. This would be a worst case outcome. court decisions on redenomination are likely to be inconsistent. and they are likely to be very slow. We propose four key elements in a contingency plan: 1) Offer guidance on the redenomination process for local and foreign law assets. and that investors are already making contingency plans for various scenarios. In a disorderly break-up scenario. There would likely be insolvencies associated with sovereign defaults. Aiming to avoid unnecessary disruption The fall-out from a disorderly redenomination process. A break-up of the eurozone is hardly going to be a smooth process. including those triggered by losses on new currency exposures associated with the redenomination process. a significant portion of bankruptcies would be arbitrary. Importantly. Nevertheless. Overall. and other financial market participants. A key goal for an orderly break-up process would be to reduce the amount of bankruptcies triggered by redenomination itself. with little forward looking guidance on the redenomination process. and would affect viable companies and financial institutions. 26 . An orderly break-up process should facilitate redenomination in a way where the break-up is not in itself a catalyst for unnecessary disruptions. potentially arbitrary from an economic stand-point. We have outlined that various forms of eurozone break-up are distinct possibilities. corporations. Combined with the current inability to hedge those exposures (as discussed in Section 8) suggests that a large wave of bankruptcies would be triggered in Europe and globally as a function of losses on new currency exposures associated with the redenomination for specific institutions. In the best of circumstances it is likely to be very disruptive indeed. although it would be an important an interesting exercise. but that is a separate matter. and that this is already having an adverse impact on capital flows. linked to specific court decisions. and 4) adopt regulation which over time is aimed at reducing intra-EMU currency risk for systemically important institutions. 3) Create a hedging market for intra-EMU currency risk. we are ready to outline key steps needed to facilitate an orderly currency redenomination process. would likely be to trigger a large number of bankruptcies among banks. But our prior is that these negative effects would be very large.
In the absence of such a framework. But the plan does present a framework for facilitating an orderly currency redenomination process. We propose the following four steps as part of the contingency planning: STEP 1: Communicate guiding principles for the redenomination of Euro denominated assets and obligations under local and foreign law in various break-up scenarios. disruptive capital flows. as a part of an overall package of contingency plans. Clearly this is only one aspect of managing an orderly break-up process. And it is certainly one aspect to which sufficient attention has not yet been given. STEP 4: Introduce a new regulatory framework to reduce intra-Eurozone currency exposure for systemically important institutions in preparation for a eurozone break-up. would have to be analyzed in detail separately. This four-step plan would not address the disruptions associated with sovereign defaults. and other important aspects of a holistic contingency plan. Those. including creating a non-deliverable FX forward market for potential new national currencies of current eurozone member countries and creating a hedging market for potential ECU-2 exposures following a break-up. STEP 3: Create a hedging market for intra-Eurozone currency exposure. But given the size of exposures involved. any break-up of the Eurozone is likely to be devastatingly disruptive. by encouraging hedging of potential new FX exposures.30 January 2012 Four steps in an plan for and orderly break-up Four specific steps would be important in a contingence plan for a break-up. nor does it outline plans for how to dissolve the ECB. and the current inability to manage risks around those exposures.. it is probably one of the most important aspects. These steps are aimed at avoiding unnecessary disruptions and bankruptcies associated with currency losses on new currency exposures resulting from a redenomination. STEP 2: Define the role of a new European Currency Unit (ECU-2) in the settlement of EUR denominated assets and obligations under foreign law in a full-blown break-up scenario. 27 . highlighting the importance of such specific contingency plans.
Nevertheless. But no single existing currency globally would provide a good and fair redenomination option. The so-called Lex Monetae principle could help establish an initial framework for redenomination of some assets and obligations. Guiding principles for redenomination of local law assets As mentioned in section 2. the key guiding principles for the redenomination of both local law assets and foreign law assets. As we will detail in the following section. and in some cases probably desirable from the perspective of limiting disruptive redenomination. Step 1 of an orderly currency redenomination process would be to communicate. 28 . and reduce delays associated with legal disputes following an actual break-up. Since the United Kingdom is a member of the European Union. then redenomination from euro to the new national currency is feasible. Fortunately. And the guidance will be particularly important in grey areas where exposures are large from a macroeconomic perspective. Clear communication on guiding principles for the redenomination process ahead of time would help resolve uncertainty in the planning process. there is a need to specify a role for a new European Currency Basket (ECU-2) in this scenario as a means to settle payments on Euro denominated assets and obligations. in planning for an orderly EMU break-up. helping to avoid triggering bankruptcies and other disruptions as a function of losses on new currency exposures. If it can be argued that the currency of a given obligation refers to the currency of a certain country. such as those outlined in Section 2. the majority of foreign law contracts (as indicated in section 3) are under the jurisdiction of English law. Guiding principles for redenomination of foreign law assets Importantly. it would generally be relatively straight-forward to devise a fairly efficient redenomination process for local law assets and obligations. to clarify areas of legal uncertainty. and it would be logical to use the same process in reverse in a eurozone break-up scenario. some form of redenomination would be necessary. In this scenario. there is an essential need to reduce the very high level of legal uncertainty about the process around redenomination of Euro denominated assets and obligations under foreign (non-Eurozone) law in a full-blown break-up scenario. as appropriate. by definition. following a limited for full-blown break-up. and the guiding principles of the redenomination process should specify the application of those principles in some detail.30 January 2012 Section 6: Guiding principles for redenomination Communicating guiding principles for redenomination of Euro denominated assets and obligations under local and foreign law ahead of a break-up would be crucial. nor would any of the potential new national currencies of Eurozone countries. Each Eurozone country. The guidance principles should correspond to established legal principles in the area. This was the process used for ECU denominated assets were redenominated into Euro in 1999. it would be beneficial to communicate guiding principles for this process. ahead of time. and make planning more efficient. Communication ahead of the event would allow market participants to prepare efficiently. there is an opportunity to use EU directives to guide the redenomination process for contracts under English law. should be able to redenominated assets and obligations in accordance with a new currency law. rather than the euro (the currency of the European Union).
29 .30 January 2012 This does not directly address the redenomination of Euro denominated assets under the jurisdiction of countries and states outside the European Union. But these assets and obligations are smaller in size (although derivates exposure under New York law is very significant). and it could be the case again in the future. Importantly. if an EU directive can offer guidance for redenomination of English Law and other non-eurozone EU area assets and obligations. there is hope that New York courts and other courts will follow that precedent. That was the case in connection with the redenomination of ECU denominated assets in 1999.
We have argued (in Section 3) that the notional value of contracts and obligations where a re-denomination into new national currencies would be problematic and potentially arbitrary is very large. When the Euro Falls Apart. Without claiming any great degree of precession. Hence. Contracts and obligations would continue to live on after the euro ceased to exist. 30 . they 5 Hal S Scott. In this context. A EUR/USD FX forward transaction between a Japanese bank and a US asset manager. The ECU-2 would play a crucially important role in facilitating efficient redenomination of foreign law contracts. crossborder loan contracts. Intl Fin 1:2 1998. and thereby serve to minimize unnecessary insolvencies due to protracted legal battles about redenomination issues and due to losses on new currency exposure. some of which could be purely a function of unpredictable court decisions Step 2 of an orderly currency redenomination process would be to specify the role of a new European Currency Unit (ECU-2) as a means of settling Euro denominated contracts under foreign law in a full-blown break-up scenario. fair and efficient as possible is an important goal in its own right. How the redenomination process would work for assets and obligations of this nature is crucially important since case law suggests that contracts and obligations are unlikely to be „frustrated‟ simply due to their redenomination.could play an important role in facilitating an orderly redenomination process for the myriad contracts and obligations that do not have a clear country specific nexus. From this perspective. making the redenomination process as smooth. we note that the Euro itself was created by the process of EU directives as well as passage of legislation in NY. and FX derivatives such as currency forward contracts (but excluding interest rate swaps). Examples where it would be very hard to link EURdenominated obligations to a specific country include: A EUR-denominated loan from a UK bank to a Polish corporation. 207-228 (see link) lists particulars of UK and NY adoption of legislation to ensure continuity of contract. we suggested that foreign law Euro denominated instruments could easily amount to something in excess of EUR30 trillion in terms of notional value. These statutes were passed to ensure continuity of the contract and in order to do so. The advantage of the basket currency redenomination The advantage of applying an ECU-2 based redenomination is that it removes legal uncertainty around obligations that would otherwise be difficult to re-denominate into national currencies. A fixed/floating interest rate swap between a French bank and a German insurance company. There are many examples of obligations and contracts where there is no clear nexus to a specific eurozone country. such as growth. a new European Currency Unit (ECU-2) – which would be a basket currency linked to new national currencies according to a pre-determined weighting scheme . Tokyo 5 and other localities (while some were determined to need no further statutes) . including in relation to macroeconomic performance.30 January 2012 Section 7: The new European Currency Unit (ECU-2) A new European Currency Unit (ECU-2) could play an important role in facilitating an orderly redenomination process for the myriad contracts and obligations under foreign law without a clear country specific nexus. The ECU-2 would be mechanically linked to the performance of new national currencies of eurozone countries in accordance with a pre-determined weighting scheme. including foreign law bonds. By issuing an EU directive. English courts would be instructed to interpret EUR in any contract to mean ECU-2 thereafter.
