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WOLFSON ECONOMICS PRIZE 2012
Minimising the financial cost, and maximising the economic opportunities, of Euro Exit
If member states leave the Economic and Monetary Union, what is the best way for the economic process to be managed to provide the soundest foundation for the future growth and prosperity of the current membership?
Table of Contents Introduction....................................................................................................................4 Background ....................................................................................................................4 Planning for a departure.................................................................................................6
Secrecy ? ................................................................................................................................ 6
Unplanned Exit.................................................................................................................................6 Planning without secrecy..................................................................................................................7 Planning in secret .............................................................................................................................8
Exit planning - relationship between Member States and the EU institutions....................... 9 Exit types ............................................................................................................................... 9
Key considerations in planning an Exit .......................................................................10
Task Force Charter............................................................................................................... 10 Planning is essential – the Task Force must be formed (and its existence denied).............. 11
The Task Force’s key considerations...........................................................................12
Exit – the run-up .................................................................................................................. 12 First priority – preventing a European, and therefore global, banking collapse .................. 12 Winners and losers............................................................................................................... 13
Euro banknotes – identifiable by country-issuer ............................................................................14
Minimising windfall gains and losses.................................................................................. 16 Redenomination uncertainty ................................................................................................ 18 Exit without Euro abandonment .......................................................................................... 19 A single country’s exit – the advent of intra-Euro currency risk......................................... 21
Hedging Intra-Euro currency risk...................................................................................................21
Why should the Task Force recommend the abandonment of the Euro ? ........................... 22
New ECU basket for termination or run-off valuation ...................................................................24 Mechanics of the new ECU ............................................................................................................25
The ECB – a major systemic risk ........................................................................................ 27
Why does the ECB/ESCB have such a large balance sheet ?.........................................................29
Target2 ................................................................................................................................. 30 ECB on Exit ......................................................................................................................... 33 European Financial Stability Facility (EFSF)...................................................................... 34 European Investment Bank (EIB)........................................................................................ 35 National Central Banks ........................................................................................................ 35
Conduct of monetary policy ...........................................................................................................35
Lender of last resort........................................................................................................................36
Task Force activation........................................................................................................... 37 Immediate aftermath – the first week .................................................................................. 39
Notes and coins ..............................................................................................................................41 Alternative methods to handle notes and coins ..............................................................................41 Rapid introduction of new notes.....................................................................................................42 Bank and savings accounts .............................................................................................................42 Mortgages.......................................................................................................................................43 Credit card debt, corporate and personal loans...............................................................................43 Pensions and insurance contracts....................................................................................................44
The individual’s perspective ................................................................................................ 44 The business perspective...................................................................................................... 45
Multinational companies ................................................................................................................45 Exporting & importing businesses .................................................................................................46 Local businesses .............................................................................................................................46
Constitutional and legal questions ....................................................................................... 46 A German-only back-up plan............................................................................................... 47 Short-term disaster planning and avoidance ........................................................................ 48
Future political, economic and financial health...........................................................50
What does success look like for the announcement phase ?...........................................................50 Stability, growth and future prospects ............................................................................................51 Argentina ........................................................................................................................................51 Argentinean and Greek parallels ....................................................................................................53
Fiscal discipline ................................................................................................................... 54 Southern Countries, inflation and the future........................................................................ 55 Northern Countries post-Exit............................................................................................... 56 Trade and the EU ................................................................................................................. 56 Post-Exit exchange rates ...................................................................................................... 56 New Europe ......................................................................................................................... 57
Summary and Conclusion ............................................................................................57
This essay will consider the wide-ranging implications of the putative exit from the Euro of one or more current member states. It proposes a plan to minimise the inevitable disruption and maximise the chances of future growth and prosperity. It will not consider the likelihood of this event (since the essay title has made this the preexisting condition). It will look in detail at the timelines that an exit might exhibit; critically, and in detail, at the implications on the financial infrastructure of such an event; at the legal questions and the ambiguities that will inevitably arise, and at the economic and financial implications in the immediate aftermath. It will briefly consider what a post-exit world might look like for a country that has departed. However, it will not present a detailed longer-horizon analysis of the post-exit economies (since it is certain to be so wide of the mark !), except where some economic analysis along well-established lines appears relevant to the central question.
Almost every contemporary reader will be familiar with the background to this essay’s central question. However, for future readers, or those small number who are unfamiliar with the background, I will summarise a very brief history of Europe’s Economic and Monetary Union (EMU) up to the end of 2011. EMU was first formally countenanced in the Single European Act of 1986, and set out in more detail in the Delors Report of 1989. The path to EMU was formally agreed at the Maastricht Summit in 1991 (signed, after some delay, in 1993), at which three stages (I, II & III) were planned, stages I & II heralding convergence to ultimate monetary union (stage III). Maastricht was signed by all the twelve member states at the time, although the UK and Denmark negotiated separate EMU opt-outs. Three further new member states joined in 1995, and they signed up to EMU by default – since the EU’s constitution is the sum of its pre-existing Treaties. Maastricht imposed four criteria for member states entering stage III (full ERM membership – i.e. adopting a currency initially called the ECU but later (1995) called the Euro). These were: 1. Inflation – no higher than 1.5% p.a. above the average of the lowest three countries 2. Fiscal Prudence – Annual Government deficits not to exceed 3% of GDP; outstanding Government debt not to exceed 60% of GDP 3. Exchange Rate – Member states to have had two years’ membership of the Exchange Rate Mechanism (and no devaluations in the period) 4. Long-term Interest Rate – Member states to have long-term interest rates no higher than 2% above the average of the three lowest inflation countries (i.e. those in (1) above). Writing in mid-2012, these criteria look rather quaint now. Interestingly, the first, third and fourth criteria have been largely forgotten; but the second – the fiscal prudence criterion – formally referred to in the Maastricht Treaty as the Excessive Deficit Procedure, has lived on rather notoriously.
The various negotiations that took place between December 1995, when the new currency’s name was changed from the ‘ECU’ (in the Maastricht Treaty) to the ‘Euro’, and May 1998, when the initial membership and exchange rates to the Euro were decided and announced, are important because they sowed the seeds of the Euro’s current travails. The decision made on 3 May 1998 to admit eleven1 states to membership was an important signal which was largely ignored. The market was genuinely unsure before the 3 May meeting whether Italy, who missed the outstanding debt criterion of 60% by a mile (with over 100% debt to GDP ratio), would be allowed to join. The decision to admit Italy, and blatantly flout the rules, turned out to be an accurate pointer to subsequent decisions on admission, and indeed to the policing of existing members. The fig leaf was instructive – Italy was admitted because its ratio of outstanding government debt to GDP was “sufficiently diminishing and approaching the reference value at a satisfactory pace”2. On any objective measure, there was no evidence in 1998 of “sufficient diminution and approaching the reference value” of Italy’s outstanding debt3. On 1 January 2001, just two years after the foundation of the Euro, Greece was admitted. There was little fanfare, and the official report which lifted the excessive deficit procedure for Greece4 allowed a great deal of optimism. By the report’s own admission, Greece’s outstanding Government debt was 104.5% of GDP in 1999 (following 106.3% in 1998). It later turned out that Greece had falsified both these figures, and also the Government deficit figures5. But even so, had these figures been correct, it would have taken Greece 25 years to reach the 60% debt reference level if the reduction had continued at the same pace ! There have been five more new Euro members since 2001 – Slovenia (2007), Cyprus & Malta (2008), Slovakia (2009) and Estonia (2011), making a total of 17. All the recent joiners are very small from an economic perspective.
The missing four being the UK & and Denmark with an opt-out; Sweden who “didn’t qualify” and Greece, who didn’t qualify by reason of its excessive government deficit and debt. Sweden’s failure to qualify was by reason of its non-membership of the ERM, and was in effect an opt-out exercised by Sweden. Maastricht Treaty; Article 104c; extract from 2(b)
Italian debt as % of GDP: 1995: 120.9%; 1996: 120.2%; 1997: 117.4%; 1998: 114.2%; Source: Eurostat, General Government Gross Debt as % of GDP (Maastricht definition). 4 2000/33/EC: Council Decision of 17 December 1999 abrogating the Decision on the existence of an excessive deficit in Greece. 5 Although the word ‘falsification’ was never used in Eurostat’s 2004 report (Report by Eurostat on the revision of the Greek government deficit and debt figures, 22 November 2004), the evidence on revisions, and the selective and inconsistent use of accounting conventions makes a damning case. As an example, this report shows that by 2004, Greece (at the behest of the EU) had revised its outstanding debt for 1998 and 1999 to 112.4% and 112.3% of GDP respectively.
Planning for a departure
Secrecy ? There are only three types of departure possible: • • • Completely unplanned Planned without secrecy (i.e. in public) Planned in secret
At one level any Eurozone exit is, by definition, unplanned. EMU’s architects designed a system in which exit was neither possible nor conceivable. Hence the subject of this essay is dealing with the unpicking of a system which was not designed to be unpicked. That being said, the apparently different routes above are a continuum rather than fully distinct. Clearly it is almost inevitable that at least one person in a senior official position in a departing country will have thought about the actions needed by that country in the event of a departure from the Eurozone6. If that person is a senior Treasury official in a Eurozone member state, does a departure of that country constitute a completely unplanned exit ? What about these thoughts having been committed to paper by this official alone ? What if thoughts have been committed to paper by a small group of officials, even working informally ? Hence the caveat about the difficulty of distinct categorisation. But for practical purposes, it does matter whether there is some time for planning or not, and indeed in the very short term, the difference between a planned and an unplanned exit is likely to be fundamental to the path of the crisis and probably the ultimate outcome. Unplanned Exit Unplanned exit is likely to be the result of a major and unstoppable financial or political crisis7 which erupts quickly despite the continued protestations of the main players that increasing fiscal integration remains the direction of policy. A completely unplanned exit is likely to have really serious consequences for both the population of the departing country, and for the remainder of the Eurozone. If multiple countries leave without planning, then the chaos is likely to be disproportionately greater. In the most extreme of unplanned exits, say in a military coup, one could imagine waking up one morning in Greece to a news announcement that the Government of the day has been replaced by a military junta; that all borders have been temporarily closed, and that a curfew has been imposed. You are told that the Governor of the Greek central bank has been replaced by a nominee of the junta, and he has announced that, with immediate effect, the new currency of the country is the (new) Drachma. The announcement may continue that the
Perhaps just by reading the short-listed entries to the Wolfson Prize !
For example, the surprise election of an avowedly ‘Exitist’ party to power in one member State; the complete failure of a sovereign to be able to borrow in the markets or from a multilateral funder; a military coup or popular uprising in, say, Greece.
official conversion rate of the Drachma to the Euro is, say, 3.4075 Drachma per Euro8. All contractual commitments, debt, assets, money, pensions, indeed everything within Greece that had been denominated in Euros would now be denominated in Drachma. With no planning, and no ability (or desire) to consult their Eurozone partners, one can imagine the chaos that would ensue. The most obvious desire would be for Greek residents to try to get their Euro banknotes out of Greece, since if they could do so, they could preserve the notes’ purchasing power. The likely result of this would be an unwillingness to bring their notes out into open circulation, since presumably the junta would also issue a decree that the moment a Euro banknote was tendered to a shop or bank, the shop or bank would be obliged to overstamp, or maybe confiscate, the note. Much worse from an international financial solvency perspective is that a unilateral redenomination of sovereign liabilities would punch large holes in the balance sheets of the European Central Bank (ECB), the European Financial Stability Facility (EFSF), and the rump of the Eurozone private sector banking system which still owns Greek sovereign debt. Similar damage would be inflicted on any non-Greek Eurozone banks with loans to the Greek private sector. The swapped Greek Sovereign bonds issued under the March 2012 swap agreement are written under English law, so redenomination could not be effected without a specific repudiation of the debt contract. Under the conditions outlined, I do not imagine that a revolutionary Greek Government would regard that as much of a hindrance. I paint a particularly bleak picture here (and there are many less bleak possibilities), but not, I believe, a totally implausible one. Planning without secrecy So is it in theory possible to plan for an exit of one of more countries without secrecy (i.e. in public) ? I believe not, and this is why: The Euro’s very nature is predicated on its indivisibility. Individuals, companies and banks within Eurozone member states were content to treat each Euro equally, wherever it was located, only because there was perceived to be no risk of arbitrary devaluation of one region’s or country’s Euro. At the time of writing (May 2012), this perception has begun to change, and I will explore the impact of this change later. However, if officials and politicians within the Eurozone embark on an open discussion about plans for a Euro departure (however remote they claim the risk to be), the perception of equal treatment of all Euros will be lost, and potentially unlimited capital flight will ensue, particularly when the current cost and difficulty of capital flight is zero or close to zero. For those readers unfamiliar with what wholesale capital flight means, I will be exploring it later in the essay.
The entry rate of the Drachma when it joined the Euro in 2001 was 340.75 Drachma (GRD) to the Euro. I (arbitrarily) choose 3.4075 as being equal to 100 old Drachma.
Planning in secret “Once you eliminate the impossible, whatever remains, no matter how improbable, must be the truth.” Sir Arthur Conon Doyle. Sherlock Holmes’s famous quote has intuitive appeal because, like the scientific method, it relies on observation and reasoning to discover the truth, untrammelled by preconception or prejudice. In the previous two paragraphs I have attempted to illustrate the undesirability of an unplanned exit, and the impossibility of a public exit-planning process. What remains planning in secret - is by Holmesian logic the only available alternative. I have been asked whether it is really possible for material plans for an exit to be put in place in secret. My accurate answer to that is that I can’t know. But I do know that the incentives for one or more Governments to do so are so high that I suspect that they will succeed in doing so. There are innumerable parallels for major projects successfully planned in secret, although most of the examples that readily come to mind are military: the location of ‘D’-day landings; the Manhattan Project’s development of the atomic bomb; Iraq’s invasion of Kuwait and Argentina’s invasion of the Falklands. All of these projects were large scale in terms of men and material, much physically larger than the planning processes required for a Euro exit. But if I were Prime Minister of the Hellenic Republic, or Chancellor of the Federal Republic of Germany, or indeed the leader of any of the Eurozone member states, I would have already commissioned a very small task force, probably led by a member of the secret intelligence service, and staffed with a small number of highly-regarded and fully vetted individuals drawn from the economics profession, the National Central Bank, the financial regulator and the commercial and investment banking community. I would invite them to contribute to the compilation of a Euro exit plan on the basis that the entire work, and its existence, was a matter of national security, and that a breach of the secrecy would be a criminal offence and, in effect, a treasonable act. This is the basis on which secret military plans are made, and it would likewise be the basis on which secret Euro exit plans would be made. Military Parallels There is quite a close parallel with another secret contingency planning activity which many developed countries undertook since the second World War – post-nuclear holocaust planning. The event was almost too terrible to contemplate (certainly in a different league to Euro exit or breakdown !) and a much more remote likelihood than Euro exit, but despite this many Governments (rightly) believed that it was their civic duty to lay detailed plans for this remote and terrible contingency. However, being seen to be planning for the event was widely believed by authorities to be likely to sow alarm and despondency among the population, and so planning, even physical construction of facilities, was kept secret. Since more than twenty years have passed since the end of the cold war, and the very significant lessening of the risk of a nuclear exchange, some of these plans have now surfaced, and from those that have, it is evident that a great deal of money and manpower has been devoted over many years to developing and updating these plans in almost total secrecy.
Small Task Force At a practical level, I do not think that a Euro exit task force need be large, nor do I think that compiling an effective plan is a particularly big task when measured by national capabilities. Perhaps twenty of the right professionals (together with support staff) employed for six months would in my opinion be able to prepare a pretty comprehensive set of plans for the politicians of the day, and perhaps five to keep it up-to-date. The only possible physical activity contemplated would be the prior printing and storing of banknotes, although alternatives to this do exist9, and I describe one later in the essay. By contrast, I do not think it would be possible for the EU or any of its institutions to conduct such a planning exercise. Such an exercise would be one of self-destruction, and therefore I believe, fundamentally difficult to execute, particularly in secret. Exit planning - relationship between Member States and the EU institutions I have suggested that planning for Euro exit must be conducted at national level. This brings me to the question of the extent to which there is communication between member states, and between member states and EU institutions on this topic. I believe there is some chance of international co-operation amongst member states, but I think that the requirement for absolute secrecy is so high that the co-operation is likely to be minimal, and probably only bilateral. I also think that there is no chance that member states will communicate their plans, or indeed their plans’ existence, to any EU institutions on the grounds that their secrecy can then no longer be guaranteed. Exit types There are a surprisingly large number of alternative types of exit possible, and although the purpose of this essay is not to guess which one will emerge, it certainly is to examine which ones are most likely to lead to long-term financial and economic stability. I set out below what I perceive as the full likely set of possible exit types (note that there are in theory many more permutations possible, but I ignore them as materially similar to those listed): 1. Group leaves out of the top (“super Euro”); Euro intact below 2. Group leaves out of the top (“super Euro”); fragmentation below (Euro abandoned) 3. Fragmentation out of the top; Euro intact below 4. Fragmentation out of the top; new group (“Mediterranean Euro”) below (Euro abandoned) 5. Group leaves out of the bottom (“Mediterranean Euro”); Euro intact above 6. Fragmentation out of the bottom; Euro intact above 7. Fragmentation out of both top and bottom; Euro intact in the middle 8. Full fragmentation (Euro abandoned)
And indeed it is possible that member states have stored old national currency notes and coins. At the reunification of Germany in 1990, East German coins were melted down, but most of the notes were stored for 11 years in underground tunnels until a minor opportunistic theft in 2002 precipitated their destruction.
Note that ‘fragmentation’ in this context means that one or more countries resume the use of their own National Currency. In the essay, from this point onwards I will use “Exit” to mean any of the above unless otherwise specified. Interestingly, most Press and other comment has hitherto focused on 6) above. I will discuss this in much more detail later as I discuss the financial and other implications of Exit.
Key considerations in planning an Exit
How a national Exit Task Force goes about its work depends crucially, in my opinion, on the member state concerned. I think that one member state – Germany – has a completely different position with regard to the Eurozone compared to all the others. Germany is the largest economy in the Eurozone by some margin; it has by far the largest trade surplus within the EU, and it and the Bundesbank have become at the date of writing (May 2012) the effective funder and guarantor of the Eurosystem. While the other sixteen Eurozone member states should be busy preparing national exit contingency plans for their own countries, I believe that Germany should be busy preparing a Eurozone-wide proposal. It may be that the implications for the Eurozone of a potential exit are so profound that Germany feels obliged to consult France on this topic. I think Germany is unlikely to consult more widely in the planning stage, as to do so would sharply raise the risk of a breakdown in secrecy. However, in view of the critical importance of Germany to the Eurozone’s existence, from now on, I am going to concentrate on the national plans that Germany might draw up. Task Force Charter When Germany’s Exit Task Force gets to work, it needs to have been given a policy framework (“Task Force Charter”) to guide its practical proposals. Sadly, this Charter will not be available for prior discussion, and the EU will have to depend on the sagacity of the Charter designers for the post-Euro order. On this will turn the success or otherwise of the future path of the EU, and, as in war, one key individual (or very small group) may emerge to show inspirational leadership in this context. But at the Charter design stage, it will all be secret. I set out below the key goals that I believe the Charter could seek to achieve: 1. Maintenance of liberal democracies in all Eurozone member States. 2. The continued existence of the EU10 as a voice in the world, and as a force for binding the nations of Europe by trade and mutual interest. 3. The continuation of a European free trade area, without capital controls, within the whole of the current EU (not just Eurozone) membership and EFTA. 4. Future economic and financial health of all Eurozone11 (and indeed EU) member States as far as is possible. This will require:
I suggest later that a name change (to ‘New Europe’, say) might be appropriate to signal the fundamental change that Euro Exit would bring. This would be the fourth name – the others (in order) were European Economic Community; European Community; European Union.
a. An Exit transition period which succeeds in preserving the integrity of the financial system in each Eurozone Member State. Which will in turn require: i. as much certainty as possible in determining the currency of denomination of all financial instruments and contracts post-Exit, and ii. the minimisation of windfall gains and losses, particularly in the banking system. b. An economic framework which provides aligned economic incentives for the future for both member state Governments and their people. c. A new European economic and financial order which is widely perceived to be sustainable and resilient in the long-term. It is essential particularly that the markets do not continue to bet on further crises. Headings 1) to 3) above are political principles which I believe would resonate with the founding fathers of the European Economic Community in the 1957 Treaty of Rome. I will not discuss them further in this essay – I will take them to be in some sense self-evident and capable of commanding wide support. However heading 4) is the practical matter where all the energy of the Task Force in planning and policy will need to be concentrated. The remainder of this essay will concentrate on this heading. Planning is essential – the Task Force must be formed (and its existence denied) In the preceding sections I have argued the following: 1. Eurozone Exit in some form is possible. 2. If such a risk exists, whatever the desire on the part of the core Eurozone members for further integration within the Eurozone, then some contingency planning must be made. 3. The consequences of a completely unplanned Exit are likely to be catastrophic, and even a full understanding of how catastrophic can only be made in the context of a secret Task Force. Hence, this essay’s first concrete recommendation is that: Recommendation 1: Germany (possibly together with France) establishes a secret Task Force, with a Charter to design proposals for planning and managing possible Eurozone Exit. Ideally France would join to give legitimacy – but secrecy and speed is essential, so only a token joint operation may be possible12.
I.e. the current 17-member Eurozone membership – as per the essay title.
Writing in May 2012 just after the election of M. Hollande to the French Presidency, it now seems less likely that France and Germany would find it easy to co-operate on the task force I suggest.
The Task Force’s key considerations
Exit – the run-up The first and overriding requirement of the Task Force is secrecy. I have already discussed the overwhelming desirability of secrecy, and the likelihood of it being maintained. The risk of secrecy breaking rises with time, hence the next requirement for the Task Force is speed. Speed is in any case essential since many current Eurozone member States (and their banks) require large amounts of financing or refinancing on a continuous basis. This brings me to my next recommendation: Recommendation 2: Whatever the results of the Task Force’s deliberations, firm plans and proposals should be in place as soon as possible using all means at the Task Force’s disposal.
It may be that the Task Force’s plans (and indeed the existence of the Task Force) never see the light of day. It may be that the plans only need to be brought to the Council of Ministers in 2015. It may be that they are needed immediately. Whatever the outcome, unless really rapid planning is completed immediately, then the EU (and the world) is at risk of a major financial collapse. First priority – preventing a European, and therefore global, banking collapse The Eurozone has created a series of unique problems for the management of an Exit. At the forefront of these is the Eurozone banking system, and its banks’ balance sheets which are currently denominated in Euros. No risk-weighting has been made (nor indeed permitted to be made) for currency risk within Euro-denominated assets. The problem is much compounded by the design of the Euro, which in effect denies that assets, liabilities or associated derivative instruments have country domicile. A founding principle of the single currency was that the country of domicile was irrelevant, and indeed often undefined. It is this single act of policy (the “welding shut of the emergency exits”) that has put the whole banking system at such risk. Let’s look at a stylised example: a Bank in a potentially ‘strong’ country, like Germany. The balance sheet is expressed in National Currency [i.e. Euro pre-Exit, and Deutsche Mark (‘Swift’ code: DEM) post-Exit]. For convenience let’s assume that the EUR/DEM conversion exchange rate at redenomination is 1:1; and that following Exit, the DEM rises 30% against what’s left of the Euro; and that the Euro survives without Germany. We will revisit all these assumptions later.
Example of German Bank Balance Sheet
National Legal Tender Currency, bn
ABC Bank, AG Pre-Exit (EUR) Assets Loans to German residents Loans to non-German residents Liabilities Deposits Term debt Equity Capital
Post-Exit (DEM) 50§ 35*
70 25 5
70¤ 25~ (10)
Assume that all German residents’ debt is converted to DEM * Assume that the continuation of the Euro means that Euro-denominated debt owed by non-Germans remains in Euros. These loans include non-German sovereign debt and non-German mortgages. ¤ Assume that all deposits in German branches are redenominated into DEM, irrespective of the domicile of the depositor (which would be difficult to ascertain). I assume this is a largely domestic bank, hence there are no depositors in non-German branches or outside the Eurozone. ~ Assume that German law requires that Euro-denominated debt issued by German resident companies and banks is fully redenominated in DEM
The upshot of this is that ABC Bank is insolvent, and the extent of its solvency or otherwise is crucially dependent on the redenomination treatment of the various components of its balance sheet. To the extent that this treatment is under Germany’s control, the uncertainty can be contained or eliminated. Indeed, it is likely that all entities operating within Germany, or under German Law, will suffer forced redenomination of all their debt, and also their assets as far as they are under German control. And herein lies the problem. A German bank owning, say, French Government bonds, will not be able to have them redenominated into DEM. They will remain in Euros, or indeed themselves be redenominated into French Francs (‘Swift’ code FRF) if further fragmentation takes place. So as a general rule, it seems likely that much or most of the liability side of banks’ balance sheets will be redenominated at Exit, but that only the domestic element of the asset side will be. Winners and losers If underlying Euro-denominated asset values are not changing, and the example German Bank above becomes insolvent, then who, if anyone, gains ? There are two classes of winner. The first is bank customers.
At the time of writing, it is possible for a Greek13 resident person to travel to Germany, open an account there at the German branch of a German bank, and deposit any amount of Euros he can lay his hands on. He might even have increased his mortgage in Greece on his Greek home if he can to give himself some extra liquidity. In doing this, the Greek resident is buying a free option. There is little or no cost in doing this; no downside, and potentially a very large upside. If the bank chooses not to accept his deposit (unlikely if it is legally obtained), our Greek can simply decide to hoard German-issued Euro notes, ideally (just to avoid any possible exchange controls and subsequent illegality in moving cash across borders) stored in a safe deposit box in Frankfurt. Euro banknotes – identifiable by country-issuer It is worth noting, to the surprise of many commentators, that Euro notes are not formally issued by the ECB, but by each member State National Central Bank. Each Euro note is accordingly marked with a prefix letter according to its issuer14 as follows:
I propose to use Greece as my example for a ‘weak’ Eurozone country, and although at the time of writing (May 2012) Greece is the most vulnerable of the Eurozone member states, I would like it understood that when I use ‘Greece’ I am referring to any weak Eurozone country with a large external (balance of payments) deficit together with a large fiscal deficit and outstanding public debt. Sadly, many member states satisfy these criteria. Euro banknotes are printed in many locations, including non-Eurozone countries (like the UK). All commentators (including the author) regard the location of the printer as irrelevant to a note’s value. The ECB retains overall control over banknote issuance, but it authorises individual National Central Banks (NCBs) to actually issue banknotes. The identity of the issuing NCB is marked on each banknote. Whether or not these are formally a liability of each NCB, or collectively of the whole Eurosystem of Central Banks (ESCB), is not entirely clear, since without a Euro exit, the question is irrelevant (and the Euro was designed without exit provisions).
Table 2 Serial Number Prefixes for Euro banknotes’ Country of Issue Country of Issue Serial Number Prefix
Estonia Slovakia Malta Cyprus Slovenia Finland Portugal Austria Netherlands Italy Ireland France Spain Germany Greece Belgium
D E F G H L M N P S T U V X Y Z
So a Greek (or indeed any non-German resident) could sort through his or her notes as they acquire them, and pass all non-X prefix notes on to shops or back to the bank, and retain all X prefix notes, perhaps in the safe deposit box in Germany. This is as close to a free financial option as any individual will ever be faced with, since the chance of loss is nil (the cost of holding ‘X’ prefix notes is the same as holding any other prefix banknote), and even compared to a bank account, the lost interest is negligible. The opportunity of gain (even if the probability is small) is very substantial indeed. Similarly with moving wholesale amounts of money via the banking system. The other winners are likely to be the banking systems of weaker currency countries. Let’s take the same size Bank as in Table 1, but analyse it as if it were domiciled in Greece. Let’s assume that the Euro survives, and that in Greece there is a new currency, the Drachma (‘Swift’ code GRD), for which the official conversion rate in this example is 1:1 (just for convenience). Assume the GRD falls by 60% against the Euro in the market on the first day of trading.
Example of Greek Domestic Bank Balance Sheet
National Legal Tender Currency, bn
ΑΒΓ Bank, AE Pre-Exit (EUR) Assets Loans to Greek residents Loans to non-Greek residents Liabilities Deposits Term debt Equity Capital
Post-Exit (GRD) 50§ 125*
70 25 5
70¤ 25~ 80
Assume that all Greek residents’ debt is converted to GRD. * Assume that the continuation of the Euro means that Euro-denominated debt owed by non-Greeks remains in Euros. These loans include non-Greek sovereign debt and non-Greek mortgages. ¤ Assume that all deposits in Greek branches are redenominated into GRD, irrespective of the domicile of the depositor (which would be difficult to ascertain). I assume this is a largely domestic bank, hence no depositors in non-Greek branches or outside the Eurozone. ~ Assume that Greek law requires that Euro-denominated debt issued by Greek resident companies and banks is fully redenominated in GRD
So we can identify at least two potential ‘winner’ categories – All non-German individuals and companies in the Eurozone (and indeed any nonEurozone resident) who has the capacity and ability to exploit the free ‘redenomination option’. Weaker-country resident Banks, and weaker country sovereigns via debt redenomination. Minimising windfall gains and losses It seems evident that one of the Task Force’s principal tasks is to minimise windfall gains and losses, since many of the losses will be in geared financial institutions, and these threaten financial stability. There is the additional moral imperative that ordinary people’s financial position is not impaired beyond repair or outside their control to an unreasonable extent. Clearly, it will not be possible to protect fully every group, just as Governments cannot, for example, fully protect classes such as savers from the effects of inflation. Let us take the two principal classes of windfall winners identified above.
Southern depositors in northern states (and debtors in southern domiciles) o There is now (May 2012) increasing evidence of capital flight from southern Eurozone states. In late 2011 and early 2012, the ECB narrowly averted a major banking liquidity crisis by extending unlimited funding at very low interest rates to all Eurozone banks. I will discuss the implication of this Long-Term Refinancing Operation (LTRO15) funding in the ECB section below. Interestingly, there is little evidence to date of bank note hoarding16. It is now evident that a hitherto little-understood form of southern-country financing (Target2) may also lead to windfall gains for weak countries at exit, and windfall losses for the ECB’s owners in proportion to their adjusted capital key17.
Weaker-country resident Banks o Reducing weaker-country resident bank windfall gains is the reciprocal of trying to minimise stronger-country resident bank losses. There is little that can practically be done to alter the core transfer of value, and this is because generally18 the currency denomination of the debtor or debt issuer is under the control of the Government of the departing State. A departing State cannot influence the denomination of an asset issued outside its borders and not under its legal control.
In practice, therefore, the Task Force needs to make informed estimates of the likely scale of windfall gains and losses of all systemically important Banks in the Eurozone (in practice, in the EU). The Task Force should then prepare each Government for the possible support needed for each bank (strong country banks), and perhaps encourage Governments to tax the windfall gains of the weak country banks. In the perfect world (unlikely in the fraught nature of these events), Governments from weaker countries might agree to transfer some of these windfall gains to stronger country Governments to help the latter support their own banking systems. Given that stronger countries have (almost by definition) stronger Governmental balance sheets, it is almost inconceivable in the real world that such transfers should be agreed and take place.
An ECB operation which has loaned about €1 trillion (at May 2012) to over 500 European banks for a 3-year term at an interest rate of 1% p.a. The loans are secured with collateral, mainly southern sovereign debt.
The ECB publishes Euro note circulation statistics, which show little movement (up to February 2012) in the value of overall note issuance. http://www.ecb.int/stats/euro/circulation/html/index.en.html
Each member state in the Eurozone has a capital key which is the proportion of the ECB’s capital to which it has subscribed. However, because non-Eurozone EU member states have essentially not subscribed their capital key proportions, and are not liable for ECB losses, the reality is that Eurozone member states’ liability is likely to be in proportion to their capital key adjusted for non-Eurozone non-subscribers. For example, Germany (the largest shareholder) has a capital key of 18.9373%, and an adjusted capital key of 27.0647% as at 28 December 2011. For more information on ECB capital keys, see http://www.ecb.int/ecb/orga/capital/html/index.en.html. [27.0647% = Germany’s paid-up ECB capital (€1,722,155,360.77) / Total paid-up ECB capital (€6,363,107,289.36)]. The position of Greek Sovereign Debt has recently changed, as the bonds issued in March 2012 as part of the enforced Greek bond swap (i.e. default) are drawn up under English law rather than Greek law. This significantly complicates the application of lex monetae in a redenomination of Greek sovereign debt in a possible Greek exit.