at a specified rate. The value of the new ECU would be mechanically linked to the performance of the new currencies of previous eurozone countries. However. For illustrative purposes. Fig.1% 1. we would focus on scenarios where all major eurozone countries will have a weight (as would be the case in a big-bang break-up). it does not make a large economic difference whether they are excluded or not. 10: ECU basket currency weights over time Original ECU weights Belgium Denmark Germany Greece Spain France Ireland Italy Luxembourg Netherlands Portugal UK Austria Finland Estonia Cyprus Malta Slovenia Slovak Republic Total Apr 1990 . Potential weights of the new ECU The specific nature of any break-up process would play a role in determining the weights of individual national currencies in a new European Currency Unit (ECU-2).7% 30.5% 9. If the break-up process happens in sequential fashion where weaker eurozone countries exit before the later full-blown break-up. shown in Figure 10 were determined based on the size of the economy and the magnitude of intra-EU trade.2% 4. provided that the break-up is multilaterally agreed.4% 20.8% 8. the new European Currency Unit (ECU-2) would be a basket currency linked to the new national currencies created after a break-up – akin to the original ECU basket (although there would be technical differences. and the redenomination process would mirror how ECU-denominated instruments were redenominated into euro in 1999. The original ECU weights.Mar 1995 Mar 1995 .3% 0.2% 100.5% 5. as detailed below).2% 20. But given their small size and small equity weights in the ECB. although no strict mathematical formula was applied. but it is more likely that the 31 .0% Note.2% 0.1% 8. if a break-up happens more like a big-bang.2% 0.3% 0.9% 9.1% 9. Based on our analysis in Section 1.6% 2. Source: Nomura.5% 31.8% 0.0% 7. A similar approach may be applied in the future.7% 0.8% 0.8% 1. ECB As mentioned.6% 0.8% 0. an EU directive could compel UK courts to re-denominate contracts into some official new currency such as the ECU-2. based on the idea that they could exit the eurozone before a bigbang collapse.3% 9. Ireland and Portugal are excluded.30 January 2012 specifically stated that frustrations that force major clauses.0% 100.2% 19. In order to ensure a timelier and more certain outcome. presumably all eurozone countries (including weaker eurozone countries) would have a weight in the ECU-2. redenomination clauses or the possibility of claiming material adverse change would all be overruled.9% 10.1% 10.Nov 1992 Nov 1992 .2% 1.Dec 1998 7.4% 2.7% 12.7% 32. then there would be zero weight attached to certain of the current eurozone countries in the new European Currency Unit. we also show weighting schemes where Greece.8% 4.5% 2.9% 11.0% 100.
4% 1.5% 4.7% 18.2% 1. based on the fair value estimates of individual eurozone currencies shown in Appendix III.1% 20. an additional caveat in relation to the weights is that the ECU would only work if new national currencies remain convertible and actively traded.3% 0.30 January 2012 ECB equity weights (derived from the size of the national population and GDP) will be used.8% 1.1% 2.8% 1. 11: Fair value estimates of a potential ECU-2 ECU-2 fair value estimation ECB Weights (A) Belgium Germany Greece Spain France Ireland Italy Netherlands Portugal Austria Finland ECU-2 calculations ECU-2 valuation 2.8% Sum (B * E) 1.1% 12. are shown in column B of the table. the estimate comes out at 1.6% 2. based on normalized ECB weights.9% Sum (C * E) 1.0% 12.9% 1. The current ECB equity weights are shown in Column A in Figure 11 below (in a raw and not normalized fashion). ECB Figure 11 above shows an illustration of an ECU-2 valuation exercise.96 0.9% 12. Source: Nomura. Note that we have excluded the six smallest eurozone countries from this calculation (Luxemburg.97 1. Malta.25 0. This is similar to the considerations behind the IMF‟s SDR basket.0% 3.7% 2.0% 19.3% 5. 32 . EUR. Ireland. Fig.8% 6. Greece. as one should expect potentially significant under-shooting of individual new national currencies and the ECU-2 basket relative to standard fair value considerations in the immediate aftermath of a break-up.02 1.8% 1.9% 2.71 1. This is because their weights are likely to be very small (their combined ECB weight is 1.4% 0. and this type of consideration could be used to exclude additional currencies.4% 18. Slovenia.86 1. given the need for sizeable risk premia.5% 27.16 Fairvalue in breakup (E) 1. Slovakia and Estonia).0% 13.6% 2. Portugal) (D) 3.57 0.36 0.8% 29.13 versus the USD (bottom row of table).9%) and because having very small and illiquid basket components in the new ECU may make it harder to manage from an operational perspective.25 - Note: ECU fair values are expressed in ECU/USD terms.7% 28.25 1.3% 14.8% 0. considerations around liquidity may make it preferable not to have very small currencies in the basket.13 ECU-2 weights (ex.0% 1. JPY and GBP). In our baseline case where all current eurozone countries. Baseline ECU-2 weights. This calculation is only shown for illustrative purposes. Greece) (C) 3.0% 2.8% 2.6% 18. Specifically.3% Baseline ECU-2 weights (B) 3. which only consists of highly liquid convertible currencies (USD. Such considerations could become particularly relevant in a situation where the break-up process creates a need for capital controls in certain countries (as discussed below). Linked to this.1% 22. except the smallest ones.21 0. Cyprus.14 ECU-2 weights (ex.7% 6. as appropriate.9% 1.5% 21.0% Sum (D * E) 1.5% 0. have a weight in the ECU basket.0% 8.
The process of re-denominating ECU obligations into EUR is also interesting as it involved an EU regulation that held that the introduction of the euro should not terminate (or alter the terms of) any legal instruments.10 ECU EUR 1. 1999. ECB Source: Nomura. 12: Spread between private ECU and official basket bp 200 100 0 -100 -200 Fig. a gap between the composite interest rate on underlying ECU currencies at the actual ECU interest rate (a fixing of which was administered by the BIS) also opened up. Denmark.20 1.40 1. including the State of New York. From 1979 to 1988. Finland and Sweden all had to exit the ERM in some form. The ECU originated as a basket of nine national currencies. each with its own particular weight based on such economic factors as the country‟s GNP and intra-community trade. Italy. FRB. This was the case especially during the ERM crisis. Spain. The value of the private ECU eventually converged to that of the underlying basket on increasing expectations (in 1997-98) that the ECB would eventually enforce par convertibility between the private ECU and the official ECU basket. Finally. however. Moreover. The ECU was intended to stabilize the national currencies and eventually create a single composite currency.50 1.90 0. new contracts were later based on the EURIBOR fixing). Initially. The exchange bands of the ERM had to be expanded to 15% in 1993. when the private ECU traded at a discount of 250bp to the basket. Linked to this. all EU area budgets were denominated in ECU and increasing portions of national debt over time. The ECU basket was adjusted in 1984 to include the Greek drachma and amended again in 1989 to include the Spanish peseta and the Portuguese escudo. the ECU was replaced by the euro at parity. which were ECU denominated futures. and from then on the private ECU was in principle a free floating currency. and only France. This „convertibility‟ at par ended in 1988. 33 . while the UK. including LIFFE futures.60 1. There was never an official mechanism to convert private ECUs one for one into the basket of the ECU currencies corresponding to the definition of the official ECU. several foreign jurisdictions. Moreover. settling at the BBA EUR LIBOR fixing. passed legislation to ensure that the euro was recognized as the successor to the ECU.30 1. (after the launch of the EUR. 13: ECU/USD and EUR/USD 1. Belgium and the Netherlands managed to avoid devaluations of central ERM parities. on 1 January. a group of private European clearing banks stood ready to convert private ECUs into the basket at par. Things changed during 1992 as tensions in European currency markets surfaced.00 -300 -400 90 91 92 93 94 95 96 97 98 0. A large derivatives market developed. These steps ensured that ECU obligations. ECB A brief history of the original ECU The European Currency Unit (ECU) was created by the European Monetary System (EMS) in March 1979.30 January 2012 Fig. the private ECU continued to trade close to par versus the official basket and this period of stability (1990-91) saw significant issuance of ECU-denominated debt instruments by European sovereigns and supranational institutions. Portugal.80 90 92 94 96 98 00 02 04 06 08 10 Source: Nomura.