In practice, many large, stronger-country banks (based mainly in Germany, the Netherlands, France and Austria) will become insolvent without Governmental assistance. It should be made abundantly clear in the Exit announcement that the Governments and National Central Banks of their respective countries are standing fully behind each of these Banks. This should fall short of a full guarantee (i.e. not go the 2008 Irish route), but give depositors and interbank markets the confidence that the entities will continue to fulfil their obligations. Support like this was administered to many of the world’s largest banks in 2008 by (mainly) the US, the UK and Switzerland. Bank bond holders (as distinct from depositors) were largely bailed out in 2008. I suspect that they may have to bear a large measure of the losses this time round along with bank equity holders. The role of the National Central Banks (NCBs) in this crisis is not to protect the value of these investments, but to guarantee the integrity of the banking system. Much work on banking solvency has been undertaken since 2008, and new instruments (bail-in bonds, contingent convertible bonds), new bonus practices (clawback, deferral and payment in shares) and higher Tier 1 capital should somewhat ameliorate what will be very serious damage to bank balance sheets. Once the immediate crisis is over, then clearly urgent thought should be given to ensuring that banks that received support should be able to resume standing unaided in the private sector as soon as is practicable. Redenomination uncertainty “If it were done when 'tis done, then 'twere well it were done quickly”. William Shakespeare, Macbeth. I turn now to one of the most intractable transition problems – namely the question of the redenomination or otherwise of commercial and financial contracts of all kinds which appear to be ‘stateless’, or where the legal system under which they are agreed to be judged is not a Eurozone member. Examples of instruments exhibiting this uncertainty are: Forward foreign exchange contracts with the Euro as one leg, undertaken under nonEurozone law o Even forward foreign exchange contracts with the Euro as one leg, undertaken under Eurozone law might be problematic if the ‘location’ of the Euro leg is uncertain.
Euro-denominated interest rate and currency swaps undertaken under non-Eurozone law. Euro-denominated debt issued by Eurozone corporations outside the Eurozone, and not under Eurozone law. Euro deposits in banks domiciled outside the Eurozone, irrespective of the residency of the depositor (another point of contention). Euro denominated commercial contracts (e.g. long-term supply contracts, etc.), particularly where at least one party is located outside the Eurozone, and not under Eurozone law.
I could go on, but it is clear that just the foregoing runs into potential transfers of value of at least hundreds of billions of Euros. The Task Force needs to ensure that denomination disputes do not become a catalyst to damage fatally both the relevant financial systems, but also the ability of commercial companies to operate in a stable framework. After much thought, I have come to the conclusion that the only way to prevent ruinous litigation (particularly relevant in the UK and US, under whose legal systems a large proportion of the world’s financial instruments operate), is to announce the complete abandonment of the Euro on the first Exit. I believe that the Task Force may well come to a similar conclusion. This may sound like the tail wagging the dog – the Task Force having to preside over the termination of the Euro project simply to find a mechanism to unblock litigation over denomination uncertainty. But there is another, equally cogent, reason for supporting this route. If there is just one Exit from the Euro, then the Euro project is over. The concept of the single currency was predicated on the impossibility of Exit – that it was irrevocable, and immune to the vagaries of market sentiment. For the Task Force to be called to put its proposals to the Council of Ministers is a final recognition that this premise was flawed. There is no half-way house on this, and indeed I set out below in some detail alternatives to complete Euro abandonment. The conclusions of that discussion will emphasise the necessity of this radical route. Exit without Euro abandonment Many commentators would argue that today (May 2012) while a Eurozone Exit is a possibility (even a likelihood), if it is contained to, say, just Greece, then the Euro would be perfectly capable of surviving. At one level, this is true. Outstanding Greek Sovereign debt is about €266bn19, which while a very large amount for a small country (123% of Greek GDP), is not a large amount in the context of a Eurozone with annual GDP of €9.4trn20. Additionally, some €50bn or so of private Greek debt is held in the German and French banking systems. Since most Eurozone banks have already taken or recognised around a 70% write-down on Greek sovereign debt, redenomination on its own should not punch a too-large-to-mend hole in European bank balance sheets. So why such a drastic recommendation (Euro abandonment) for such a small Exit ? The recommendation is because, as I stated above, any Exit demonstrates to the market that Exit is possible. Currently (May 2012) there remains a strong strand of belief (although
Source: Eurostat – Greek Sovereign debt at end 2011 = €356bn (=165% GDP). Since then, in March 2012, Greece has reduced its debt by about €100bn net by defaulting on bonds held by the private sector by the mechanism of enforcing a debt swap on very disadvantageous terms. Hence the May 2012 position is about €356bn + €10bn (half year deficit) - €100bn (default) = €266bn.
Source: Eurostat – 2011 Estimated 17-member Eurozone GDP at current prices
concentrated particularly in Eurozone countries) that Exit is impossible21. This belief would be shattered, and once that happened, almost all of the advantages that a single currency had over an exchange rate mechanism would evaporate. Elsewhere in this essay, I spell out some of the pressure points where this loss of certainty would be felt. The history of the European Exchange Rate mechanism (ERM) within the European Monetary System (EMS) is instructive in this regard. The ERM (a 1979 successor to the moribund European ‘snake’) survived a series of mini-crises [usually resulting in a revaluation of the DEM, and devaluations of the FRF and the Italian Lire (‘Swift’ code ITL)] for over a decade. However, when the Pound Sterling joined the ERM in October 1990, the scale of Sterling in the FX markets, and its relative independence from European economic cycles, created instability which encouraged a speculative attack, culminating in the exit of the Pound, ITL and the Swedish Krona in September 1992. But by now the market had recognised that it had the power to break even quite well established and sustainable links. In the summer of 1993 there was an unprecedented speculative attack on the DEM/FRF parity, which resulted in a crisis which effectively ended the ERM experiment. In August 1993, new bilateral bands of ±15% replaced the former bands of ±2.25%. These bands were so wide that they allowed a free-float of the currencies that remained within the system. From that point onwards, the ERM effectively ceased to exist as a currency stabilisation mechanism. The lesson of this period (and indeed going back further to the 1971-73 collapse of the Bretton Woods fixed parity system), is that if markets believe, with corroborating evidence, that they have the power to break systems of controlled exchange rates, then they have an incentive to do so. This applied in 1971-73; it applied in 1992-93, and it would apply to the Euro the moment the corroborating evidence (e.g. a Greek Exit) appeared. After that, history tells us that a full Euro break-up, with all the series of crises that that would imply, would ultimately be inevitable. If the supporters of the Euro project do pass the point of no return – which in my opinion is the first Exit – and they do not give up the project, then the economic and financial, not to mention political, losses may be many times greater (and certainly unknowable) than would be the case with an early capitulation. There is only one sustainable counter-argument to this line of reasoning. That would be an enduring political union formed around whatever shape the single currency took at the time, and which was much more than simple fiscal discipline or even fiscal integration. It would have to be the creation of a new country, with a single democratic (or other) system of power and governance, and with a common and widespread desire, culture and will to be one country. The US is a good model for this case – although it only achieved ‘country’ status as we understand it after a vicious and destructive civil war nearly a hundred years after its formation as an independent state. Let’s look in a little more detail at the market implications of a single country’s exit.
…“As I see it, the Bundesbank’s Target2 claims do not constitute a risk in themselves because I believe the idea that monetary union may fall apart is quite absurd.”… Dr Jens Weidmann, President of the Deutsche Bundesbank, Open Letter, 13 March 2012.
A single country’s exit – the advent of intra-Euro currency risk As we have already seen in 2010 and 2011, markets are constantly probing and re-evaluating the probabilities and scale of alternative outcomes, and managing their investment and derivative positions accordingly. To date, most of the market pricing of Euro stress has been concentrated in the sovereign debt markets. But this represents just one of two risks within the Euro – the risk of sovereign default. The other risk – the risk of redenomination – has so far not found direct expression in the markets. In February 2012, the Financial Times ran an article22 which explored the development of hedging instruments to protect investors and others against the direct exchange rate risk of a redenomination (i.e. exit) within the Euro. The article reported on a newly developing foreign currency hedging contract, which rather than protecting investors against fluctuations of defined currencies (say US Dollar versus Euro), would instead protect investors against the risk of redenomination by referring not to ‘the US Dollar’ and ‘the Euro’ but to ‘the legal tender from time-to-time of the USA’ and ‘the legal tender from time-to-time of (say) Germany’. By explicitly linking a hedging (i.e. forward foreign exchange contract) to a specific country’s currency, rather than naming the currency, it would be a simple matter (in the legal and financial sense) to create an active two-way market in intra-Euro currency risk. How is this relevant ? The answer is because if one country leaves the Euro, then it will generate real and present fear that other countries are potentially vulnerable to exit, and that therefore all Euros are not the same. One could call this ‘the Geographisation of the Euro’, so that a ‘German Euro’ is perceived as different from a ‘Spanish Euro’ or ‘Greek Euro’. Under these circumstances, all remaining monetary assets that are ‘moveable’ to northern countries will be (since, as I have already mentioned, the cost of doing so is close to zero), and indeed investors and debtors (particularly banks) will want to explore the cost of hedging themselves against the next country’s exit for those assets and liabilities which are immoveable. This is where hedging contracts come in. Hedging Intra-Euro currency risk How would you price a voluntary contract which promised to deliver you, in exactly six months time, 100 units of the legal tender of Germany from time to time in return for X units of the legal tender of Greece from time to time23 ? This is a contract in which you buy ‘German Euros’ forward, and sell ‘Greek Euros’. I suspect the following pricing model may hold sway: if the market perceives the likely depreciation of the new Drachma, if it arrives, would be, say, 60% versus the Euro (i.e. it would be worth only 40% of its current international value against the Euro), and that the risk
‘Investors seek hedge against euro split’, by Alice Ross, FT, 20 February 2012
The mechanics of the contract are such that it would not matter whether Greece chose a new Drachma at 1:1 with the Euro, or 340.75 to the Euro (the 2001 entry rate). On an act of redenomination, the contract terms, originally set at a 1:1 exchange rate (because today a German Euro is worth the same in the market as a Greek Euro) would be adjusted by the official redenomination exchange rate, so that if Greece went back to the old Drachma, then a 1:1 contract would become a 1:340.75 contract, i.e. if the contract is entered into at 1:1, the contract buyer is delivered 100 Euros in six months, and would have to deliver 34,075 Drachma. If the Drachma was trading in the market at, say, 900 per Euro, then the contract buyer would only have to spend €37.9 (=34,075/900) to buy the Drachma they were contracted to deliver, and so would make a €62.1 profit, because he would receive €100 under the contract terms.
of this happening at any time in the next six months is, say, 10%, then X would be set by the market at (0.9 x 100) + (0.1 x 40) = 94. So under these expectations, willing buyers and sellers could exchange six month forward ‘legal tender’ contracts between Germany and Greece at something like 94 cents24 in the Euro for the Greek Euro. Under this pricing, the market expects the German Euro buyer to lose money (€6) 90% of the time, and to make €60 10% of the time. But if this market develops, which I argue it would after a single country’s exit25, then lenders will no longer be prepared to lend to creditworthy Greek domestic borrowers at normal Euro interest rates. Since they can lend (say mortgages) to German borrowers instead at, say, 3% p.a., and then buy “Greek Euros” legal tender contracts at 94 cents in the Euro (or less), the implied interest rate that they are charging for taking Greek redenomination risk is 12.4% p.a. (= 1.06 * 1.06)26, and to this they would add the German interest rate to fully price Greek lending. This is a Greek interest rate of 15.4% p.a., even though the Greek borrower is fully creditworthy – it is not a credit premium – it is a currency risk premium. Arbitrage will ensure that Greek LIBOR rates will have to move near to this level. A full set of differing interest rates could arise, fundamentally destroying the concept of a single monetary policy without giving the southern states the benefit of a more competitive exchange rate. A side effect of such a market response, rather bizarrely, might be that it could provide an effective mechanism to re-privatise the funding of deficit southern states – i.e. provide a mechanism to reverse the inexorable rise of Target2 funding. I will return to Target2 funding later. Why should the Task Force recommend the abandonment of the Euro ? If the Euro continues in existence, then there will be billions of Euros of contracts, of debt and of other instruments operating under non-Eurozone law, which will continue, in the legal sense, to be fulfillable and therefore required to be fulfilled. Most of these will have been undertaken ultimately by entities within the Eurozone or its trading or investing partners for the purposes of normal commercial, financial and investment activity. If these contracts continue to exist, then they are most likely to become divorced from their original purpose. Let’s take as an example, say, the departure of Italy from the Eurozone, but the continuation of the Euro within other Eurozone states. An Italian pension fund holds currency forward contracts to currency-hedge its US assets. These contracts would be to sell US Dollars forward, and buy Euros forward at a fixed exchange rate. If that pension fund finds that all its
94 cents does not include a risk-premium for the weaker currency – just the statistically ‘expected’ outcome. So maybe it would trade at 90 cents, to give the buyer a risk premium (i.e. an expected positive return). If the departing country is Greece, then the contracts described would apply to other countries at risk of exit, not to Greece, which would then have its own currency. The Greek example is just designed to be illustrative of the concept. If there is no redenomination, then the Greek Euro buyer is paid 6 Euros after six months, and then has 106 Euros to ‘hedge’, rather than 100. He therefore buys a further contract for the final six months of the years for 106 German Euros, which equates to 99.64 Greek Euros. If there is no redenomination in the second six months, then he will be paid a further 106-99.64 = €6.36. So he will have €12.4 in addition to his interest rate. If, by contrast, there is a redenomination, then he will lose exactly the same amount on the legal tender contract that he would have lost had he simply lent to a Greek borrower.
26 25 24
pension obligations, and all its domestic assets, are redenominated into a new Lire under the Lex Monetae27 principle, then its currency hedge becomes economically disconnected with the underlying risk, and therefore potentially very damaging. However, if (notwithstanding the recommendation in this essay) the Euro continues, then it would be impossible for the pension fund to renege on its obligations towards these contracts without default. This scenario would be played out in countless different ways, many of them within highly geared financial institutions (banks, etc), whose inability to perform the contracts satisfactorily would again be highly damaging. It is not only derivative contracts that would continue to run if the Euro continued to exist – it would be all debt obligations operating under non-Eurozone law. It is very difficult to quantify what proportion of Eurozone debt (commercial, bank and sovereign) has nonEurozone jurisdiction, but we already know that Greek Sovereign debt issued under nonGreek law traded at a higher price than Greek Sovereign debt issued under Greek law28. This implies that the market had already started pricing-in the probability of redenomination separately from the probability of default. I recommend that the Task Force proposes the abandonment of the Euro because the alternative is to permit rolling contagion and crises over many years, and because abandonment would force the legal frustration of all outstanding Euro contracts, which would itself allow stateless Euro obligations and contracts to be treated in a common way as far as is possible. I envisage that immediately following the Exit announcement, frustrated Euro contracts, with no natural domicile, could with the agreement of the parties be valued and terminated using a European Currency Unit (ECU) calculation similar to the basis for entry into the Euro29. Since the Euro would no longer be deliverable, it seems possible that (at the behest of the EU) both the US and the UK (and other relevant, supportive jurisdictions) could enact legislation that allowed their courts to value outstanding contracts using a newly defined ECU basket representing the value of the defunct Euro, and if delivery was the only option, to deliver the basket. I suggest that actual delivery of national currencies would mostly be inappropriate, and that contracts would typically be valued and terminated with a payment-for-difference one way or the other.
Lex Monetae is the principle that a country may determine its own currency, and hence no party may default on a contract if a government alters its national currency, using a particular conversion rate, so long as they settle in that currency. Amounts specified in the contract will simply be redenominated to the new currency by using the specified conversion rate.
Nomura estimated in December 2011 that, for example, foreign-law Greek sovereign debt accounts for about €16 billion out of a total of €300 billion of total Greek sovereign debt. That value has (in March 2012) been hugely inflated by the issue of Greek sovereign bonds under the enforced Greek debt swap which are under English law jurisdiction.
At the moment of creation of the Euro, 1st January 1999, the ECU ceased to exist, converting to the Euro at 1:1. At that moment, its value was a weighted basket of fixed amounts of 12 EU currencies, 9 of which joined the Euro on 1 January 1999. The others were UK, Denmark and Greece (which joined the Euro in January 2001).
New ECU basket for termination or run-off valuation The Euro’s constituents have expanded since its foundation in 1999. Only 10 current Eurozone member states’ currencies were represented in the ECU that was abandoned at the end of 1998. The Task Force needs to design a fair currency basket instrument, that would command the support of the banking and business community, and which would provide termination and run-off value to the myriad of derivatives and other ‘stateless’ Euro contracts, debt and assets outstanding at the time of writing. My suggestion is that the obvious weights should be the adjusted ECB capital key which determines the effective shareholding (and loss-bearing) weights of the ECB. I set out the current (May 2012) Adjusted Capital Key weights in Table 4 below: Table 4 Euro area NCBs’ contribution to the ECB’s capital A
NCB Banque Nationale de Belgique Deutsche Bundesbank Eesti Pank (Estonia) Central Bank of Ireland Bank of Greece Banco de España Banque de France Banca d'Italia Central Bank of Cyprus Banque centrale du Luxembourg Central Bank of Malta De Nederlandsche Bank Oesterreichische Nationalbank Banco de Portugal Banka Slovenije Národná banka Slovenska Suomen Pankki – Finlands Bank Total
B Paid-up capital (€)
220,583,718.02 1,722,155,360.77 16,278,234.47 101,006,899.58 178,687,725.72 755,164,575.51 1,293,273,899.48 1,136,439,021.48 12,449,666.48 15,887,193.09 5,747,398.98 362,686,339.12 176,577,921.04 159,181,126.31 29,901,025.10 63,057,697.10 114,029,487.14 6,363,107,289.36
C = (B/ Total B) Adjusted Capital Key %
3.4666% 27.0647% 0.2558% 1.5874% 2.8082% 11.8679% 20.3246% 17.8598% 0.1957% 0.2497% 0.0903% 5.6998% 2.7750% 2.5016% 0.4699% 0.9910% 1.7920% 100.0000%
Capital key %
2.4256 18.9373 0.179 1.1107 1.9649 8.304 14.2212 12.4966 0.1369 0.1747 0.0632 3.9882 1.9417 1.7504 0.3288 0.6934 1.2539 69.9705
If these weights are applied to new national currencies at official conversion (i.e. redenomination rates), and converted into amounts of each currency as per the original ECU methodology, then the weights at market rates would change automatically as the market reprices the new national currencies. This would be very likely to raise the German weight, and lower the weights of the southern states. But with this mechanism, there would be a ‘proxy’ for the ‘post-Euro’ value of the Euro. 24
Mechanics of the new ECU In Table 5 overleaf, I set out how a new ECU might be calculated, and how changes in market values of the new national currencies would feed through to the valuation of the ECU versus a reference currency (say the US Dollar). I assume for the purposes of this example that new national currencies are the same both in name and in official (redenomination) exchange rate (see Column A in Table 5) as their predecessor currencies at Euro entry. This need not be the case, but countries that chose differently (say Greece choosing to knock two digits off its conversion value) would not undermine the principles set out here. The table shows how the ECB Adjusted Capital Key (Column B) could be used to determine the amount of each new currency in one ECU (Column C). I have assumed that on the Exit day, the USD/EUR rate is 1.25. This allows us to calculate international (i.e. US Dollar) values of all the new national currencies (Column D) at official ‘ECU’ rates (i.e. the redenomination rates). The first day of trading post-Exit, each of the new national currencies will be priced by the market versus the US Dollar. I have made some (arbitrary) assumptions about the likely appreciation or depreciation of each new currency (Columns E & F), subject to the constraint that on this occasion I assume the market will leave the ECU value close to $1.25 (Total Column G). From the market valuation of the ECU’s constituents following exit, we can recalculate the new weights of national currencies in the ECU – in this example, the Deutsche Mark’s weight rises from 27.1% (the Adjusted Capital Key) to 36.5%. The international value of the ECU would not necessarily stay at $1.25 – it would vary according to the independent market pricing of each new national currency versus the US Dollar. But with this mechanism, there could be a transparent and fully independent marketbased resolution and run-off pricing mechanism for all stateless Euros.
Possible Construction of the new ECU
A Country (National Currency) National Currency Entry / Exit Rate per Euro B ECB Adjusted Capital Key C=AxB Currency Amount per ECU D = A / 1.25 USD Exchange Rate at official exit rates EuroUSD Rate at Exit = (say) 1.25 32.2719 1.5647 12.5173 0.6301 272.6000 133.1088 5.2477 1549.0160 0.4682 32.2719 0.3434 1.7630 11.0082 160.3856 191.7120 24.1008 4.7566 E % Change of National Currency (say) F = D / (1 + E) Example postExit market exchange rates vs USD G=C/F USD Value of ECU's constituents H = G / Total G New ECU Market Weights %
Belgium (Franc) Germany (Mark) Estonia (Kroon) Ireland (Punt) Greece (Drachma) Spain (Peseta) France (Franc) Italy (Lira) Cyprus (Pound) Luxembourg (Franc) Malta (Lira) Netherlands (Guilder) Austria (Schilling) Portugal (Escudo) Slovenia (Tolar) Slovakia (Koruna) Finland (Markka) Total
40.3399 1.95583 15.6466 0.787564 340.75 166.386 6.55957 1,936.27 0.585274 40.3399 0.4293 2.20371 13.7603 200.482 239.64 30.126 5.94573
3.4666% 27.0647% 0.2558% 1.5874% 2.8082% 11.8679% 20.3246% 17.8598% 0.1957% 0.2497% 0.0903% 5.6998% 2.7750% 2.5016% 0.4699% 0.9910% 1.7920% 100.0000%
1.3984 0.5293 0.0400 0.0125 9.5689 19.746 1.3332 345.81 0.0011 0.1007 0.0004 0.1256 0.3819 5.0153 1.1261 0.2985 0.1065
0% 35% -10% -30% -50% -30% 0% -20% -40% 0% -25% 10% 5% -35% -15% -20% 5%
32.2719 1.1590 13.9081 0.9001 545.2000 190.1554 5.2477 1936.2700 0.7804 32.2719 0.4579 1.6027 10.4840 246.7471 225.5435 30.1260 4.5301 USD value of ECU =
0.0433 0.4567 0.0029 0.0139 0.0176 0.1038 0.2541 0.1786 0.0015 0.0031 0.0008 0.0784 0.0364 0.0203 0.0050 0.0099 0.0235 1.2498
3.4670% 36.5418% 0.2303% 1.1113% 1.4043% 8.3085% 20.3271% 14.2896% 0.1174% 0.2497% 0.0678% 6.2706% 2.9141% 1.6263% 0.3995% 0.7929% 1.8819% 100.0000%
The great advantage of the route of full abandonment is that all Euro contracts would automatically come to an end, because the disappearance of the Euro would mean legal frustration of the contract. While in law there is no concept of “Lex Euro-Monetae” – i.e. allowing the Eurozone to determine without legal frustration a change in its own currency from the Euro to the new ECU, the re-creation of the ECU as a run-off currency would enormously aid the process of stateless Euro-contract resolution. The process would need to be conducted as quickly as feasible, especially with the support of the Governments of the US, UK and others. Other relevant non-Eurozone Governments likely to assist in a common resolution framework are Switzerland; Singapore; Australia; Hong Kong; Canada; Sweden, etc. I now turn my attention to the ECB. The ECB – a major systemic risk The ECB is a very unusual central bank, in that it does not have a single Government sponsor. For all major developed countries with their own currencies, the NCBs are, in effect, an arm of Government, and are treated by the markets as if they were the Government of the relevant country. There is good precedent for this. To my knowledge, no developed-country NCB has in modern times defaulted on its obligations without the sponsoring Government simultaneously also defaulting on its obligations. Under normal circumstances, the ECB would not pose a particular threat to the European financial system. Its main remit is to control European inflation by exercising monetary policy – in effect setting Euro interest rates30. However, beginning in 2008, the ECB began to provide ‘liquidity’ in large amounts to banks in the Eurozone. I put ‘liquidity’ in quotation marks because liquidity operations are normally just that – unlocking the value of less liquid assets so that banks under liquidity constraints can always provide the funds that their customers and counterparties require at all times. This ‘lender of last resort’ function is a well-established and very valuable part of the system of management of the integrity of national banking systems. It does not imply any kind of guarantee to any bank, nor does it prevent insolvent banks failing. It is designed to smooth liquidity shocks and short-circuit runs on banks. The ECB’s behaviour, however, has led it towards ‘solvency provision’ as well as liquidity provision. Since the start ‘proper’ of the Euro crisis in 2010, the ECB has been providing core funding to a large number of Eurozone banks who cannot fund themselves except at ruinously high interest rates, or indeed at all. In effect, southern banks have been shunned by investors; these banks have turned to the ECB for funding, with the ECB in turn funding itself with deposits from northern banks flush with cash and with no secure assets to invest in. The scale of the problem was illustrated just recently when the ECB opened a 3-year funding window (LTRO)
“The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term”. Source: ECB.
to Eurozone banks at very advantageous interest rates31, and in one day €489bn was snapped up! A second round saw a further €530bn taken up in late February 2012. The unusual constitution of the ECB, and this large-scale credit provision, has led it into a very vulnerable position. It has a very small capital base – currently €6.4bn. This will rise by the end of 2012 to €10.7bn, and so this last €4.3bn can currently be seen as a 17-nation sovereign guarantee for this amount. But these amounts are tiny when compared to the ECB’s current balance sheet. Its last reported Accounts (December 2011) showed liabilities of €224bn. At that date the ECB’s capital was €6.4bn – this is a 2.8% ‘equity capital’ ratio, well below the requirements of the commercial banking system, and with very concentrated risk indeed. But the ECB’s reported balance sheet is only half (indeed much less than half) of the story. The ECB is the heart of a larger grouping called the ‘European System of Central Banks’ (ESCB – also colloquially known at the ECB as the ‘Eurosystem’). The ESCB is the aggregate of the activities of all the 17 NCBs and the ECB, obviously netting off intra-system transactions and assets/liabilities (like Target2 – see below). The liabilities on the ESCB balance sheet at 4th May 2012 (which includes at the time of writing to an unknown extent the ECB proper) stood at €2.96trn32. The liability side of the balance sheet includes some €1.11trn of ‘cash balances’ held by the private Eurozone banking sector (in effect an ECB overdraft with the commercial banking sector – sometimes called ‘high-powered money’), as well as €880bn of banknotes in circulation. On the asset side sits €1.12trn of lending to the banking sector, much/most of it collateralised with Eurozone sovereign debt, and a line entitled ‘other claims on euro area credit institutions in euro’, which has risen strongly recently, and sits at €205bn. I suspect that at least some of the other assets are non-Euro sovereign debt (the old ‘FX Reserves’ of the NCBs), although the classifications are so anodyne in the reporting (“Securities of Euro area residents in Euro = €607bn”; “Other Assets = €254bn”) that we really do not know. If the ECB had a large Government (like the US) standing behind it, one would not worry about its solvency, beyond worrying about the solvency of the State itself. But with lending (even collateralised lending) to the European banking sector on this scale, and unknown quantities of less-than-perfect-credit sovereign debt, the ECB’s capital is evidently totally inadequate to be a stand-alone entity. We cannot know what the quality mix of the collateral at the ECB is like, as the ECB has been handed a mandate which enforces its acceptance of Eurozone sovereign debt as collateral. As we have seen in the past two years, much of this has been continuously marked down by the market to such an extent that the market is pricing in a high probability of default for several fringe Eurozone member states – and has already had to cope with default for Greece.
Three year Long Term Refinancing Operation (LTRO) at 1% p.a. interest rate. A first tranche was offered on 21 December 2011, 560 banks took up this facility to the tune of €489bn. The second tranche was offered at the same interest rate on 29 February 2012, and 800 banks took up €530bn. This is, in effect, recycling northern bank deposits to southern banks to keep them liquid. Source: ECB Monthly Bulletin; Monetary Policy Statistics; Table 1.1 Consolidated financial statement of the Eurosystem; 4 May 2012.
Why does the ECB/ESCB have such a large balance sheet ? The ECB’s balance sheet is being inflated for a uniquely Eurozone reason partially described above. But the need for the ECB to bail out the European banking system has partially arisen through a self-inflicted wound. What wound ? The ‘wound’ is the scale of southern (and Irish) sovereign bonds which have been bought by the European banking system. Under normal circumstances, commercial banks would not hold longer-dated sovereign bonds. They offer neither the yield needed to be commercially attractive, nor the interest rate structure to match banks’ typical liabilities, which are generally variable (i.e. short-term). By contrast, banks do typically hold Government treasury bills, which are a fundamental source of liquidity, but which are typically less than one year in duration. No Government wishing to promote non-inflationary growth would contemplate financing their deficits solely with sales of treasury bills (or indeed treasury bonds) to the private banking sector, except temporarily and in exceptional circumstances. The literature on this – ‘printing money’ - is about as extensive as any in macroeconomics. The orthodoxy would have Governments sell their debt to long-term savers – Pension Funds and Insurance companies - where these securities’ impeccable credit rating and long duration matched these institutions’ liabilities. But as part of the Eurozone project, Eurozone banks were told, by their national regulators and by the ECB, that if they chose to hold sovereign bonds, these would be nil-risk-weighted in the calculation of their capital requirements. Under normal circumstances, this would not be odd – indeed bank regulators worldwide also assign nil risk weighting to their own sovereign bonds in their banking system balance sheets33. But of course the Eurozone is different. It does not have one sovereign Government sponsor which can ‘print’ its own money, or tax its own citizens at will. So when banks saw that southern sovereign bonds were trading at a modest interest rate premium to banks’ costs of funding (particularly funding from the ECB), a ‘riskless’ arbitrage appeared: Buy Sovereign bonds for, say, Euribor + 2%; fund at Euribor, take the 2% as pure profit, and have no additional ‘risk’ visible on the balance sheet, and no additional capital required. This could be done almost ad infinitum, since the ECB would fund Eurozone banks who offered sovereign bonds as collateral with almost no ‘haircut’. It looked like a ‘money machine’, and to the banks, still does. Except now they can make 5%-15% p.a. on the interest rate differential, depending on the quality of the Eurozone sovereign. The problem, of course, is that the ‘marked-to-market’ value of the bonds has fallen almost continuously over the past two years. The ‘income’ story remains compelling; the ‘capital’ story is a slow-motion disaster. So the ECB/ESCB is the creditor to a large number of fragile banks in the Eurozone to the tune of about €1.3trn. These banks are now poor credits because of their uncontrolled exposure to risky sovereign bonds, and indeed to new risk – the currency redenomination risk of some or all of these bonds. And all this because EU regulators made the rule that Eurozone
Under the (now rather discredited) Basle international bank capital rules, sovereign OECD debt has generally been accorded a zero risk weighting. This still applies under Basle III – the 2010 version of the rules.
sovereign bonds had nil risk attached to them. This was undoubtedly a consequence of the commitment to the ‘Eurozone project’. In practice, therefore, quite aside from the question of Eurozone Exit, the ECB may already be insolvent without additional support from its national Government sponsors. Target2 The Dutch Central Bank (amongst many others) has recently written an explanation of the way that a little-understood intra-Eurozone payments mechanism - Target2 - works34. It was designed just as a payments and clearing system, reasonably equivalent to Fedwire in the US35. Rather to the surprise of Target2’s designers, since the start of the financial crisis in 2007, Target2 has also acted as an ‘automatic’ lending system to weaker countries’ banking systems, not just a clearing system. The Dutch Central Bank explains it well36: “Target2 is the payment system enabling direct transfers between commercial banks in the eurozone. These transfers can arise from many different sources, including trade transactions and interbank loans. Target2 payments are channelled via accounts that banks hold at their national central bank (‘NCB’). If the banks in a particular euro country are net receivers of cross-border payments via Target2, this results in that country’s NCB having a claim on the ECB, which acts as the central counterparty within the Eurosystem. The NCB in a euro country with a net payment outflow will have a liability to the ECB. The accounting entries representing the amounts that NCBs owe to or are owed by the ECB are referred to as ‘Target2 balances’” This explanation makes it clear that Target2 NCB credit balances are an obligation of the ECB, not the NCB that extended the credit. This paper also includes the following statement: “In the extreme and highly unlikely scenario of several countries leaving the EMU, the risks for the remaining NCBs would increase correspondingly as any losses would then have to be shared by fewer NCBs.” While this statement is an opinion, not an established legal position, a cursory reading of the statutes of the ECB does imply that only Eurozone member states have a loss-absorbing role at the ECB, and so it appears that the act of leaving the Eurozone would expunge any liability, assuming that the ECB is not, at the time of departure, already bankrupt. Sadly – and I flag this with much trepidation – the section of the ECB statutes dealing with ECB losses (Article 3337) is very short – much too short to deal with some of the complexities, and the scale, that
“Target2 balances: Indicator of the intensity of the European debt crisis”, 12 April 2012. De Nederlandsche Bank.