during a reverse process of re-denominating euro obligations into ECU-2. its component parts would need to be transparently priced (likely with the BIS as pricing agent) and actively traded. from 1990 to 1998. The private ECU was to some degree anchored by expectation of eventual conversion of ECU assets into EUR assets. some provision would likely be needed to allow settlement of ECU-2 denominated obligations in national currencies. similarly to how certain currencies were excluded from the original ECU basket. To avoid problems associated with this lack of determinacy. based on official fixing rates between the ECU-2 basket and national currencies. in accordance with the market-based value of the ECU-2. there would be no such anchor because there would be no expectations of future conversion at a given rate. there would also be a need to shift from Euro interest rates to ECU-2 interest rates. including jumps in the ECU-2 exchange rate versus the Dollar and other global currencies. Capital controls and convertibility: If capital controls are imposed by a given country.g. But allowing delivery in one convertible currency would not address issues around lack of pricing transparency. However. Specifically. Differences relative to the original ECU regime: As mentioned above. it may make sense to exclude the currency of that country from the ECU-2 basket for operational reasons. and reweight the basket in a fashion which would minimize the fall-out. Such issues could be partially addressed by allowing settlement of payments on ECU-2 assets and obligations in one convertible currency (rather than delivering the components of the basket) in accordance with the market exchange rate between that currency and the ECU-2. ECU-2 interest rates: Linked to the currency redenomination. possibly with the BIS as a fixing agent for daily ECU interest rates. Transparent pricing: In order to use the ECU basket effectively for settlement and delivery purposes. with effect from 1 January.. A few technical considerations around the ECU-2 Settlement issues: Following the implementation of the EU directive and re-denomination into ECU-2 of certain contracts. having non-convertible currencies in the new European Currency Unit would be potentially problematic in relation to maintaining efficient settlement and pricing mechanism.30 January 2012 whether under local (EU) jurisdiction or foreign (e. and the weights stipulated in ECU-2 basket. or more specifically. could be smoothly redenominated into euro. an acceptable equivalent in a given new national currency. the private ECU traded freely in the market and there was no private or official mechanism in place to ensure it traded in line with its theoretical value. but the strength of this anchor varied based on the conviction of the market that eventual conversion would happen. this would be a blended interest rate. 34 . as defined by the weights of the individual ECU component parts and their market-based exchange rates. derived arithmetically from the underlying interest rates in individual eurozone countries. payment on contracts and obligations which were originally in euro would then be affected by delivering ECU-2. 1999. New York) law. as calculated from ECU-2 weights and the exchange rates of its component parts. and this could become a real issue in a situation of severe capital controls and potential dual currency regimes.
and a significant depreciation risk for the new Greek drachma (all estimates are expressed relative to the dollar. and as we will argue in the next section. and risk management of eurozone exposures has generally not been taking into account the redenomination risk associated with different Euro denominated assets and obligations: The risk of intra-Eurozone currency fluctuations following a break-up has generally not been incorporated into real-life risk management exercises. market participants would need instruments to reduce intra-EMU currency risk ahead of an actual break-up taking place. Commensurate with this new reality. Since the risk of a break-up is no longer negligible.requires identification and quantification of intra-Eurozone currency risk. A more prudent strategy would allow market participants to reduce intra-eurozone currency exposure ahead of a possible break-up. as well as efficient instruments to hedge those risks. These instruments would help to ensure the survival of a greater number of banks who should be able to exchange and mitigate some of the ongoing redenomination risk of which they are increasingly aware. Such hedging requires an instrument. it is generally perceived that a new German mark would be stronger than the Euro‟s current value. These estimates show a slight appreciation potential of the new German mark. The need for a hedging market for intra-EMU exposure A key element in risk management of intra-Eurozone currency exposure. as well as future inflation risk. and political considerations could hold back the process within the eurozone itself. where it is likely to be the most important. this is a potentially dangerous strategy. such risk reduction – in relation to intra EMU currency risk . This should include creating a nondeliverable FX forward market (NDF) for potential new national currencies of current eurozone member countries as well as creating a hedging market for ECU-2 exposures resulting from a break-up.30 January 2012 Section 8: A hedging market for intra-EMU FX risk To facilitate an orderly break-up process. Developments during 2011. based on a simple two-factor approach. this process is particularly important for systemically important institutions. we show some specific illustrative estimates of potential fair values for new Eurozone currencies. have shown that break-up risk is non-negligible. As a general point. Adoption of the Euro was supposed to be irrevocable. The creation of non-deliverable currency forward markets for potential new national currencies of eurozone member countries would be an important step in facilitating such risk reduction. The important point here is not the specific point estimates. depending on the type of exposures present at the micro level. But this process is in its infant stage. incorporating metrics of current misalignment. would be the creation of efficient hedging instruments. including sensitivity to redenomination of certain assets and obligations. Step 3 of an orderly currency redenomination process would involve creating a hedging market for intra-Eurozone currency exposure. but rather the general finding that a eurozone break-up would be likely to 35 . however. The availability of an efficient hedging market for intra-EMU currency risk ahead of a bread-up would serve to minimize redenomination related disruptions in an actual break-up. Some bank regulators are already asking major banks to present analysis of break-up scenarios. risk management practices are in the process of being amended to account for break-up and redenomination risk of within the Eurozone. In the appendix. which shields market participants against depreciation of potentially weak new eurozone currencies and against appreciation of potentially strong new eurozone currencies. It is generally perceived that a new Greek drachma would be substantially weaker than the Euro‟s current value. Similarly.
Cash settled in US dollars Maturity on specific quarterly dates. which would settle at expiry based on value of the German currency at that time. As is generally the case with non-deliverable forward contracts. once a liquid NDF market for new national currencies has been developed. If Germany has the Euro at the time of expiry. For example. Obviously. it would be relatively easy to develop hedging markets for future ECU-2 exposure. and this again highlights that consideration should be given to liquidity issues. China.30 January 2012 see large currency moves between the new currencies of the individual eurozone countries. Brazil. the contract would settle in accordance with the DEMUSD exchange rate at the time. and similar to the majority of NDF contracts (which are common in emerging market countries). If Germany has adopted a new German mark as its currency ahead of the expiry of the contract. Hence. an official fixing rate. likely corresponding to IMM futures. the contract would settle in accordance with the EURUSD exchange rate at the time. Creating instruments for hedging ECU-2 exposure Following on to the development of hedging markets for new national currencies. contracts would settle in USD at expiry. versus US dollar Official currency and FX rates determined by the country‟s central bank. There would be NDF contracts associated with each Eurozone currency. generally from the central bank. would be used to determine the specific pricing at expiry. Specifically. when determining the basket weights in the ECU basket (as discussed in section 7). Ensuring efficiency of intra-eurozone NDF markets Setting up and NDF market for new eurozone currencies may be relatively straightforward in theory. it seems likely that such a market will develop to some degree in coming 36 . we imagine a new market with the following characteristics: Non-deliverable forward (NDF) contract. there would be a German NDF. it would be a relatively little additional step to expand the menu of hedging instruments to include those needed to hedge ECU-2 related exposures. for standardization purposes.g. Market makers would be able to market markets in ECU-2 instruments (without taking excessive risk in the process) by hedging exposure in the basket components (the country specific NDF countracts). Creating instruments for hedging intra-EMU currency risk A so-called non-deliverable forward contract (NDF) could be used to allow market participants to hedge currency risks associated with current exposures (asset and liabilities) to certain eurozone countries. India Settlement based on FX rate of official currency of the current Eurozone member country. this would be a contract linked to their potential future national currencies. very similar to NDF contracts in many offshore emerging markets e. with new currencies entering the picture in a break-up scenario. the liquidity of the ECU-2 hedging market would be linked to the liquidity of the underlying NDF markets. Since current eurozone member countries don‟t have their own currencies at this stage. In fact. provided that guidance on the role of the ECU-2 and its possible weights is sufficiently explicit (in line with the issues discussed in section 6).
and such an option should be investigated as a part of the planning process for creating efficient hedging markets for intra-EMU currency exposures. the availability of hedging instruments would offer an avenue for risk reduction at the eurozone institutional level. it would make them more resilient in an actual eurozone break-up. the NDF market would allow banks. Global banks should be able to re-distribute the risk more efficiently (at an appropriate price) to financial market participants around the world. the market would need to have active participation from a diverse set of banks. including intra-EMU currency mis-matches. UK. including US.30 January 2012 quarters given that end-users are increasingly concerned about and looking to reduce Eurozone currency exposures. Having NDF contracts trade on an exchange could also help reduce counter-party concerns. as well as a diverse set of end-users globally. this would also serve as an avenue to reduce systemic risk in the Eurozone banking system. as well as in the run-up to the actual break-up event. Relative to the current situation. In addition. where risk is likely to be concentrated in certain eurozone financial institutions. Given that eurozone banks are likely to be under severe pressure from various sources in a break-up scenario. In order to build a liquid and efficient market. hedge funds. and make the hedging product more liquid. creating a hedging product is only one step towards creating and efficient hedging market. including asset managers. and other systemically important institutions to manage and limit their intra-Eurozone currency risk. 37 . etc. However. which would already be under severe pressure in a break-up scenario. having participation of global banks would be crucial in terms of limiting counter-party risks in an actual break-up. Moreover. it would be important that other global banks. In the ideal world. By reducing excessive exposures. Japanese and other banks would participate actively in the market.