35 36 37
For more information on Fedwire, see http://www.federalreserve.gov/paymentsystems/fedfunds_about.htm Footnote 34 op cit.
The only section of Article 33 dealing with losses is section 33.2. Art. 33.2 “In the event of a loss incurred by the ECB, the shortfall may be offset against the general reserve fund of the ECB and, if necessary, following a decision by the Governing Council, against the monetary income of the relevant financial year in proportion and up to the amounts allocated to the national central banks in accordance with Article 32.5.”. Art. 32.5 reads “The sum of the national central banks' monetary income shall be allocated to the national central banks in proportion to their paid up shares in the capital of the ECB, subject to any decision taken by the Governing Council pursuant to Article 33.2.”
will almost inevitably arise. If the ECB does incur significant losses – which is virtually inevitable with the departure of one or more Eurozone members – then the carving out of the national responsibility for these losses, given that the losses will also fall on the weaker southern states, is likely to be the subject of very intense international negotiation, with the possibility of quite serious international conflict if they are not quickly resolved. The issue of Target2 balances would not matter much, were it not for the burgeoning balances that are now evident. Chart 1 below shows the German Central Bank’s credit balance in the Target2 system as at 30 April 2012. The latest figure at the time of writing is €644bn, which is 26% of German GDP, and rising rapidly. The Dutch credit is a similar percentage of GDP (although the information is less detailed and timely), but for Luxembourg, the Target2 balance was about 250% of GDP at end-2011 ! Chart 1
Germany's net Target2 position
Source: Deutsche Bundesbank; Series EU8148B; Jan 1999-Apr 2012; €bn
700 600 500 400 EUR bn
300 200 100 0 -100 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
These flows represent capital flight. But is there an economic explanation for these burgeoning balances, aside from capital flight ? In my view, yes. They represent, inter alia, the impact of the cumulative external balance of payments surplus of Germany with respect to the other Eurozone counties since the start of the Eurozone in 1999. In Chart 2 below, I have illustrated this cumulative trade surplus since Jan 1999. This chart shows that the April 2012 German Target2 balance and the cumulative trade surplus from January 1999 to February 2012 are of a similar order of magnitude38.
The data in Chart 2 are just the trade surplus (cumulative exports to the Eurozone less cumulative imports from the Eurozone), not the full balance of payments, which is not available for this trading pair. For Germany, the trade balance and the balance of payments including services, net interest and dividends are not that dissimilar.
German cumulative trade surplus with Eurozone
Source: Deutsche Bundesbank; Exports (Series XS7084) - Imports (XS7085); Jan 1999-Feb 2012; Euro bn
0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
If a country wishes to import more than it exports, it must borrow money to do so (or sell existing assets). In trade across currency blocs, it must also borrow foreign currency (and lend its own) to willing private sector participants. If this is not possible a country simply cannot run an external (trade) deficit. Inside the Eurozone, it is different. A Eurozone country whose private sector is choosing to import more than its exporters are able to export does need to borrow money, but it does not need to sell or lend its own currency in favour of a foreign currency. Until 2007, it appears from the Target2 balance data that deficit (southern) countries were successful in borrowing from the private sector (to the tune of some €600bn), so that the respective central banks were able to clear all their cross-border Euro transactions, and so stay in balance. Since 2007, southern states have found it difficult or impossible to attract voluntary private sector lenders willing and able to lend money to them39 in sufficient quantity to cover their trade deficits; indeed there has been unwinding of previous loans. So now (May 2012) the privately-funded gap between the cumulative German trade surplus and Target2 is €380bn, and falling. There is no reason why the private sector should not continue to extract itself from all lending to southern countries, leaving only the vulnerable national banking systems, supported by their National Central Banks, in turn supported by ever-rising Target2 balances, to fund them. One way or another, this puts the taxpayers of the respective Eurozone countries at very substantial risk should there be an exit. My contention is that one country’s exit from the Euro would trigger both a political and a market response that would undermine the whole rationale of the Euro – a single monetary policy. Add to this the uncertainty that would inevitably contaminate everything associated
39 For this analysis, it does not matter whether the loans are to the private sector or the public sector – what is important is that they are made to the geographic entity. Southern capital flight is not necessarily a response to specific debtor creditworthiness (although that is undoubtedly a factor) – it is a response to possible currency redenomination (and therefore devaluation).
with Euro-denominated contracts, both after a small country’s exit, and with the prospect of a larger country’s exit, and you have a recipe for rising, and possibly runaway, levels of financial stress combined with a possibly serious weakening of the political will holding the project together. Hence it is the contention of this essay, and I believe an accurate representation of the evidence available, that the Exit of a small country from the single currency would sound the ultimate death knell for the Euro. In view of this, and to prevent disorderly break-up, I make the recommendation that the Euro must be abandoned on the first Exit. Recommendation 3: If circumstances require, the Task Force would propose to the Council of Ministers that the Euro should cease to exist on the day of the Exit announcement, to be replaced by new National Currencies.
Which brings us to the position of the ECB on Exit. ECB on Exit Let us start with a small country Exit, but the continuation of the Euro. Then we will move on to the position where if an Exit becomes inevitable, the Task Force recommendation that there is complete abandonment of the Euro is accepted. Unless it is Germany that exits first, the ECB will be a ‘strong country’ bank (see Table 1 on page 13). This will mean that it will suffer redenomination losses on its collateral, and its debtors (Eurozone commercial banks) will suffer redenomination losses on their ‘Exit country’ assets. In addition, the ECB will suffer losses on its Target2 credit balances as any departing debtor National Central Bank redenominates its Target2 obligation into its national currency. Assume that these combined losses are large enough for the ECB to be in evident need for more capital, then who is going to pay ? National Governments and their NCB’s will have their hands full with fragile or insolvent commercial banks. It is quite easy to see from that position that, let’s say Germany, who will be picking up a lot of commercial banking tabs, will begin to question the process by which the ECB became so exposed; to question the transparency of the information provided by the ECB; indeed to question whether the losses are really ‘their’ losses. I could quite easily see a subsequent row which would quickly crack investor confidence in the ECB – with disastrous results for the European banking system, and ultimately the Euro. Suppose now that the first Exit brings about the abandonment of the Euro. An inevitable concomitant of this would be the demise of the ECB. In view of the risks that the ECB is now posing to the continued stability of the Eurozone, it is my opinion that the Task Force should come to the Council of Ministers for a complete resolution package for the ECB at the same time as the Exit plan. It might look something like this: The ECB to be dismantled with immediate effect, with only a small resolution staff remaining to tie up practicalities. The balance sheet of the ECB to be carved out pro rata according to each country’s adjusted capital key (but see below on banknotes).
All operations of the ECB to cease and critical operations to be transferred immediately to the relevant NCBs. Eurozone NCBs have remained well-staffed over the life of the Eurozone, so the skills and infrastructure are already in place. Euro obligations within former Eurozone States’ legal jurisdiction will be redenominated into the new national currency at official conversion rates agreed by each State (original Euro entry rates ?). Euro banknotes in circulation to be allocated to each NCB by serial number prefix, with the equivalent proportion of ECB assets allocated to that NCB. Euro banknotes could continue to function as a fractional denomination of the new national currency until new currency notes could be printed. This would mean that the international value of ‘Y’ denomination banknotes could be worth, say, less than half the international value of ‘X’ denominated notes. I will discuss alternatives to this later. ‘Orphan’ ECB Euro assets and liabilities, i.e. those with undetermined domicile, or operating under a non-Eurozone legal jurisdiction, could be the subject of potential dispute. To mitigate this, I recommend that the ECU is used for all orphan run-off and closure valuations. The provisions I suggest in the ‘Redenomination Uncertainty’ section above, however, may mitigate much of the uncertainty, and the abandonment of the Euro will precipitate and force a resolution. The majority of the ECB staff to be redeployed in NCBs if possible, otherwise made redundant. Failure to announce agreed terms on the closure of the ECB, and the repatriation of its central banking responsibilities back to the NCBs would leave the markets with a huge amount of uncertainty, which would be quite likely to compromise the support needed for the national banking systems. Leaving the ECB alive runs the risks that either States themselves, or the markets, question the basis on which the ECB will be resolved. In my opinion, the ECB must be closed and its responsibilities apportioned to NCBs immediately on an agreed basis. Which brings me to my next recommendation: Recommendation 4: The ECB would be closed and its functions terminated with immediate effect. All its functions to be transferred to the relevant National Central Banks (NCBs). Its balance sheet to be shared out pro-rata to NCBs by reference to the ECB adjusted capital key and (for banknotes), NCB banknote issue.
European Financial Stability Facility (EFSF) I have not discussed the EFSF in any depth so far, and there is a reason for that. The EFSF is an institutional arrangement for ‘Europeanising’ the sovereign debt of the weaker Eurozone member states – i.e. a limited mechanism for allowing Greece, Portugal, Ireland, Spain and Italy to borrow on the same or similar terms as Germany and France with their funds and/or their guarantee.
It reinforces, yet again, more of the misalignments of interests of the various Governmental parties in the Eurozone that has led the Eurozone into the deep and dangerous waters that it is now in. Fortunately, the EFSF is superfluous in the post-Eurozone world, and I would recommend that the abolition of the EFSF [and its longer-term successor, the European Stability Mechanism (ESM)] is announced at the time of Exit. In practice this would mean the parcelling-out of the assets of the EFSF to the capital contributors. Member states would have to come to an agreement, similar to that which would apply to the ECB, to share out the losses which the EFSF would inevitably bear. Such agreement may be contentious, but it must be concluded rapidly to allow member states to move on. European Investment Bank (EIB) One further EU multilateral institution will be hard hit by Exit – the EIB. The EIB was designed as a source of long-term funding on favourable terms for EU (and some extra-EU) projects which matched their criteria40. The AAA-rated EIB has raised funds on very fine terms from public markets with bond issues, and it benefits from capital and guarantees from member states totalling €232bn. The four largest states (Germany, France, Italy, UK) have all provided capital and guarantees totalling €37.5bn each, of which only 5% is paid up capital, and the rest is, in effect, a guarantee from each state (i.e. a guarantee of €35.6bn each). The EIB’s balance sheet is €472bn41, much of it loans to Spanish (€72bn) and Italian (€60bn) projects. These will be significantly impaired if there is a Euro breakup, and the shareholding countries will be obliged to contribute pro-rata to these losses. National Central Banks Eurozone National Central Banks (NCBs) will be required to resume all the functions that were removed from them with the arrival of the Euro. Most are in my opinion fully equipped to do this with little need for additional staff, expertise or infrastructure. For example, Germany’s central bank, the Bundesbank, currently employs 9,750 staff42, whereas the Bank of England, which has retained all the central bank functions since the UK did not adopt the Euro, employs 1,76043. The core functions which will revert to the NCBs are (a) the conduct of monetary policy and (b) the lender of last resort. Many NCB’s still partially provide the second function – none currently provides the first. Taking each in turn. Conduct of monetary policy Most developed economy NCBs outside the Eurozone have adopted both a similar intellectual framework and similar inflation targeting techniques. The common intellectual framework is that inflation is (at least partially) amenable to monetary policy, which includes both interest
40 41 42 43
EIB aims and strategy can be found at http://www.eib.org/about/strategy/index.htm. Source: EIB 2011 Annual Report. Source: Bundesbank; December 2010 data.
Source: Bank of England Annual Report 2011; Number of staff (full and part-time) with permanent contracts. February 2011 data.
rate policy and quantitative money supply targeting (or at least monitoring). One might call this ‘soft monetarism’44. Most economists, including those at many NCBs, think that inflation is not purely a monetary phenomenon, and that the transmission mechanisms for inflation are complex. They believe, as do I, that there are several different feedback loops, including (importantly) inflation expectations, general levels of aggregate demand and external (international) effects. Despite this acknowledged complexity, most NCBs have been content to accept responsibility for inflation targeting, and content also that the main lever available to them in this regard is the control of short-term interest rates. Hence it should not be too difficult for the newly enfranchised NCBs of Eurozone member states (and their Governments) to craft monetary policy remits that are effective and non-controversial. Lender of last resort NCBs’ role as active lenders of last resort is by definition only called into play occasionally. The importance of the role is similar to that of the nuclear deterrent – its very presence changes behaviour. It is therefore less easy to characterise the ‘normal’ way to conduct this role, and indeed an important part of this role is to provide confidence to fragile banking systems when needed, but not to provide an implicit guarantee, nor to underwrite excessive risk-taking by systemically important banks. So the details of the lender of last resort role are almost by necessity implied rather than contractual, unspoken rather than transparent. This whole topic is one which has been extensively covered over the past four years, and I do not intend to replay that debate here. Suffice it to say, that subject to the political will, and the solvency of the national Government to fund itself, NCBs will quite naturally take on the lender of last resort role.
Once one member has concluded that they (or other members of the Eurozone) wish for them to Exit the Eurozone, either through ‘force’ or through choice, and this decision has become irreversible, then following the recommendations of the essay, Germany (and France if involved) would need to activate the Task Force plan. (I do allow for some variations on the plan below, but as we shall see, these may be limited or constrained by necessity). Exactly how that process comes about is unknowable, but to give some flesh it may be one or more of the following: A simple decision by the Government of a member state that they wish to leave the Euro A Council of Ministers decision that a member state’s continuing membership is untenable The election of an ‘Exitist’45 party to power in a member state
By contrast, I would characterise ‘hard monetarists’ as those who believe that inflation is entirely a ‘monetary’ phenomenon, and that as a result, they believe in the causal direction running only from money stock to inflation, and not (via feedback loops) the other way round. …or one unprepared to conform to EU-imposed national fiscal constraints.
The complete inability of a member state to fund itself, either through private or public channels A military coup in a member state, and their abrogating the Euro A complete breakdown of law and order in a member state – i.e. a revolution This list is not exhaustive, but gives some idea of the possible catalysts. Task Force activation The moment an Exit becomes inevitable, Germany would call a Council of Ministers meeting (ideally on a Friday evening – but that may not be possible) which would take place that night between EU Heads of Government. It need not be a fully physical meeting. Germany will reveal to the Member States’ leaders the existence of the Task Force, its Charter, and the outline of its Exit plan. In my opinion, there is only one question that Germany needs to ask, namely “is the Council of Ministers prepared to endorse the Task Force’s Plan ?” I suspect that current Treaty provisions get nowhere near being able to accommodate this question (and I briefly discuss this later), but the political reality is that if the Council of Ministers agree, then they can decide in due course to amend the existing Treaties and associated domestic legislation to give their decisions legal force later. Of course, there will be serious domestic legal ramifications (for example, several countries have a constitutional requirement for a referendum on EU Treaty changes). However, Germany and its supporters can point to the catastrophic consequences of failing to adopt the Task Force’s plan, and each EU Member States’ political leaders can make up their own minds as to the balance of risks and rewards in giving or withholding their consent. I suspect that if we have got this far, then Germany’s backstop is to say that in the event of no agreement from the Council of Ministers, they will unilaterally withdraw from the Euro, and unilaterally announce the activation of a German-only Task Force Exit plan. I briefly cover this later. Let us assume for the moment Germany does achieve the agreement it needs. From that moment, the Exit announcement should be made (perhaps early on a Saturday morning). The initial announcement need only be quite short: From the moment of the announcement, the Euro no longer exists. Each State will revert with immediate effect to its previous national currency, converted from Euros at the entry rate into the Euro46. All Euro banknotes are no longer Euros. They are fractional denominations of their respective national currencies; the currency being determined by the prefix on the banknotes. Similarly for coins, which are more easily identifiable. Only nationally issued Euro notes and coins are legal tender in each respective country. Foreign-
This is just for convenience – any State could choose different currency names and exchange rates, but for the market to be able to react quickly and with confidence, this seems a good default.
issued Euro notes and coins will have to be exchanged at a bank for domestically issued notes and coins at market exchange rates47. All bank current and savings accounts held in each Eurozone country are redenominated into national currencies at the official exchange rate with immediate effect. The official exchange rate is the rate at which each national currency entered the Euro. The domicile of the owner of any bank account is irrelevant to its denomination; the only relevant test is the domicile of the branch of the bank which operates the account. Bank accounts held in foreign currencies are unaffected; bank accounts held outside the Eurozone, but denominated in Euros, will be subject to the treatment accorded by the relevant national legal system, most probably to be valued in new ECUs, and converted at market rates to a national currency. All other commercial and financial contracts, including labour contracts, pensions and insurance and savings contracts, mortgages and debt contracts, will be redenominated according to the legal jurisdiction of the contract – i.e. Lex Monetae shall apply. Absent clear determination, the default position will be determined by the country of domicile of the issuer of the obligation (i.e. the debtor). Each National Central Bank will provide unlimited liquidity to its own banks – all customer money in Eurozone banks is therefore secure. New notes and coins will be printed and issued as soon as possible, but Euro notes and coins will be legal tender for at least one year48. There will be a two-day bank holiday in the EU on Monday and Tuesday. Shops and commercial premises are welcome to open, but they must be aware of the new value of notes, coins and bank accounts. From Wednesday, banks will re-open, and there will be no exchange controls, and no limits on cash or deposit withdrawal. Notes, coins and bank accounts can move freely across the exchanges, but all parties must be aware that exchanging different prefix notes is a foreign exchange transaction, and that moving a bank account to another former Eurozone country is also a foreign exchange transaction. From the moment of the announcement, the ECB ceases to function as a central bank, and all its functions are transferred to the respective National Central Banks. The EFSF and the ESM are abolished, and what commitments and assets they have are repatriated back to their respective National Governments. [If possible.…]The respective Governments of all non-Eurozone EU member states, and the US, Japan, Canada, Australia, Hong Kong, Singapore…etc. have agreed to facilitate as far as possible the same treatment for legacy Euro contracts as specified above. Genuinely ‘stateless’ contracts will be closed and settled if possible using a basket with currency weights of the newly specified ECU, and at market exchange
Alternatively, it could be decided that all Euronotes and coins could become new ECUs – a basket of currencies, exchangeable at market rates for national currency notes when they become available, or for paying into national currency bank accounts at any time (again, at market foreign exchange rates).