such a process should have a global component in order to shield the global banking system from shocks emanating from a eurozone break-up. following the implementation of steps 1-3 of the contingency plan for orderly redenomination. within the Eurozone. Hence. Specifically. and other systemically important institutions.30 January 2012 Section 9: New regulatory frameworks The final step in preparation for an orderly eurozone break-up would be to implement new regulatory frameworks. particularly those within the Eurozone itself. But clearly very large intra-EMU currency exposures have been accumulated since 1999. they would need to sell peripheral currency risk through the newly created NDF markets. We will not go into detail with other sectors. The quantification of intra-EMU currency exposures is likely to show very large contingent open currency exposures for a number of institutions. should initially ask Eurozone banks. A new regulatory framework aimed at limiting disruptions associated with currency redenominations in a eurozone break-up would need to include several elements. The currency valuation estimates for new national currencies shown in Appendix III could be used for such an initial risk assessment. A Similar arguments can be made for French banks. would face devaluation risk on those assets in a break-up scenario. following a suitable transition period. Second. or reduce exposure by other means. German banks with significant exposures to other Eurozone countries on the asset side of their balance sheets. First. Over time. The need for quantification of intra-eurozone currency risk Regulators across the Eurozone. to quantify and disclose to regulators. German banks would have a significant need to hedge contingent intra-EMU currency exposures. and globally. The purpose of such a framework would be to monitor and over time reduce intra-Eurozone currency exposure for systemically important institutions. this would involve encouraging and ensuring reduction of potential new FX exposures in a break-up scenario. incorporating break-up related risks. and banks in other countries. there would be a need to encourage risk reduction in relation to intraEMU currency risk for systemically important institutions. This step of the preparation process can only happen after the initial step – clarification and communication of process and rules for redenomination – has already taken place. German banks. At the same time. which are likely to see relative appreciation relative to the rest of the Eurozone. and quantifying them across sectors and individual institutions would be a first step in a new risk management exercise. their intra-eurozone currency risk. including by taking advantage of newly created hedging instrument for this purpose. there would be a need to quantify intra-eurozone currency risk at the institutional level and at certain aggregated levels to evaluate systemic risks. Given the prevalence of Euro denominated assets and obligations under foreign jurisdiction. Step 4 of an orderly currency redenomination process would involve introducing a new regulatory framework to monitor intra-Eurozone currency exposure for systemically important institutions in preparation for a eurozone break-up. For example. possibly under the guidance of the EBA. 38 . which rely on local deposits would be likely to see those deposits redenominated into new DEM in a full-blown break-up scenario.
30 January 2012 Risk limits for systemically important institutions The final step in a new regulatory framework would be to impose risk limits on open intraEMU currency exposures in preparation for a break-up. 39 . This would obviously be a final step. Hence. to manage down intra-eurozone currency risk. if a break-up happened sooner. Sufficient time would also be needed to allow institutions a transitions period. and after hedging markets for intraEMU currency risk had developed. potentially spanning a number of years. there would not be sufficient time to notably reduce systemically important intra-EMU exposures ahead of the event. This in itself would be an argument to implement policies to delay a break-up. and one which could only be implemented after rules for the redenomination process had been spelled out and communicated. even if a break-up is deemed as ultimately inevitable by policy makers.
with major implications for economic output over a multi-year period. over time. This is just one aspect of an overall plan for an orderly break-up of the Eurozone. The process is likely to be a disruptive one to some degree regardless of how well it is managed. It would be a disorderly process characterized by protracted legal battles. Finally. Our four-step plan is focused on achieving orderly currency redenomination. STEP 2: Define the role of a new European Currency Unit (ECU-2) in the settlement of EUR denominated assets and obligations in a full-blown break-up scenario. we would likely be facing a chaotic situation. and this could have a significant positive impact on aggregate lending dynamics relative to the alternative scenario of an unmanaged and ad hoc redenomination process. averting protracted legal battles would in itself free up resources for productive investment. In conjunction with the development of effective hedging markets for new national currencies (and the new ECU) this would allow banks and other institutions to reduce open (contingent) exposures to certain new national currencies of eurozone member countries. by encouraging hedging of potential new FX exposures over time. STEP 1: Communicate guiding principles for the redenomination of Euro denominated assets and obligations under local and foreign law in various break-up scenarios. is an incomplete one.30 January 2012 Section 10: Concluding remarks This paper has focused on four steps to plan for an orderly break-up of the EMU. focusing on issues related to currency redenomination. In the absence of any guidance and contingency planning in relation to redenomination of EUR assets and obligations ahead of a break-up. But the point about degree is an important one. It is just one aspect of a full plan for an orderly break-up process. and unnecessary failures in the bank sector and elsewhere. More clarity on the redenomination process would allow institutions to plan and manage risk ahead of time. and widespread insolvencies across various market sectors. including a full-blown break-up scenario where the Euro ceases to exist. STEP 3: Create a hedging market for intra-Eurozone currency exposure. Moreover. new regulation could. These four proposed steps will not make a eurozone break-up an easy process. Any plan for a break-up. Allowing planning and hedging would help avert unnecessary bank failures and corporate insolvencies due to currency redenomination. including creating a non-deliverable FX forward market for potential new national currencies of current eurozone member countries and creating a hedging market for potential ECU-2 exposures following a break-up. occasionally arbitrary court decision. but a crucially important aspect. STEP 4: Introduce a new regulatory framework to reduce intra-Eurozone currency exposure for systemically important institutions in preparation for a eurozone break-up. The plan offers a framework for orderly currency redenomination in a break-up scenario. and one which underestimates the large disruptive force associated with an uncontrolled and unmanaged redenomination process. 40 . But it is likely to be a crucial one given the very large contingent open currency exposures which have been accumulated since 1999. Such an ad hoc and uncontrolled redenomination process would inevitably lead to large losses for certain institutions. which does include a framework to ensure an orderly currency redenomination process. help reduce contingent intraEMU currency risk within systemically important institutions. solely as a function of currency losses linked to new currency exposures resulting from redenomination.
7 2.8 37.6 7.6 10.9 49.9 81.0 16.5 0.4 53.4 1.3 2.6 14.1 616.9 208.0 1.4 15.9 79.1 9.8 15.2 3.5 1.1 18.8 0.2 11.6 26.1 134.30 January 2012 Appendix I: Illustrative bank loss calculations in debt restructuring scenarios Fig.2 64.9 39.0 15.9 7.7 19.6 6.1 6.0 2.6 6.1 18.4 0.7 3.8 23.3 1.0 88.7 1.0 7.0 0.9 10.0 2.0 15.6 129.5 20.6 65.4 0.2 814.3 24.4 1.8 30.4 17.5 67.7 6.8 262.5 25.7 45.3 7.7 0.3 14.7 Note: “Periphery countries‟ total losses” are the sum of bank losses in Greece.3 4.4 94.6 7.2 61. Source: Nomura.9 17.7 28.0 6.6 18. and Spain.5 173.5 1.0 0.6 219.5 72.3 1.3 2.9 0.5 18.9 34.0 1. Italy.1 22.2 3.2 21.3 21.4 18.1 78.0 1.6 5.9 0.5 0.6 3.5 29.1 315.3 39.3 0.7 0.4 7.2 94.5 57.4 170.2 251.8 2.1 234.1 3.9 1.3 19.7 4.7 156.0 4.5 16.1 5.4 50. IE.7 0. Portugal.6 166.7 22.3 64.0 2.8 13.4 9.0 67.5 5.1 50.5 43.2 1.0 13. Ireland.7 7.0 9.3 0.0 9.4 4.8 15.4 45.1 54.1 11.2 21.4 180.5 54. PT 17.9 27.0 26.0 21.6 4.7 0.6 327.2 116. 1: Bank losses in sovereign default scenarios Germany Spain France Italy Other EMU UK Japan US ROW Total Total EMU Type of Exposure Sovereign Banks Other Total Sovereign Banks Other Total Sovereign Banks Other Total Sovereign Banks Other Total Sovereign Banks Other Total Sovereign Banks Other Total Sovereign Banks Other Total Sovereign Banks Other Total Sovereign Banks Other Total Sovereign Banks Other Total Sovereign Banks Other Total Spain Losses ($bn) resulting from default in: Italy GR.3 172.3 6.3 84. BIS 41 .5 Total 61.4 61.2 59.6 8.8 3.7 52.6 290.6 72.3 35.3 15.7 53.0 16.1 61.0 93.2 50.8 11.7 83.3 52.6 251.3 208.8 5.4 4.2 40.6 9.0 1.
3. incorporating additional defaults in banking and non-financial sectors as a function of sovereign debt restructuring. 42 .30 January 2012 Our calculations of the losses are based on the cross-border exposure calculated by the BIS as of the second quarter of 2011. but with a lower recovery rate of only 40%. We conduct scenario analysis of direct and indirect bank losses in a „realistic restructuring scenario‟. The restructuring of the banking sector also leads to restructuring/defaults of some non-bank debt. the local peripheral banks will also be forced to also restructure their debt. Here. As a result of the losses on their holdings of sovereign debt. Our main assumptions are: 1. we assume that about 50% of non-bank debt needs to be restructured with a recovery rate of 40%. 2. as negations around the current Greek PSI process indicate. These figures are for illustrative purposes only. The sovereign will restructure its debt with a recovery rate of 60%. and the actual haircuts could end up being substantially larger.
9 4.9 1.5 12.6 1.6 140.9 11.2 4.0 30.5 3.8 66.9 0.4 114.8 680.4 1.3 12.0 16.1 0.9 11.1 0.7 265.9 7.4 1.5 9.1 26.1 14.5 35.7 2.9 48.0 21.30 January 2012 Fig.0 120.2 177.9 177.0 18.9 1.0 16.8 39.0 44.0 0.3 13.8 6.0 75.3 1.8 7.8 106.6 0.7 1.9 53.0 25.2 2.9 52.6 507.7 1.1 3.5 38.3 9.5 132.1 21.9 Italy 47.9 19.1 78.9 0.5 0.4 1.1 3.1 8.1 1.4 5.5 4.2 2.2 59.0 1.9 6.4 2.2 Source: Nomura.7 9.9 4.0 1.6 1. BIS 43 .2 3.9 64.5 69.5 126.5 25.8 121.3 100.9 46.2 19.9 20.9 0.0 0.2 2.4 251.1 2.4 0.5 8.5 2.9 153.6 1.9 52.9 4.8 3.6 81.3 32.9 0.9 2.2 1.1 11.5 0.3 17.3 9.2 22.8 270.0 100.4 0.4 13.8 1.6 5.5 0.3 53.9 Total 101.6 14.0 0.6 0.0 91.6 157.0 0.9 30.7 1.2 1.1 7.3 19.0 180.5 17.2 1.9 10.4 0.4 8.9 76.3 40.6 0.4 30.7 16.2 12.9 9.5 14.4 5.8 150.7 3.2 88.9 353.4 39.2 138.3 110.8 25.0 0.0 473.4 11. 2: Eurozone sovereign exposures to periphery countries Q2 2011 Type of Exposure Public sector Banks Non-bank private Total Public sector Banks Non-bank private Total Public sector Banks Non-bank private Total Public sector Banks Non-bank private Total Public sector Banks Non-bank private Total Public sector Banks Non-bank private Total Public sector Banks Non-bank private Total Public sector Banks Non-bank private Total Public sector Banks Non-bank private Total Greece 12.6 85.6 43.8 2.8 44.0 50.9 10.0 0.7 0.3 4.0 16.2 29.6 7.6 48.3 9.0 0.9 422.5 43.7 30.1 3.8 11.2 5.1 3.2 227.2 9.9 3.6 18.6 28.2 10.9 6.4 6.5 37.6 Germany Spain France Italy Other Eurozone Great Britain Japan US ROW Exposures ($bn) to: Ireland Portugal 3.8 161.9 16.5 38.9 9.2 7.6 33.2 108.7 7.2 24.1 26.9 Spain 29.3 2.7 95.3 65.5 55.4 73.0 416.8 0.7 1.3 0.9 2.1 1.9 0.9 47.4 0.5 109.
3 4346.0 21.7 155.4 108.7 445.0 256.1 738.8 18.8 Austria Belgium Finland France Germany Greece Italy Ireland Netherlands Portugal Spain Total Source: Nomura.0 171.7 905.2 1022.4 192.9 49.2 204.1 9. 1: Assets outstanding in the eurozone – by location of issue .2 228.8 Nonfinancial Domestic International 35.7 549.5 621.9 79.7 1043.5 47.0 8.7 88.5 94.7 0.2 54.7 18.9 35.1 321.9 1284.9 18.4 585.5 1316.2 6025.3 40.2 51.7 1.3 10.6 218.9 20214.6 821.1 94.3 229.6 331.4 74.9 Financial Domestic International 123.2 24.6 3600.5 549.4 7459.9 309.9 10.6 128.4 102.5 1622. BIS 44 .9 148.5 85.9 3713.9 128.3 309.7 981.2 Total 553.4 1234.BIS data Assets outstanding in the eurozone by location of issuance (bn EUR) Sovereign Domestic International 112.4 648.3 383.7 17.9 148.9 2673.2 350.30 January 2012 Appendix II: BIS data on international bond issues by Eurozone issuers Fig.6 61.0 1432.1 158.6 1876.3 34.1 1448.9 45.3 388.0 195.3 21.0 286.9 4371.3 1926.
8% -23. we are not regarding the break-up scenario as our central case. To quantify the economic magnitude of the redenomination risk. The estimates could be relevant both in a limited break-up scenario (for the departing countries) and in a full-blown break-up scenario (for all eurozone countries). Such estimates will be “moving targets.10 -47.7% -9. The framework is based on: i) current misalignment of the real exchange rate. But it has become a real risk over the last few months.6% -27.96 0.34 -7. ii) future inflation risk. and a possibility which investors and policy makers should now plan for.34 as of early December. Fig. and regional political developments in the European Union For full disclosure.71 0.2% 1. The framework quantifies the medium-term depreciation risk associated with a redenomination into new national currencies. the global environment.30 Austria Belgium Finland France Germany Greece Ireland Italy Netherlands Portugal Spain Note: These fair value estimates are calculated for the national currencies of each of the 11 original eurozone members and are based on a 5-year horizon following a potential eurozone breakup.9% -6.6% -57.5% -6. we discuss potential valuation of new national currencies following a eurozone break-up.25 0. the potential depreciation risk is very material.25 1.3% 1.30 1.4% 1.70 1.25 0. The percentages included in the chart represent the degree of appreciation/depreciation from the EUR/USD value.50 1. 1: Fair value estimates for new national currencies in a eurozone break-up scenario 1.36 1. Here.50 0.90 1.97 0.02 1.3% -35. we develop a transparent framework for valuing new national currencies. Source: Nomura 45 . Currency risk in a eurozone break-up We have discussed the importance of legal jurisdiction as a major determinant of redenomination risk in eurozone countries.86 0.21 0. For a number of current eurozone member countries. influenced by country specific policies. which stood at roughly 1.30 January 2012 Appendix III: Valuing new national currencies Investors holding EUR assets and obligations are facing risk of redenomination of contracts into new national currencies.1% -28.57 0. We view these estimates as an initial benchmark for where currencies may trade in a “new equilibrium” following a potentially lengthy and extremely volatile transition period.
especially in terms of downward adjustments of wages. given rigidities in nominal prices. These extraordinary risk premia will vary by country depending on factors such as market volatility and liquidity conditions. 2. Similarly. as even if some eurozone countries manage to maintain a currency union. Current real exchange rate misalignments: The eurozone currency union has. currency projections at the national level can be used in a bottom-up valuation exercise for a new European Currency Unit (ECU-2). Moreover. and the uncertainties associated with a eurozone break-up further complicate the analysis. The national central banks would have differing inflation fighting credibility and face varying degrees of pressure to provide liquidity for banks and public institutions. Quantifying current real exchange rate misalignment It is fairly uncontroversial that some eurozone countries are facing significant competitiveness issues associated with overvalued real exchange rates. we want to focus on a relatively simple and transparent framework. although we recognize that they could be crucial in the short-term. We think this exercise is instructive. Future inflation risk: A break-up of the eurozone would mean that individual eurozone countries would return to independent monetary policies. To simplify the analysis. The first component in our valuation framework is an estimate of the current real exchange rate misalignment. And we want to stress up-front that these estimates are unlikely to be particularly precise. Portugal and Spain in the post-EMU period (see Figure 2 below). A eurozone break-up will create additional short-term risks and require new risk premia for investors. after which we believe temporary transition effects should be smaller.30 January 2012 A framework for valuing new national eurozone currencies Currency valuation is a complex exercise. the value of a new composite currency is likely to be linked to the value of the individual component currencies. as well as issues relating to capital controls. Our framework for valuing potential new national eurozone countries concentrates on two main medium-term effects: 1. They are intended to give a sense of potential magnitudes involved over a 5-year forward time frame. we will focus on currency valuation at the national level – country by country – rather than for possible new groups of countries. real exchange rates are now potentially significantly misaligned from their “equilibrium” levels in some countries. by definition. There are many possible permutations for a break-up. including possible taxes on capital flows. Since the uncertainties in the valuation exercise are large. One simple indication of this is the extremely high peak and average trade and current account deficits observed in Greece. disabled the normal FX adjustments. which would happen under a flexible exchange rate regime. 46 . The second component in our valuation framework is the projected future inflation risk. we will not focus directly on these more temporary effects. Since our analysis is focused on equilibrium considerations over a 5-year period. Those differences would leave potential for significant divergence in inflation trends.