The period should be as short as possible commensurate with secure printing and distribution of new National Currency notes and coins. One year is arbitrary.
rates and interest rates on the first Friday49 after Exit, and thereafter, if necessary on subsequent official settlement days. The Task Force would have a detailed, hour-by-hour plan of the practical steps to make all of this a reality. I have chosen several parameters here which are not set in tablets of stone – they are just examples of the clarity that would be required. One or two small but heavily indebted states may not be able to make the liquidity commitment to their banks with any conviction, and the IMF may agree to provide short-term liquidity to these. It has to be accepted in such a major crisis that there may be casualties – undoubtedly there will be businesses and or individuals who will fail financially as a result of the actions taken. The Task Force’s remit is to minimise these – it cannot eliminate them totally. Many in the ‘strong currency’ Governments may wish to go further, and say that during the transition phase they will provide whatever additional capital that each bank needs to remain solvent. We have sizeable precedents for this in the 2008 recapitalisation of US and UK banks by the US and UK states respectively, so the mechanics of the process are now quite well rehearsed. There will undoubtedly be major teething problems with such a massive financial convulsion in such a short space of time. There will be unintended consequences that create unforeseen problems, but once the first step of the transition is completed, the next several steps are in much more familiar territory. Immediate aftermath – the first week It is idle to speculate, but useful for policy makers to brace themselves, as to what will happen in the week following the announcement. The level of uncertainty, and the surprise effect of the announcement, would be so high that global equity markets would be most likely to fall sharply. The quantum of the fall is inherently unknowable, but major shocks often engender an initial strong downward movement followed by some retracement as the market reassesses (and usually moderates) the long-term implications. Since in my opinion, the longer-term implications are strongly positive (versus where the Eurozone is today), it may be the market also perceives this, and initiates a rally. Bond markets would not react in a common way – it would depend on the country, and currency, in which they were domiciled. One might expect German bond markets to be broadly flat or possibly rise, while most others might fall somewhat (expressed in their own, new currencies). Highly indebted countries, and those with a history of inflation, might see a much stronger fall in their bond markets expressed in the new currencies. However, the likelihood of sovereign default for several sovereign bond issuers might recede (since it would be perceived that the newly independent National Central Banks could ‘print money’), so currency and inflation risk could partially replace default risk in the eyes of the market. For countries with the most fragile sovereign debt position, like Greece, bond markets expressed in the new national currency might even rise – only to be more than fully offset by a sharp fall in the new national currency’s international value.
Friday (i.e. after three days of post-Exit trading) is arbitrary, and might have to be longer.
There is no doubt that the first week would be extremely fraught. However, EU national Governments and their NCBs, possibly with the exception of Greece, are generally credible as providers of financial and liquidity support, and so once the first week had passed, the scene could be surveyed, and adjustments made to help particular casualties. The absolute key is to give members of the general public, and all businesses, a framework which they believe will be stable and sustainable. They will then be able to adjust, and most will find that possible. Some, particularly exporting businesses in the weak countries, will find life quickly becomes busy as their newly-competitive products find renewed world-wide demand. In planning the announcement, I suggest that the Task Force give a high weight to avoiding panic ‘protective’ action or reaction from the general population or business. In my next specific recommendation, I have sought to find a mechanism to avoid panic reaction to the announcement: Recommendation 5: Assign where legally possible (i.e. within Eurozone jurisdiction) currency redenomination to depend on (a) the country of domicile of the debtor (not the creditor) and, (b) ideally, based on immoveable geographic reference points. This will prevent as far as is practicable Eurozone individuals’ panic moving of assets or liabilities to achieve more favourable redenomination treatment. Stateless assets, debts and derivatives should be valued and closed using a new ECU.
I choose to emphasise ‘immoveable geographic reference points’ because there is a tremendous risk at announcement (and possibly if there is any leakage prior to announcement) that people will panic, and try to move either themselves, or their assets, cash or debt, to different domiciles. This is a recipe for chaos, and possibly a disastrous breakdown in public order. We need to make it purposeless – and seen to be so – to take any precipitous action. What do I mean by ‘immoveable geographic reference points’ ? I mean that when each asset or liability is redenominated, this is done by reference to geographical characteristics which cannot be disputed (say like the location of a property on which a mortgage is secured), and which cannot change quickly, or indeed at all. Ideally, it should not be based on the domicile (or claimed domicile) of (mobile) individuals, nor on the physical location of mobile bearer instruments, like cash. So to avoid armed guards being forced to use their weapons at Eurozone borders, I recommend that borders remain open (both physically, electronically and legally), with no imposition of exchange controls at any stage during the Exit aftermath, and that this intention is announced at the time. This will mean that no-one will have an incentive to try to cheat or manoeuvre the locations of their assets or debts. This equally applies to corporations and institutional investors – who may not be climbing over barbed-wire border fences, but will certainly wish to move their assets and debt as fast as they can, if such a move assists their solvency or allows windfall gains. Making the redenomination reference points immoveable as far as possible short-circuits this behaviour. If you know you can’t move your assets or debt to change their currency of denomination, and nobody else can too, then you won’t even try. I also recommend that the domicile of the debtor, not the creditor, is the key determinant of the currency of redenomination. So a debt taken out as a personal loan by a German resident, 40
will be redenominated into Deutschemarks, even if the ownership of the lending branch or bank is French or Spanish, and located in France or Spain. By contrast, a deposit in Germany by a Spanish citizen in the German branch of a Spanish bank would be redenominated into Deutschemarks – following the debtor’s domicile (German branch), not the creditor’s. In the following sub-headings, I set out some detailed recommendations for both banknotes and other asset and debt types. Notes and coins My recommendation for the determination of the post-Exit value of Euro banknotes has already been set out in the ECB section above, and depends, for the avoidance of doubt, solely on the prefix letter on the banknotes (i.e. the identity of the issuing National Central Bank). I suggest that nothing else will matter, and in particular the location of the notes will be irrelevant (but see below for alternative possible arrangements). This has two powerful arguments in its favour. Firstly that the windfall effect on note value, positive and negative, will be spread across the Eurozone, rather than concentrated inside specific geographical borders, and secondly that this method creates a fait accompli – no noteholder has any incentive to hide or smuggle notes. It also follows the ‘debtor’ domicile principle. On 1 Jan 1999, national currency banknotes became ‘fractional denominations’ of the Euro. Exactly the same needs be done in reverse whenever the Task Force Plan comes into force. So Euro banknotes will become ‘fractional denominations’ of new national currencies. This would mean that apparently similar notes (except for the prefix) will become worth different amounts, and the exchange rates between them will be highly variable. No long transition period is therefore desirable50, since the public will find coping with notes that look ostensibly the same, but are very different in value both a practical and a psychological challenge. While national Governments might be able to aid note identification with overstamping to make the prefix clearer, nevertheless national Governments will quickly want to give their population their own banknotes, with all that this implies. Alternative methods to handle notes and coins The suggestion of using the Euro note prefix is bound to be controversial. There are competing alternatives, and I cover some of these below. Whichever route is chosen, it should minimise panic, confusion and uncertainty, as well as minimising the damage to national and ECB balance sheets. There are several alternatives to consider: • • Overstamping or clipping Euro notes located within a departing jurisdiction with a country identifier to convert the note into the new currency Allowing all Euro notes, wherever they are located, to be redeemed as Euros (assuming it still exists), or as a ECU-type basket (if it does not)
In contrast to the introduction of the Euro, when there was a three-year ‘national-currency-only’ banknote period, and a two month ‘both in circulation’ period.
Rapidly distributing existing stocks of national currency notes if it turns out that they have not been destroyed.
Taking these in turn: Overstamping or clipping notes within an exiting jurisdiction would encourage and handsomely reward note hiding and smuggling. How do the authorities stop every note being presented for stamping in the strongest country, inflating the liabilities of the (legacy) ECB or of the German Bundesbank, and draining weak countries of notes ? This is probably a fatal objection. Allowing all notes to be redeemed/converted as Euros or an ECU basket. This would have a similar effect on the ECB balance sheet as using the issuing-country note prefixes, but it would spread the citizens’ note redenomination gains and losses evenly throughout the Eurozone. It would avoid Euro notes having to be distinguished by country issuer, or country location, but would, in effect, create a dual-currency period in the Eurozone, where every exiting country would be using foreign notes, with a variable exchange rate, to effect transactions in the new domestic currency. This alternative is a serious candidate, and probably workable. Details (which are numerous and complicated) would have to be worked out by the Task Force. Distributing existing stocks of national currencies. This author does not know the fate of the notes and coins of the national currencies, withdrawn in 2002. They may have been destroyed. But if they have not, they could presumably be quickly brought into circulation again, at least as an interim measure. If this were possible, the use of Euronotes could be rapidly curtailed. Even if this route was available, the authorities would have to decide whether Euro notes were tradeable for the new currency notes at market rates (i.e. the middle suggestion above), or whether prefixes or stamping would convert existing Euronotes to the new currency. In the last analysis, this option is just an accelerated version of the options above. Rapid introduction of new notes In view of this, and to help the general public to accept the fait accompli that has been presented to them, I would recommend that the Task Force facilitates the design, printing and distribution of new national currency banknotes as fast as is possible. This probably cannot be commenced prior to the Exit announcement51, and indeed it will clearly be the responsibility of each national Government to take responsibility for the design and production of their own banknotes. Serious thought should be given by the Task Force to providing the printing and distribution capacity needed for this to be completed at the highest possible speed. Germany alone, as the Task Force’s sponsor, may be able to short-circuit some of the lead time. Bank and savings accounts I recommend that the Task Force plan directs that all personal bank accounts, and all savings institutions’ customer accounts, be redenominated into the currency of the domicile of the branch or business from which the account is conducted. If the domicile of the two parties
Although it is conceivable that sufficient secrecy could be maintained to allow prior printing.
(bank and customer) is different (but both Eurozone) then redenomination should go with the geographical location of the bank or savings institution (i.e. the debtor), not the individual saver. If nothing else, this avoids individuals trying to manipulate their domicile – and certainty (even if bad news) is much better than uncertainty in this context. So as an example, if a Greek resident chose to open a savings account in Germany, corresponding with or visiting a German-based institution, then this account would be redenominated into the new German national currency. If he held an account in Greece, even if it was the branch or subsidiary of a German institution, it would be redenominated into the new Greek national currency. In the example on page 13 (the German bank balance sheet), I only deal with a domestic bank with a domestic deposit (i.e. liability) base. Each foreign operation (branch or subsidiary) of each bank could be analysed this way to discover each entity’s mismatch – and then these aggregated within the group to understand the impact on the whole balance sheet. Multinational retail banks obviously complicate the regulatory and lender of last resort issues as well, but this is a pre-existing problem, unrelated to the Euro, which we are not going to be able to resolve here. Mortgages My suggestion for the Task Force is that there is considerable economic and political mileage, and little financial disadvantage, to making a slightly different rule about redenomination for mortgages. Instead of the domicile of the mortgage lender being the determining factor for redenomination, I suggest that the domicile of the property on which the mortgage is secured is substituted as the only factor in determining the domicile, and therefore the currency of redenomination of the mortgage. This will sterilise consumers (in both directions) from windfall gains and losses (net of their property value), although it may expose banks to somewhat more currency risk than they might have expected. However, even if denomination was determined by the domicile of the lender, if the security (i.e. property) was redenominated (as it would inevitably be), then the banks might have to write the mortgage asset down on currency grounds anyway52. The treatment proposed therefore gives a manageable outcome for the banks, a neutral outcome for most householders, and certainty for both banks and their customers. Credit card debt, corporate and personal loans The denomination of the account will depend on the domicile of the borrower, not the domicile of the branch or subsidiary who lent the money. For more international individuals and businesses, this could create some windfall gains or losses, but for most people and small businesses, credit card and personal loans should not be too large, nor will a large proportion be international, and therefore redenomination should not be an overwhelming problem. I deal with multinationals in a separate section below.
I will make this point again with reference to Argentina.
Pensions and insurance contracts These should be based on the domicile of the pension provider or the insurance company (i.e. the debtor or guarantor). The same branch or subsidiary provisions should apply as with bank and savings accounts. The individual’s perspective In really serious crises, all of us turn to our personal and family positions as our first instinctive response. “Are we safe ?”; “What is the effect on my family finances ?”; “Are we bankrupt ?”; “Will I lose my job ?”; “Can I afford to live in my house ?”, “Can I keep the things that I care about (healthcare; education; holidays) ?” are the kinds of questions that every individual and family in the Eurozone will first think about at the moment of the announcement. The answer to most of the questions is that, at least in the short-term, most families will thankfully not be ruined, nor indeed materially damaged financially either. Let us quickly look at four stylised household types. Conventional family; children living at home; one parent in work, homeowners with Euro mortgage, no other major assets or debt. o The critical element for this group is that their home is redenominated to the same currency as their mortgage Most property will be secured on mortgages originated in the same country, and under that country’s legal jurisdiction, hence mortgage and property will have the same currency post-Exit. A minority may have the legal jurisdiction of the mortgage, and/or its country of origination different from the country of the property. I have already recommended that in enacting emergency Eurozone Member State legislation, Governments could ensure that Euro mortgages secured on residential property within the Eurozone are all redenominated to the currency of the country in which the property is situated. This would eliminate all uncertainty, and minimise windfall gains and losses to individuals. Foreign currency mortgages (e.g. US Dollar; Swiss Franc) would remain unchanged, and may continue to give their owners a currency mismatch. A few families may live in Eurozone countries which are different from their country of employment. This will create a mismatch between their income and their expenditure, and these households will have to make future decisions (employment; domicile) bearing this in mind.
Single person (or sharing in a household) in work; no children; renting accommodation; no other major assets or debt o There are few critical elements for this group. In the longer-term their prosperity will depend on the wider national economy
Retired couple or individual; children left home and independent; own or renting accommodation; some savings; no debt; dependent on pension for living o This group is potentially high risk because of their dependence on savings and pensions. Under my plan for the proposed Task Force, all national pensions will be redenominated to the country where the pension provider is domiciled (not where the pensioner is domiciled). Where the pensioner and pension provider are domiciled in the same country (the large majority, I suspect), there will be no immediate impact either way. Individuals who are drawing a pension in one country’s pension system, but living in another country, will see a material and immediate change to their living standards, but this could be better or worse depending on the domicile of the pension provider and the domicile of the pensioner. I suspect this might turn out to be quite a significant political and social issue. Virtually all pension systems are still national, rather than international, so there should be little uncertainty here about their domicile (except perhaps for the employees of EU institutions!). Unemployed individual or family, rented accommodation, some debt, no material assets o This group is potentially high risk because of their dependence on the State and social insurance However, for the vast majority of this group, domicile is clear, and will be the same as the State social insurance system which supports them. They should therefore not suffer any material immediate windfall gains or losses.