current currency misalignment is estimated to be the largest in Greece (18. although the general bias is towards moderate overvaluation.8 -3. the Dollar relative to the rates which prevailed in the period prior to EMU entry.7 4.7 0. Eurostat In order to quantify current exchange rate misalignments. although the specific magnitudes of implied misalignment differ to some degree.8 -2.4 -2. Averaging the two approaches shown in the chart by country.9 5.8 -1.1 -1.5 1. we use a standard framework based on equilibrium current account and sustainable net foreign assets positions to estimate currency adjustments in real effective terms which would be consistent with achieving external balance.8 1. Germany and Finland stand out as the two countries with potentially undervalued real exchange rates (-1.2 -0. we use two alternative frameworks: First. Pre-EMU period is defined as 1989-1999. to allow the averaging mentioned below).5 -2.4 -2.2%). All other eurozone countries appear to have real exchange rates which are closer to fair value currently.6 0. 47 .1 Note: Post-EMU period is defined as 1999-current day for all countries.8 -0. but it does provide a sense of currencies‟ „natural‟ equilibriums over a period where market forces generally played a dominant role.7 -1.6 -1.9 -1.4 2. we look at the position of current bilateral real exchange rates vs.4 -2. The two approaches give generally similar conclusions. we use a time-series based approach to gauge real exchange rate misalignment.1%) and Spain (11.7 1.30 January 2012 Fig.6 1. respectively).1 -2.0 -5.6 2.9 -1. Source: Nomura.8 -6. since structural changes may have happened in the meantime.1 3.1% and -0.1 4.5%. including Greece.0 -1.6 -10.4 Pre-EMU (%) Average -3.3 1.9 -5.3 -3.1 0. Specifically. This is not a perfect benchmark.1 -9. Specifically. At the other end of the spectrum.0 -5.9%).0 -1. we draw on the work of the European Commission in terms of assessing competitiveness and we use the average estimates of the real effective exchange rate misalignment from the current account and net foreign asset based approaches (for simplicity.6 0. Second.3 4. historical (% of GDP) Peak Greece Portugal Spain Ireland Italy Belgium France Germany Austria Finland Netherlands Post-EMU (%) Average -14. we assume that bilateral misalignments versus the dollar would be similar in size to the trade-weighted misalignment reported by the European Commission. followed by Portugal (16. 2: Current account deficits of eurozone countries: recent vs.6 -11.9 Peak -9.
From this perspective. Projecting future inflation is challenging under normal circumstances. in which case central bank action may be partially dictated by the liquidity needs of banks. This is especially the case since sovereign default is likely to trigger a domestic banking crisis. Austria Italy 2. Here. We do not view this as a complete analysis. but rather as an initial attempt to quantify some of the key parameters involved. which captures a number of these effects. indexation. there is potential for significant divergence in inflation rates. We use estimates from academic studies of the exchange rate pass-through coefficient per country and we combine this with the observed volatility of CPI inflation in the past at the country level. such as energy price shocks. We look at the implied default probability in 5yr CDS to quantify sovereign default risk per country. Inflation pass through: The degree to which the inflation process is vulnerable to shocks depends on openness. We focus on four parameters which measure future inflation risk: 1. Nevertheless. Source: Nomura Quantifying future inflation differentials In a break-up scenario where individual eurozone countries return to independent monetary policy. sovereign default risk will be a key parameter influencing future inflation risk. 48 . there are a number of parameters which help gauge the country specific inflation risk in a eurozone break-up scenario.30 January 2012 Fig. unionization. but it is doubly difficult in an environment of severe instability and structural changes associated with establishing new frameworks for monetary policy at the national level. 3: Estimates of current misalignment of country-specific real exchange rates 30% 25% 20% Time-Series Misalignment Structural External Balance Misalignment 27% 18% 16% 15% 8% 6% 2% 6% 2% 6% 1% 3% 9% 13% 15% 10% 5% 0% 9% 7% 10% 9% 1% -1% -5% -10% -2% -4% Ireland France Spain Finland Netherlands Portugal Germany Belgium Greece Note: Positive figures indicate overvaluation. we will focus on four main parameters that we think are important. Past inflation volatility is another proxy for susceptibility to shocks. The exchange rate pass-through is a summary measure. terms-of-trade volatility and other factors. Sovereign default risk: Financial stability and conduct of sound monetary policy is closely linked to fiscal stability.
The table shows that Russia is an outlier. we look at the lowest CPI readings observed in the eurozone over the last 20 years. Russia 1998 and Mexico 1994). A number of the other examples (Indonesia. Thailand 1997. following a eurozone breakup. 49 . with implications for money demand and inflation dynamics.30 January 2012 3. The first step is to define the range of possible outcomes for future inflation. as compared to the inflation level in the two years prior to the crisis.1 -0.0 16. but peak deflation has generally not seen CPI inflation drop below minus 2%. we use a simple scoring method. due to successful macroeconomic stabilization.3 14. and past experiences may matter when new monetary policy frameworks are put in operation. 4: Inflation dynamics in times of currency crisis (y-o-y CPI inflation) 5 years following currency crisis Average post2 years prior to Inflation (from date of de-peg) currency crisis currency crisis shock inflation (A) (B)-(A) 1st year 2nd year 3rd year 4th year 5th year (B) Russia Mexico Indonesia Argentina Brazil Thailand Turkey 14 8 7 -1 8 6 59 97 35 34 26 15 9 57 32 35 50 15 7 2 43 22 21 2 4 7 1 25 17 16 10 10 4 2 10 14 17 13 11 4 1 8 36 25 22 13 7 3 29 22. Fig. We use this as the lower limit of the inflation shock.6 14. Indonesia 1997. as a simple metric of capital flow vulnerability by country Past inflation track record: Inflation expectations can have long memory. To define a lower limit. In order to translate these different metrics of future inflation risk into a common indicator. There is no obvious upper limit to how much inflation could result in a worst-case scenario. Eurostat. We look at inflation performance in the pre-Euro period (1980s and 1990s) by country. Bloomberg. But we think a look at countries affected by currency crises in the past may provide some clues. with a negative inflation shock. with a very large inflation shock of 22%. The inflation track-record before Euro entry may therefore be important. defined as the current account balance plus net foreign direct investment flows. A vulnerable balance of payment situation may imply a higher risk of capital flight.4 -2. Capital flow vulnerability: Combination of Large current account deficits combined and a weak structure of capital flows can leave a vulnerable capital flow picture. while Turkey was an outlier in the other direction. 4. We define the “inflation shock” as the increase in average annual inflation in the five years following the beginning of the currency crisis. Mexico and Argentina) show a cluster around 15%.8 -30. We look at the basic balance. OECD We use this analysis to define an extreme upper limit of 15% on the potential inflation shock eurozone countries could experience on an annual basis over a 5-year period. There have been many episodes of moderate deflation.8 Source: Nomura. The table below looks at inflation dynamics around a number of prominent currency crises in the past (Argentina 2001.
At the other end of the spectrum.2 32.83 1.7 2.9 99. inflation pass-through.9% 0.7 15.1 1.8 -2. Bloomberg. Our model has an explicit medium-term focus. relative to the dollar.2% Capital Flow Total Future Past Vulnerability Inflation Inflation (%) (%) Shock (%) 3.79 0.56 2.2 -4. 50 .0 -11.8 7.9 9. both countries also have a better inflation track-record than the US. which could be very significant in the transition period toward a new equilibrium.2 1.7% 0. past inflation measures into a -2%-15% scale using the cross-sectional distribution of the parameter values.1 3.7% in nominal terms over a 5-year period in order to compensate for the cumulative inflation differential associated with an annual inflation shock of 11. Valuation of new national currencies: A two-factor approach Having quantified the two components of our valuation framework. equivalent annual depreciations of nominal exchange rates would be needed.0 -7. we map the external balance measures into a 0% to 15% scale.3% 0.0 -12. These calculations are summarized in Figure 5.30 January 2012 The second step is to map the four inflation risk parameters into this scale (from -2% to +15%).6 3. and our estimates suggest that Germany may experience only very moderate inflationary pressure in a eurozone breakup scenario (less than 1%).8% 0.3 4. and in order to make the investment implications clear.8 8.9 7.7 5.7% 0. assigning a value of 0 to all countries with a positive external balance.1 Source: Nomura. Eurostat. which is our benchmark country. We do this by mapping sovereign default risk.1 4. 5: Inflation risk parameters and potential future inflation shock in a break-up scenario Sovereign Default Risk (%) Austria Belgium Finland France Germany Greece Ireland Italy Netherlands Portugal Spain 14.6 2.82 1. For example.1 0.79 0.5 11.6 45.8 15.7% 0.2 7. we can derive fair value estimates of new national currencies as the product of the two effects: i) the current real exchange rate misalignment.3 6.0% 0.77 1.9 59.2% 0.94 0. and ii) the future inflation risk.7 28.7 11.78 1.3% 1. see Box 1: Complete calculation of future inflation risk below) Fig. We note again that the framework is not incorporating extraordinary risk premia. and maintain competitiveness.5 3. Germany and the Netherlands stand out.04 1.77 0.75 0.6 -5.9% 0. the results are expressed in nominal terms.5 4.3 5.5 1.2 22. (For a more detailed view of future inflation risk calculations. Similarly.4 Inflation Pass-Through FX PassCPI Through Volatility 0.6 0. FRB In order to keep the real exchange rate constant.7 4.1 5. In addition. assuming no inflation shock in trading partner countries.7 9.4 7.1% over the period.9 0. this analysis suggests that the new Greek currency would need to depreciate by 47.
34).1 0.4 1.8 -23.1 -37. and they are based on the nominal exchange rate value versus the dollar from early December (1.5 -5. Spain and Italy are likely to see significant depreciation of new national currencies in a break-up scenario.5 Estimated change due to: Current FX Future Misalignment (%) Inflation Risk (%) -3.3 -5.3 0. Cyprus.6 -27. 6: National currency fair value projections in a eurozone break-up scenario Fair Value Estimate Estimate Austria Belgium Finland France Germany Greece Ireland Italy Netherlands Portugal Spain 1.4 -3. our estimates also suggest that Ireland. Germany stands out as facing no material depreciation risk within the equilibrium framework considered.0 -16. and Estonia from this initial study.9 -47. followed by a 47% depreciation of the new Portuguese escudo. The reason is two-fold. We estimate depreciation of about 25-35% for this group.7 -9. although the effect is too small to be economically meaningful.25 1.25 0. We may do a customized analysis for those countries at a later date.71 0.2 -35.4 1. 51 . Malta.6 -19. First. We have also excluded the five newcomers to the eurozone: Slovenia.57 0.21 1.5 -7.2 -2. these countries are all relatively small in terms of the size of their economies and their financial markets. Perhaps not surprisingly.3 -57.25 1.1 -11. Fig. although the analysis excludes Luxembourg.36 0.6 -28.7 -10.96 0. At the other end of the spectrum. Source: Nomura The fair value calculations show potential for significant (58%) depreciation of the new Greek drachma relative to the US dollar.86 Total Change (%) -6.9 -7. In fact.97 1.2 -4.9 -6.02 1.3 Note: Estimates should be viewed as 5-year ahead fair value projections.2 -27. The countries not in our story… Our study has focused on the first 11 eurozone member countries.3 -7.30 January 2012 The key results are summarized in the table below. Second. our estimates suggest a marginal appreciation potential. given its very small size. Slovakia. the methodology we have been using is not directly suitable for the countries which joined the eurozone later on.1 -47.0 -21. driven by a combination of the two factors in our framework. which is likely to re-peg its currency to another “stable” European country.8 -5.2 -18.8 -19.
the Argentine Peso staged a dramatic drop of 72% in nominal terms in the five months 52 . We recognize that structural reform initiatives could have a significant impact on productivity growth. for example. other influences on the exchange rate could be significant. which generally have limited commodity resources. it seems almost impossible to quantify such effects. Our estimates are explicitly dealing with a medium-term concept of currency fair value. and we have not yet made the attempt. meaning that it settles at a new equilibrium level after the effect of temporary shocks have abated. Bloomberg The framework also does not incorporate cyclical effects. Fig. A break-up scenario would likely involve important growth underperformance in Europe overall. In the shorter-term. however. Since. But this effect would come in addition to the effects analyzed here. Our estimates are based on the notion that the real exchange rate in most developed markets tends to have a mean-reverting component. for example. and may need more consideration over time. In the Argentine crisis. 7: Depreciations of currencies in the 2 years surrounding breaks from pegs 140 ARS IDR 120 100 80 60 40 20 0 -2 1 THB MXN RUB -1 0 2 Years before/after break in peg Source: Nomura. we do not think the exclusion of terms-oftrade dimension is likely to be crucial. and we do incorporate an effect from varying inflation pass-through when accounting for inflation risk in our framework. relative to the Americas and Asia. At this stage. we are dealing with eurozone countries. This again implies that the nominal exchange rate in the medium-term (which we define as a 5-year period) can be viewed as a function of i) the current real exchange rate misalignment. which could permanently affect the level of the real exchange rate. The framework does not explicitly incorporate effects.30 January 2012 How to interpret the results Our estimates provide an initial attempt to quantify potential medium-term depreciation risk of individual national eurozone currencies in a break-up scenario. with implications for real interest rate dynamics. which could be material. This is the experience from previous currency crises. Such effects include permanent terms of trade shocks and diverging productivity trends. and ii) cumulative inflation differentials. however.
9% 1.0 12.75 0.0 0.2 22.9 3. High local interest rates may provide partial compensation for such risk.3 4.6 -5.7 2.2% 2.3 6.3 5.2% 1. the short-run path is likely to be influenced by the interaction between a number of forces.9 99.5 11. In general.0 -12.1 0. which could well be in a very fragile state.9 59. FRB This table is an extension of Figure 16. there may be additional risks associated with capital controls.8 8.6 3.2 7. Bloomberg.5 0.82 1. In the case of inflation pass-through.1 5. although this may again depend on the condition of the banking system.30 January 2012 following its break off the peak.4 0.04 0.3% 0.6 5.9% 1. which was indexed from 0 to 15 because a surplus in a country’s balance would not imply negative inflation risk.6 0.79 0.79 0.7 11. In addition.1 2.9 0.0 0.56 0. Each subcomponent is indexed from -2 to 15.77 0.9 7.8 0.7 5.8 2.5 1.0 -7. indexed FX pass-through and indexed CPI volatility were averaged together to find a final indexed value of inflation pass-through (inflation risk #2).4 1.0 11.1 4.7 4.7% 0.5 3. Box 1: Complete calculation of future inflation risk Sovereign Default Risk Implied Inflation risk Default #1 Probability Inflation Pass-Through Capital Flow Vulnerability Basic Balance Inflation risk #3 Past Inflation (%) FX Passthrough CPI Volatility Inflation risk #2 Past Inflation Inflation risk #4 Future Inflation Risk (%) Austria Belgium Finland France Germany Greece Ireland Italy Netherlands Portugal Spain 14.0% 2.1 Source: Nomura.9 9.6 -0.7 3. and this move arguably exceeded what turned out to be justified from a real exchange rate analysis perspective.6 0.0 1.1 3.5 8.9 5.7 9.8% 0.2 32.0 11.0 3.8 3. Certain extraordinary risk premia are likely to be required by investors and other market participants to compensate for risk associated with excess volatility and illiquidity.1 1.83 0. 53 .7 28.0 0. The exception to this indexation method is the basic balance.2 -4.7% 1.4 7.8 7.1 5.77 0.7% 0.2 6.2 1.6 5.7 14.0 4.0 15.5 6.7 2. showing the raw inputs contributing to each of the four intermediate measures (labeled Inflation risk #1-4) u sed to calculate the final future inflation risk percentage.7 1.0 7.5 1. including taxes on capital flows.2 4.6 45. Following this process. with values less than zero representing future deflation and values greater than zero representing future inflation.1 6.5 1. Eurostat. inflation risks #1-4 were averaged together to find an overall future inflation risk value for each eurozone country.9 -1.8 -2.1 1.6 2.8 15.94 0.5 3.6 -0.7 0.2 3.5 4.0 -11.1 3.78 0.1 6.3% 1.7 15. limiting the need for a depressed currency value.1 10.