The business perspective No analysis would be complete without examining in some detail the immediate impact of Exit on businesses both within and outside the Eurozone. We have already looked in some detail at the impact on bank balance sheets, and so I will now briefly look at the balance sheets of different categories of commercial businesses. I will look at their profit & loss prospects in a later section. Multinational companies These are typically large and sophisticated economic entities, already with well-developed mechanisms in place to analyse and hedge currency and other financial risk. The difficulty that Exit presents for these entities is the sub-division of a currency bloc about which they had repeatedly been told (especially by any regulators involved) that it was a permanent feature, and for which no intra-zone hedging was either necessary or desirable. Outside the banking system, my perception is that few large multinationals have large intraEurozone financial exposures to individual countries which are not backed by physical presence or established business revenues. Unlike banks, commercial companies are able to directly control the domiciles where they locate their assets and liabilities, and in view of the nearly two years to the date of writing when there have been increasingly loud warning bells
over Eurozone stresses, any commercial entity made insolvent purely by the fact of Euro Exit has been badly managed, and deserves to be so treated. There is one caveat to this, though. Where there is genuine uncertainty as to the domicile (and therefore currency of denomination) of a company’s Eurozone assets, debt, derivatives and other financial contracts by reason of being ‘Stateless’, and/or having been concluded under non-Eurozone legal jurisdictions, then the company may be left in a dangerously uncertain position with suppliers, creditors, debtors and shareholders unable to establish the position clearly. This is the mirror image of the uncertainty problem for Banks, and it is especially important in this context that the major non-Eurozone jurisdictions’ Governments agree to co-operate (ideally on a Statutory basis, not just ‘encouraging’ civil courts) to help short-circuit this uncertainty. I have already suggested using a new ECU basket as the pricing mechanism for termination or run-off valuations for those contracts which are genuinely stateless. Despite all the foregoing, there will clearly be winners and losers in the short-term, and this simply cannot be avoided. There will be much greater gains and losses, however, in the medium-term as the new economic realities kick in. We will come to these shortly. Exporting & importing businesses Many businesses are not multi-national, but have a significant amount of international business as their cornerstone. Unless a business in this category has an unusually exposed and complicated balance sheet, I don’t expect a significant proportion of these businesses to be seriously embarrassed by Euro Exit in the short term. In the medium-term, international changes in competitiveness are likely to have a profound effect on these businesses, but this will be on future profit & loss account, not the immediate balance sheet. Local businesses The vast majority of businesses by number (although not by employees and turnover) are privately-owned, and operate in one locality and/or one speciality. These are all the selfemployed, or small employers up and down every country which lubricate all the minutiae of everyday economic life. Mostly these businesses have very simple balance sheets, and are more likely to be affected in the same way as families and households are by Exit, rather than like multinationals. As a result, very few (just the reckless or the very unlucky) will be badly hit, at least on their balance sheet. Constitutional and legal questions All of the above pre-supposes, even with unanimous agreement from the Eurozone (and indeed the EU) members, that the requisite actions can be taken in a timely way without serious legal or constitutional challenge. This is an area where I boast no expertise, nor, I suspect, do many individuals, since the questions being asked have so little precedent.
There has been some public comment by law firms and others, mainly very recently, when discussing the demise of the Euro had finally been ‘allowed’53. However, my instinct is that if sufficient political capital is invested by a sufficiently large and powerful group within the Eurozone, then in practice, leaders will do whatever needs to be done under whatever EU Treaty or national legislative or constitutional provision they find (and they will undoubtedly find one). Then, when things have calmed down, there will be a slower national legislative programme to catch up, and an even slower EU Treaty to formalise and legalise the ‘de facto’, and set out a vision for the ‘New Europe’. I will make some suggestions for that ‘New Europe’ towards the end of this essay. A German-only back-up plan Germany needs to ask the proposed Task Force to prepare a secondary plan, which deals with its possible failure to secure Eurozone agreement to the principal plan from the Task Force. This plan must be credible enough that Eurozone members’ leaders believe that Germany would follow it through if there is no agreement; it must be evidently less palatable to the non-German Eurozone members; and it must be deemed to be acceptable to the German public (although they would only have the opportunity to review it after the fact). In my opinion, Germany must propose that it unilaterally breaks away from the Euro; reestablishes its own national currency, severs its links with the ECB [accepting liabilities and assets pro-rata to its (27.1%) adjusted capital key], and takes no further part in the resolution of the Euro crisis (i.e. adopts a position like the UK). This is a less complex scenario (at least initially) for the Task Force planners, since it would not require the closure of the ECB and the total abandonment of the Euro. Many of the issues of redenomination uncertainty would still arise, but on a smaller scale simply because only Germany would be involved. It is already clear from the earlier analysis that German banks would be badly hit by this route, but on balance no worse, I suggest, than with a total Euro abandonment. The German government would offer the same unlimited liquidity to German banks as in the main Plan, and would undoubtedly have to shore up the capital position of the largest German banks with new equity (or quasi-equity) capital injections. It is not hard to envisage the reaction of the markets and the other Eurozone members to this turn of events – shock possibly followed by panic. My guess is that the threat of withdrawal of German support for the weaker members of the Euro, and from the ECB, would be enough to ensure that this plan never saw the light of day. If by mischance it did, my next guess is that complete and disorderly fragmentation of the Euro would quickly, possibly instantly, ensue. The EU Treaties do not provide for the plan above; but then, as discussed above, neither do they provide for the main Task Force Plan. In extremis, as history teaches us, treaties are
See, for example: Herbert Smith, Eurozone crisis: economic challenges and legal risks, Dec 2011; Slaughter and May, Eurozone Crisis – What do clients need to know ?, Oct 2011; Nomura Fixed Income Research, Currency risk in a Eurozone break-up - Legal Aspects, Nov 2011; Clifford Chance, The Eurozone Crisis and Eurobond Documentation, Nov 2011. Blackrock, Euro Crisis Fallout and a call to Policymakers, Nov 2011, Linklaters, Eurozone Bulletin: Do I need a contingency plan?, Dec 2011, J.P. Morgan, Answers to 10 common questions on EMU breakup, Dec 2011.
often torn up for political and other (including military) necessities. This would be one of those occasions. I very much doubt that the EU would be able to survive in anything like its present form if Germany had to go it alone in a Eurozone departure, and it runs the risk of engendering internecine warfare between former Eurozone members. This could herald a new and very dangerous period for Europe and the world, and is therefore to be avoided at all costs. Short-term disaster planning and avoidance To avoid the failure of planning that characterised, for example, the aftermath of the US-UK Iraq invasion, the Task Force needs to draw up as detailed a plan as is feasible to anticipate and deal with the enormous number of unique problems that the abandonment of the Euro will engender. Again, it will be impossible to anticipate every major problem and every possible outcome. But the driving criteria should be that no really serious issue emerges which was not already considered and an action plan formulated. In this short essay, I cannot possibly hope to cover all of the issues, but here are a few of the more obvious ones (together with the briefest of suggestions for Task Force responses): Redenomination uncertainty creates an unstoppable run on Eurozone banks – plunging the global banking system into a crisis similar to Oct 2008 (or worse). o Eurozone Governments to stand ready to provide unlimited liquidity to their banking systems, and possible re-capitalisation by the state in the event of a systemic banking system collapse.
One or more member states refuses (or claims to be unable) to agree to the Task Force plan, and makes this refusal public. o The Task Force presses on with its plan, and leaves the door open for the recalcitrant member to soften. It could ask the IMF to help this country in the very short-term, but not to the extent of encouraging this behaviour to persist. A ‘refusnik’ country could in theory state that they will keep the Euro, but their own ‘Euro’ would in-effect turn into their own currency (i.e. a Spanish ‘Euro’), which would, de facto, be the same as a ‘new Peseta’.
In the immediate fall-out of the Exit announcement, one or more of the Governments of the Member States falls, freezing decision-making. o Press ahead with the plan, and allow the political process in the affected countries to take its course. Under the plan as set out, the abandonment of the Euro will mean that each member has no choice but to accept redenomination. The comment in the paragraph above applies – namely that with no action, the national use of the Euro would most likely become, de facto, a new national currency, even if no domestic legislation is passed to put its new status into legal effect.
One or more Member States are so incensed at not being consulted prior to the Exit announcement that they unilaterally withdraw from the Eurozone (and possibly the EU). o This is an outcome much to be regretted, but it would not derail in any respect the Task Force plan.
The US (and others (China?)) are so incensed at not being consulted prior to the Exit announcement that they withdraw all co-operation with the EU, including cooperation to reduce redenomination uncertainty. o Again, this is an outcome much to be regretted, but such a move would not be irrevocable. Hence the larger and more influential countries could lead a charm offensive towards these nations to placate them, and involve them in the detail at the next stage of European developments.
An incensed China (Russia; Saudi, etc) declares that it will divest itself of all Eurozone members’ assets in their Foreign Exchange Reserve fund, and announces that it will not re-invest in any of the new currencies of Europe. o Again, this is an outcome much to be regretted, but such a move would damage China more than the former Eurozone members. Europe as a bloc runs at approximately in trade balance with the rest of the world, with Germany in large surplus, and most of the remainder in various sizes of deficit. China’s divesting of reserves would force the new exchange rates down vis-à-vis the rest of the world, an outcome which, on balance, would help struggling European economies, and damage China’s exports to Europe.
A group of Eurozone members break away from Germany and attempts to form a new single currency immediately. o This is outcome 2) or 4) on page 9. It seems unlikely that markets will look very kindly on a new single currency formed immediately; without planning, and (particularly) without Germany. It would not affect the demise of the Euro directly, but it would require almost superhuman levels of confidence and optimism amongst the relevant Member States’ leaders to embark on a new single currency at exactly the moment of destruction of an old one.
Germany fails to convince a critical mass of other Member States that the Task Force plan is the only viable route. o This is covered on page 47 in the ‘Germany Only’ plan
Germany itself suffers unsustainable political turmoil; the Government falls, freezing the abandonment process. o This is a potentially serious development, since a high level of active political commitment from Germany will be required, firstly to abandon its current commitment to the Eurozone, and secondly to support its banking system. The hope is that the German leadership will in practice not be prepared to
leave the country rudderless and vulnerable, even if there is also a political process going on in parallel potentially to replace them. There is a serious breakdown of law and order in one or more Eurozone members o This would clearly be highly regrettable, but European nations will be required to conduct themselves as they respectively see fit, and in the postEurozone world, there would be no role beyond encouragement, support and advice for other European nations. There is no reason to suppose that such a development would change the course of the abandonment of the Euro; the key for the Task Force is to ensure there are sufficient firebreaks in the banking system support network.
In extremis, one or more Eurozone members suffer military coups to restore ‘order’ o A similar comment as the previous paragraph applies.
This list is somewhat daunting. A similarly daunting list could have been drawn up (and probably was), at the critical junctures of major international decision-making. The Cuban missile crisis; the collapse of the Soviet Union; the liberation of Kuwait; the invasion of Iraq and the rescue of the global banking system in Oct 2008 probably all had alternative, unpalatable scenarios which have remained unseen and unused. I sincerely hope that none of the above materialise. I suspect that mostly they won’t. But to the extent that they represent risks of major scale, they do need to be recognised, analysed and each have action plans. To those readers who see so much potential downside that they back away from Euro abandonment, I would say that if the Euro cannot survive, then it will not survive. Hence, if an orderly rather than a disorderly Exit is to be achieved, some plans must be made, and however unpalatable, these are an example of such plans. Failure to plan at all would run even greater risks of disorder and chaos.
Future political, economic and financial health
I will turn now to look at the period post the immediate aftermath of the Exit, and make the optimistic, but probably realistic, assumption that the EU emerges intact, and that the former Eurozone members come through without major social and political disorder. Let’s start with looking back at the end of the first week. What does success look like for the announcement phase ? In my opinion, a successful first week would be: First and foremost, a widespread belief among the general population, the markets and the political classes that all the shock and pain has been taken in one hit, and that the future looks viable and stable, with no further major ‘bad news’ anticipated. A belief that the EU can mend itself and survive as a free trade and economic cooperation area. No Eurozone nation-to-nation vendettas, and no EU departures. Active political and legal support from the US, UK, Switzerland, Canada, Australia, China and the other major non-Eurozone nations. But note – no new bail-out money.
An absence of any of the risks listed in the previous section materialising on any scale. Major markets (equity; bond; currency) in equilibrium, with two-way trading prices, by Friday of the first week. Stability, growth and future prospects After the shock effect of the Exit announcement has worn off, the Task Force’s aims will be to provide a framework where (former) Eurozone members can successfully plough their own independent furrows. What sort of conditions are needed for each member state for this to be the case ? Each country should, I believe, attempt to minimise the domestic economic and financial impact of the Exit. Each must encourage normal economic, political and social life to continue. Business must be encouraged to continue as if nothing has happened, and for many, particularly in the short-term, this may broadly be true. However, all businesses, from multinationals to sole traders, will be profoundly affected by Exit in the long term. Exit will return Eurozone countries to self-reliance, and to the disciplines of financing themselves in a world where financing deficits is voluntary, not a political imperative. It will expose Eurozone countries to feedback loops which had been cut – so fiscal indiscipline will engender higher national borrowing costs, a lower exchange rate and a higher risk of inflation. It is to be hoped that a successful Exit will form a firebreak with the past, and that bank financing unfreezes as it becomes clear that banks will be supported by their respective Governments, and that the worst has come and gone. Commercial businesses will have to adjust to a more volatile economic relationship with other former Eurozone members, and businesses in weak currency countries will reap new cost advantages where they cannot now, and businesses in strong currency countries will find their competitiveness is tested by a new, higher, relative cost base. For many weaker country businesses, there could be a bonanza. Any sceptic should look at the aftermath of emerging markets’ currency collapses of 1997 and 1998, and of Argentina’s in 2002. In all of these cases, apparent financial calamity preceded a low-cost-producerdriven export boom, which in the case of many of the emerging markets and, indeed, Argentina (as we shall see below) continued for more than a decade. Argentina’s economic history 1990-2010 shows particularly strong parallels with the weaker countries within the Eurozone, particularly Greece. I have therefore chosen to examine below, in somewhat more detail than at first might seem relevant, Argentina’s experience over this period. Argentina In the 1980s Argentina suffered from a series of bouts of serious hyper-inflation. To keep the denomination of the currency manageable, in 1983, 10,000 Pesos Ley were redenominated into one Peso Argentino; after further hyperinflation, in 1985, 1,000 Pesos Argentino were redenominated into 1 Austral. The Austral lasted until 1991, when after yet another bout of hyperinflation, 10,000 Australs were redenominated into 1 Peso (ARS), and this remains the
currency of Argentina today. Greece has not suffered serious hyperinflation in its recent past, so the parallel is not strong here. In 1991, in an effort to cut the vicious cycle on inflation, and impose price and wage discipline on the country, the then Government announced that the new Peso would be permanently pegged to the US Dollar 1:1. They enforced this by a mechanism called a ‘Currency Board’, in which all Peso notes and coins issued were backed by an equivalent amount of US Dollars held at the Currency Board54. Any increase in note-issuance meant an increase in the US Dollars in reserve at the Currency Board, preventing the free ‘printing’ of money. The Currency Board mechanism co-existed with free convertibility of the Peso on both current and capital account at 1:1 exchange rate, enshrined in law. The Peso was pegged to the US Dollar, but Argentina’s economy was and remains very different from the US economy, and this meant, among other effects, that Argentina’s export markets dried up as the Dollar appreciated (along with the pegged-Peso) in the 1996-2001 period. As a result of Argentina’s increasing international lack of competitiveness, it began to run larger and larger external (i.e. trade) deficits. The country financed these deficits not by private sector investment in the Peso (i.e. voluntary inward capital flows), but by Government borrowing in US Dollars, with which Pesos were bought in the market to maintain parity. This covered up the downward pressure on the Peso, by countering the current account external deficit, and also allowed (in fact, obliged) the Government to run increasingly large fiscal deficits to both cover the external deficit from a currency point of view, and to resupply domestic aggregate demand which had been sucked out by the excess of imports over exports. The parallels with Greece here are striking – twin deficits (one – the external largely hidden); a fixed exchange rate in an ‘immutable’ system, and a relative export disadvantage. In 2001, downwards pressure on the Peso in the currency market was becoming intolerable, and the Government was struggling to support it. Eventually, Argentina ran out of borrowing power; the Government fell, the currency peg could no longer be maintained, and fell in the space of about six months to about one quarter its par-value (3.75 pesos per US Dollar), before recovering to about 3 per US Dollar, where it roughly remained for nearly decade (it is now about 4.3 Pesos per US Dollar). Most of Argentina’s sovereign debt was denominated in US Dollars (a result of the Currency Board and parity peg), and the devaluation made the debt unsustainable – so Argentina defaulted in the largest single sovereign default (about $100bn) up to that date. Greece’s March 2012 default is the only larger sovereign default in history. Domestically, the financial impact of the crisis was very severe indeed – there was a freeze on bank account withdrawal; many Argentinean households and businesses had borrowed in US Dollars, and so there were a large number of people with houses worth less than half their mortgages! The banking system nearly came to a complete halt in early 2002, with real and tangible effects on jobs and poverty in the population. There was serious rioting, and loss of property and life.