1 683.1 57. 2: All EUR-denominated bonds Sovereign Amount Outstanding (EUR bn) Total 6723.7 502.9 684.1 7264.9 Other 56.7 236.3 872.1 431. Bloomberg 54 .6 1477.5 56.3 Local 2775.8 132.1 219.1 New York 17.1 128.5 1339. 1: Euro-denominated bond amounts outstanding in the eurozone (EUR bn) Sovereign Domestic International Domestic Financial International Domestic Nonfinancial International Total Foreign Foreign Foreign Foreign Foreign Foreign Local Law Local Law Unknown Local Law Local Law Unknown Local Law Local Law Unknown Law Law Law Law Law Law Austria 176 2 0 0 1 124 9 27 49 30 9 4 2 16 9 Belgium 306 15 4 0 5 2 0 0 7 1 7 4 2 6 86 Finland 69 0 0 1 0 8 1 1 13 10 3 1 0 8 1 France 1376 15 46 4 12 167 6 254 132 125 56 8 83 81 100 Germany 1491 1 39 0 23 1544 7 509 58 130 25 8 28 8 43 Greece 255 8 0 1 5 6 2 13 16 47 2 2 0 0 1 Italy 1498 56 19 19 14 531 29 36 112 90 15 12 1 31 210 Ireland 114 0 0 0 0 14 19 36 92 49 0 7 0 8 239 Netherlands 282 15 0 0 0 44 20 144 61 131 9 31 14 164 448 Portugal 105 12 2 1 2 21 2 18 14 22 14 2 3 0 26 Spain 627 42 11 32 16 469 13 21 19 33 10 3 4 29 279 Total 6299 166 121 58 80 2930 109 1060 574 670 150 81 138 351 1443 459 446 115 2466 3916 360 2673 579 1363 244 1608 14230 Source: Nomura.8 253.7 % 100% 33% 67% 81% 19% 74% 8% 10% 8% Nonfinancial Amount Outstanding (EUR bn) 2162.0 % 100% 55% 45% 93% 7% 59% 8% 8% 25% Financial Amount Outstanding (EUR bn) 5343.7 Source: Nomura.4 70.4 6.5 53.1 Allocated 2999.9 German 16.0 % 100% 68% 32% 37% 63% 55% 13% 31% 1% Total 14229.4 119.8 2897. Bloomberg Fig.4 Foreign 223.30 January 2012 Appendix IV: Eurozone assets by legal jurisdiction – further detail Fig.9 6965.9 5925.4 Unallocated 3724.1 3580.9 English 133.9 1763.
7% 18.5% 27.97 1.6% 2. and The (expected) FX rates of the individual new national currencies.3% 5.0% 3. we will rely on the initial estimates of new national currencies we have published separately (see Currency risk in a eurozone breakup: Valuing potential new national currencies .0% 13. Greece.25 1.8% 6.4% 18. Ireland.13 ECU-2 weights (ex. Ireland.02 1.71 1.5% 4.0% Sum (D * E) 1. and should be viewed as longer-term equilibrium estimates.0% 1.30 January 2012 Appendix V: How to value the new ECU We have argued that defining a new ECU would be important in facilitating an orderly redenomination process for certain eurozone assets and obligations.1% 12.5% 21. rather than an attempt to predict where currencies would trade immediately following a break-up. The estimate rises to 1.8% 1.6% 18.25 - Note: ECU fair values are expressed in ECU/USD terms.4% 1. twofactor framework.9% 1.1% 2.7% 6.0% 8.7% 28. there are two key fundamental inputs in the ECU-2 valuation exercise: The weights of individual national currencies in an ECU-2 basket.0% 12. Turning to the potential value of the ECU-2.2% 1.1% 22.21 0.5% 0. In this appendix. Conceptually.3% Baseline ECU-2 weights (B) 3.14 ECU-2 weights (ex.7% 2.16 (USD per ECU-2) if Greece. We note that these estimates are based on a simple.6% 2.9% 2.0% 19.8% Sum (B * E) 1. and Portugal are 55 .8% 29.1% 20. although the process is highly unlikely to be as smooth as was the case in 1999.8% 1.8% 1.9% Sum (C * E) 1. Greece) (C) 3.9% 1. We also argued that introducing an ECU would be logical from a historical perspective.16 Fairvalue in breakup (E) 1.8% 2. All estimates are expressed versus the USD.3% 14.4% 0.8% 0. Portugal) (D) 3.13 (USD per ECU-2) in our baseline case where all current eurozone countries.3% 0. 2011) and presented in Appendix III of this document. have a weight in the ECU basket. ECB Figure 1 shows potential ECU-2 valuation of 1. we focus on the potential future value of the new ECU (ECU-2).36 0.0% 2.25 0. Fig.9% 12.57 0.86 1. A transition process from EUR to ECU-2 for certain EUR denominated obligations could potentially reduce a number of difficult legal problems associated with redenomination. except the smallest ones.December 5.96 0. 1: Fair value estimates of a potential ECU-2 ECU-2 fair value estimation ECB Weights (A) Belgium Germany Greece Spain France Ireland Italy Netherlands Portugal Austria Finland ECU-2 calculations ECU-2 valuation 2. Source: Nomura.
Fabrizio Perri.16 is well within the range where the euro has been trading versus the dollar since inception. among others. see Cavallo. Figure 2 below. 56 . and from a longer-term perspective. Without going into detail. There is a large academic literature on currency „undershooting‟ in connection with 6 currency crises . but that analysis will require another paper. Taimur and Goldfajn. 7 Baig. Fig. How these effects interact with long-term inflation risk is likely to depend on country-specific dynamics. such as external reserves. Whether this magnitude of an undershooting effect would be appropriate for eurozone countries as well would depend on an evaluation of countryspecific parameters. The estimate is higher since these countries‟ currencies are expected to be particularly weak in a break-up scenario. and net foreign asset positions. December 1998. these estimates may be reasonable. certainly for a number of the currencies in the ECU 7 basket. The historical examples highlighted here indicate an “average” undershooting effect of 21% in past currency crises. The range of estimates 1.” Federal Reserve Bank of San Francisco Working Paper. illustrates the magnitude of the „undershooting‟ effect in certain historical currency crisis. “Exchange rate overshooting and the costs of floating. and Nouriel Roubini. May 2005. “Monetary Policy in the Aftermath of Currency Crises: The Case of Asia.13-1. we think the same type of mechanics would apply in a eurozone currency crisis. derived from an IMF study by Baig and Goldfajn . Michele.30 January 2012 excluded. one should expect potentially significant under-shooting of individual new national currencies and the ECU-2 basket in the immediate aftermath of a break-up. 2: Depreciation and “under-shooting” in past currency crises 80 70 60 50 40 30 % Estimated overvaluation (pre-crisis) Real depreciation (post-crisis) Estimated "under-shooting" 20 10 0 -10 Philippines Mexico Malaysia Indonesia Source: Nomura.” International Monetary Fund. default risk. Kate Kisselev. Ilan. But the size of the difference is small given their small weight in the basket in the baseline case. However. IMF Chile Sweden Thailand Korea UK 6 For example. political stability.
P. Cavallo. 2011. 1999. 2010. “Exchange rate overshooting and the costs of floating. Proctor. 1998. 2005. Scott. International Monetary Fund per Jacobsson Lecture.:“The Past and Future of European Integration: A Central Banker‟ s Perspective”.” Federal Reserve Bank of San Francisco Working Paper.” International Monetary Fund. “Nomura Europe Special Report: Event risk in Greece”. and Nouriel Roubini. 17 June 2010. “Nomura Rates Insights: European Financial Stability Fund”. 21 July 2010. Niall: “2021: The New Europe”.: When the Euro Falls Apart. ECB Legal Working paper series No. Proctor.. Oxford UP.30 January 2012 References Athanasiou. 8 December 2011. BIS (2010): Triennial Central Bank Survey: Foreign exchange and derivatives market activity in April 2010. “Nomura European Rates Flash: The CDO at the heart of the eurozone”. “Nomura Special Topic: Currency risk in a eurozone break-up: Valuing potential new national currencies”. Charles. 2005. The Wall Street Journal. Taimur. 2009. “Nomura Rates Flash: EFSF revisited”. Ferguson. 207-228. Monetary and Economic Department of the Bank for International Settlements (BIS). W. Mann on the Legal Aspect of Money. IESEG School of Management working paper series. 57 . 29 June 2011. Fabrizio Perri. and Ilan Goldfajn. 2011. Dor. The Greek Crisis and the Euro – A Tipping Point. p. 19 November 2011. Duisenberg. Proctor. 6th Ed. Charles. Hal S. 4 October 2010. 2010: “Surveillance of intra-euro-area competitiveness and imbalances”. “Monetary Policy in the Aftermath of Currency Crises: The Case of Asia. Leaving the Euro zone: a user’s guide. Eric. KfW Bankengruppe (2006): “Law concerning KfW”. 5 December 2011. 1 December 2011. European Commission. Kate Kisselev. Intl Fin 1:2. 10. 2011.1998. “Nomura Global Guide to Corporate Bankruptcy”. Economic and Financial Affairs. The Euro-fragmentation and the financial markets. Michele. Cap Markets Law J 6(1). Charles. “Nomura G10 FX Insights: FX after ECB: Taking Stock”. Baig. BaFin (2006): “KfW risk weighting eq”. “Withdrawal and expulsion from the EU and EMU: Some reflections".
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