In practice, a proportion of its US Dollar assets were Argentinean Dollar-denominated Government Bonds, which, although Dollar assets, created an element of circularity.
As one response to this, most domestic US Dollar debts, bank accounts, mortgages and contracts were (in February 2002) unilaterally and forcibly converted to Pesos at non-market exchange rates. The Peso was falling rapidly against the US Dollar as the time (and was about 2 Pesos/USD by end-Feb 2002); Pesification (as it become known) required domestic Argentinean USD-denominated Bank loans to private sector debtors (i.e. mortgages; business bank loans) to be converted at 1:1. This was, in effect, a haircut to Banking sector assets of 50% (since the market exchange rate at the time was 2:1), and a one-off gain to the private sector of the same amount55. By contrast, the Pesification conversion rate for private sector bank deposits (i.e. bank liabilities), and loans to the (Argentinean) Public Sector, was 1 US Dollar : 1.4 Pesos. This was, by contrast, a (somewhat lesser) transfer from the private sector to the banking sector on the one hand, but also a significant haircut for owners of domestically-issued public sector debt, even if the haircut was a little less than that forced on the banks with respect to private debtors. The asymmetric Pesification was a deliberate choice to drain the banks of capital (to the apparent benefit of the general public), and, as could be predicted, it sent the banking system into insolvency (to be rescued by the Government). Pesification is as close as any country has come in modern history to the kind of wholesale redenomination that a Euro Exit would require. Pesification was a recognition that the country could not operate with legacy US Dollar asset and debt denomination, and despite the arbitrariness of the exchange rates, it did allow a reasonably swift return to liquidity of the banking system. As for the very large subsidy to the private sector debtors (the 1:1 exchange rate), since many US Dollar debtors were never going to be able to pay their debts anyway, it was less of a unilateral transfer than might be assumed. Government spending was severely curtailed (principally by the Government’s inability to borrow), and 2002 saw a very painful contraction in the economy, as public spending, lending and domestic expenditure collapsed. But, in an illustration of the power of economic signalling in markets, 2003 saw a return to very strong growth, led by an export boom stimulated by the much lower exchange rate. Real growth in Argentina remained very strong for the remainder of the 2000s, averaging over 6.5%56 p.a., despite Argentina’s sovereign default and ‘pariah’ status in international finance continuing for much of the period. Argentinean and Greek parallels Argentina in the 1990s and Greece in the 2000s share poor political governance, a severe fiscal deficit; a large external deficit; an unsustainable Government debt burden and a fixed exchange rate, pegged to a large economy with fundamentally different characteristics. These are the parallels. The difference is that were Greece to leave the Euro, the whole Greek economy would be redenominated, including most of the Government debt, into a new currency. So much of the
Note that the private sector was in dire straits (and this helped, somewhat), since the property on which, e.g., mortgages were secured would have fallen in Dollar terms by half in a couple of months.
2003-10 average Argentina per capita annual real growth rate at constant 2005 Dollars & exchange rates. Source Economic Research Service, USDA.
pain suffered by ordinary Argentineans through the currency mismatch between assets and borrowings would be avoided. International markets have proved surprisingly forgiving to sovereign defaulters, and although Argentina is still fighting isolated rearguard actions against recalcitrant bond-holders, nevertheless it has now broadly been rehabilitated. It is possible to imagine, although probably unlikely now, that Greece could redenominate its sovereign debt on Exit into Drachma, and choose not to default on any more of its sovereign debt. If it could manage this feat, it would I suspect find the markets even more forgiving than they were to Argentina. But default or not, the closest historical parallel we can find shows that economic life after a currency collapse can recover very quickly indeed. Fiscal discipline One of the most intractable problems faced by the architects of the Euro, and subsequently by its more disciplined members, was the seeming endemic lack of fiscal discipline of many of the weaker members. The founding fathers of the Euro clearly recognised this problem right at the start, but did not, it turned out, find any effective mechanism to create real disincentives for fiscal laxity. On the contrary, the system seems to have provided incentives at the member state level for a casual approach to budgeting – the strong members providing ‘cover’ (low interest rates; the protection of the ECB) for incontinent sovereign borrowers. In the post-Exit world, it is my strong recommendation that (former) Eurozone members are not given any material inter-regional transfers, guarantees or protection. They should be told that they are standing on their own two feet, and that all their decisions will be ones they will have to take the longer-term consequences for. The abolition of both the ECB and the EFSF should reinforce this message. The markets will have to conduct some very rapid calculations on some of the new post-Exit members. It seems likely that the more indebted nations will see their new national currencies fall sharply against the conversion rate, and borrowing costs, both short and long-term, rise. But, as mentioned earlier, the markets may find themselves pricing inflation risk rather than default risk in many of the weaker members. Some countries – the most obvious being Italy – will find the new regime very challenging indeed. Italy has a very high debt to GDP ratio (118.4%57); it generally has quite short maturity sovereign debt; and the average interest rate it is paying on that debt has been modest at 4% p.a.58. If Italy returns to a monetary environment similar to the 1980s and 1990s, then it can expect to pay interest rates in double figures, or certainly high single figures. If we suppose that average debt service interest rate turns out to be 10% p.a., this would mean that Italy would be paying some 12% of GDP, or some 26%59 of total Government revenues just on debt service.
Source: Eurostat, Dec 2010.
Source: Eurostat, Data for Italian Government borrowing; apparent average interest rate paid, 2010. For comparison, Germany is 3% p.a. for 2010.
26%=12%/45.8%, where 45.8% is Italian general Government revenue as % GDP 2010. Source: Eurostat.
Weaker, and more indebted, nations will find this a common problem. Market discipline will be a great deal tougher than Eurozone fiscal rules, and it implies that public expenditure will have to be severely cut to balance, or more than balance, these Governments’ books in the early months and years post-Exit, thereby satisfying the markets that the borrowing is sustainable. Since Government revenues are already running in percentage of GDP terms from the high 30s to low 50s for most Eurozone countries, imposing much higher tax rates is likely to be counterproductive on tax revenue for most. For the weaker countries, inflation is likely to become the major challenge after fiscal discipline and debt service. Of course in one way it is the solution – it reduces the real value of overleveraged household, public and banking sectors. But inflation has proven in history to be destructive of business confidence; to be undermining of ‘economic morality’, and to be unpopular with the public in general, and with savers in particular. It is, after all, the enforced transfer of very large amounts of money from the careful, prudent and generally elderly (savers), to the young and generally economically active (borrowers). In practice, it may be that in the early years post-Exit, inflation is seen as moderately benign for the reasons first stated, and then in time, the perception will slowly change, as it did in the UK in the 1970s, so that inflation becomes political public enemy number one. Southern Countries, inflation and the future There is a great temptation amongst the economics profession to try to nanny the macroeconomic progress of countries. The profession makes policy recommendations that fit the contemporary theoretical framework, even though the profession’s track-record is at least as bad as many politicians’, and possibly worse. The celebrated 1981 open letter to The Times newspaper from 364 economists60 to the then UK Prime Minister, Mrs Thatcher, exhorted her to stimulate UK demand by fiscal expansion, in contrast to her budget policy of fiscal contraction and tight money. She ignored their calls, and was vindicated by very strong economic performance of the UK in the subsequent 10 (and indeed 25) years ! In the aftermath of an exit of one or more Euro member states, it will be the politicians of each country that will choose their respective economic policy. The complexities and tensions of that dynamic decision-making process are way beyond the scope of this essay. One thing is certain, however. Whether a departing state chooses austerity and fiscal prudence, or inflation and monetary and fiscal laxity, the market will bring moderating forces to bear, ensuring that only what is possible is undertaken, and rapidly feeding back reality to both electorate and politicians alike. Each country’s politicians will only have to account for their performance to their own electorate – not to another layer in Brussels. This will re-unite the democratic process with the economic authority and responsibility for policy decisions. Given Greece’s performance in the Eurozone, it is quite likely that it will endure high inflation/devaluation cycles in the subsequent post-Euro years. It may also, however, learn
In April 1981, following the Budget, 364 leading academic economists (certainly a large proportion of the mainstream UK academic economic profession at the time) signed a letter strongly criticising the 1981 Budget proposals, which were for monetary restraint and fiscal tightening in a period of recession. Only a handful of (monetary) economists could be found who supported the budget. UK real per capita growth from 1981 to 1991 (the ten subsequent years) was 2.5% p.a. – a full percentage point p.a. higher than the previous ten years. Source: National Accounts, ONS.
from this, and, like Argentina, construct periods of monetary stability through effective policy-making. Northern Countries post-Exit Whatever the arrangements that pertain post-Exit, the northern trade-surplus countries (Germany, Netherlands, Finland) will almost certainly find that they lose competitiveness as their currencies appreciate versus the Southern States. This loss of competitiveness will naturally depress aggregate demand, and tend to reduce trade surpluses. Germany in particular has an export mix which is reasonably price inelastic (dominated by high-quality engineering), so the loss of competitiveness may show a reverse ‘J’ curve – initially higher trade surplus as the terms of trade improve, followed by a loss of export volume as the longer-term elasticities take hold. Germany will face the challenge of having to stimulate domestic demand to replace its falling net export demand – and this against a backdrop of a very indebted public sector under almost any of the conceivable scenarios. This has been Japan’s problem since 1990 – and it is not easily soluble. Trade and the EU It is vital, in my opinion, that the single market remains intact in the EU as a whole. Although the single market has not succeeded in spreading to all business sectors (housing; pensions; insurance and financial services generally are examples), in many areas the single market is working well, and already copes with ten countries within the single market, but outside the Eurozone. I see no reason why this cannot continue with all 27 countries having individual currencies. I do not underestimate, however, the fundamental blow which an Exit will have inflicted on the EU project. At the core of the EU there will be deep despondency at the failure of the most important single flagship policy. There is a danger in this environment, I think, that the EU could begin a retreat across many fronts, and that the Eurosceptics, their tails in the air, will vigorously pursue a more nationalistic agenda egged on by national politics which will have been shaped by the painful recent experience. This is a recipe for renewed protection, for domestic preference, and for all the little ‘Spanish practices’ that prevented fully effective trade in many periods of history. If we are to avoid a full-blown depression like the 1930s, then it is vital that the energising force of international trade, and its positive effect on the welfare and wealth of nations, is allowed to flourish. Post-Exit exchange rates In my opinion, there will be little appetite for renewed exchange rate systems post-Exit. Although it is currently popular to talk about the ‘Mediterranean Euro’ or the ‘Super Euro’, as successors to the Euro, once the Euro has shown itself to be mortal, then new currency groupings will look mortal themselves, and the markets, flush with their recent triumph, will take no time in attempting to demolish any new system, whether or not there is any fundamental rationale for demolition or not. Politicians may find that the public appetite for single currencies is much reduced, and my guess is that the single currency project is put on long-term hold.
The foreign exchange market is remarkably resilient, and it has shown itself capable of adapting to almost any new conditions that present themselves. In my opinion, the foreign exchange market will very quickly find equilibrium exchange rates for all the new currencies, and even though I am sure these rates will be volatile in the early post-Exit period (just like in the 1970s post-Bretton Woods), the existence of deep, liquid markets will ensure that trade and investment can be conducted quickly and with certainty at very low transaction costs. This brings me to my last recommendation: Recommendation 6: Continued membership of the EU to require that each member state does not impose tariffs or restrictions to trade on any other member state, including requiring open and free-market currency markets in both current and capital account in unlimited amounts for all EU citizens.
If citizens of the EU are genuinely confident that their Governments will not impose restrictions on their ability to move their money to wherever they choose, then both EU and non-EU investors will remain confident about leaving their money domiciled within the EU. New Europe In my opinion, the Treaty of Rome set out a vision of a Europe of independent states united in friendly and co-operative trade, understanding and mutual respect. I can see a new beginning for Europe under a new banner (“New Europe ?”), replacing the discredited EU post Exit. The Treaty of Rome was a response to the horrors of the WWII, and in the minds of their grandsons and granddaughters now running the EU, the European project is still a project to prevent Europe ever again falling into military confrontation and conflagration. I think that the same spirit could inform ‘New Europe’, and I can envisage a new generation of politicians committing themselves to a New European ideal of co-operation, but respecting the differing cultures and customs, and celebrating the sovereign democracies of each individual state. I could see the rolling back of EU-level legislative institutions, to be replaced only by Treaties that seek to make the playing field reasonably level. In this framework, I can see Europe prosper again.
Summary and Conclusion
In this essay, I have sought to design a route out of the Euro for one or more countries, which will minimise economic, financial and political damage, and allow growth and prosperity to replace crisis and austerity. The route that I recommend requires the formation of a secret Task Force by either Germany alone, or (possibly) by Germany as the lead, and France as a junior partner. I deem absolute secrecy and deniability to be essential, because if the markets get wind of any plans for the dismantling of the Eurozone in its current form, then events will accelerate and spiral out of these Governments’ control, rendering the Task Force’s plans irrelevant. The constitution of the Task Force is difficult, because the requirement for absolute secrecy needs to be combined with a requirement for legitimacy. I conclude that the latter can only be realised by having Germany as the Task Force sponsor, and with France as the only possible
partner. A larger sponsor group would increase the risk to secrecy without adding sufficiently to the legitimacy of the plan. This Task Force should, in my opinion, develop a plan which envisages the first Exit being the only Exit - namely the complete abandonment of the Euro when it becomes inevitable that one member is to leave. This radical approach has only been adopted with some reluctance. The complete abandonment of the Euro would be a momentous step for Eurozone members, and would mark the end of the integrationist project for the EU. This essay recognises the magnitude of complete Euro abandonment, but I have considered very carefully the alternative (piecemeal departures), and concluded that the moment one country leaves the Euro, then the view that the Euro is ‘unbreakable’ or ‘permanent’ becomes untenable. This would give markets the evidence and the ammunition to continue to turn their fire on Euro structural weaknesses elsewhere. This is a recipe for a continuation of the crisis, resolved only when the last target that the market can find is demolished. In practice, this would be the enforced slow-motion dismemberment of the Euro. It may be that no country does leave the Euro in the near future. However, if the plan I set out is adopted, Germany would henceforth be equipped with a blueprint which it may find serves it very well in the crisis conditions under which it would be obliged to make it public, and put it into action. The essay looks in some considerable detail at the practical and immediate implications of Exit. It considers the major problem of redenomination uncertainty, the solvency of the ECB, and the conduct of National Governments and their National Central Banks in the first few days and weeks following Exit. It spends some considerable time discussing the difficulties likely to be encountered by the Eurozone banking system, and concludes that it is likely that all banks will need liquidity provision by the National Central Banks in the immediate aftermath of the crisis, and that some banks will need major recapitalisation. The only entities capable of doing that at the speed, and in the scale required, are the respective National Governments of the countries’ banks. In this plan, National Governments announce their commitment to this recapitalisation at the outset. I consider several unpalatable possibilities, but conclude, by drawing some parallels with the Argentinean experience, that open economies can recover surprisingly fast from currency collapses (and even sovereign defaults), and establish a path of sustained strong growth. I make six practical recommendations in the essay: Recommendation 1: Germany (possibly together with France) establishes a secret Task Force, with a Charter to design proposals for planning and managing possible Eurozone Exit. Ideally France would join to give legitimacy – but secrecy and speed is essential, so only a token joint operation may be possible. Whatever the results of the Task Force’s deliberations, firm plans and proposals should be in place as soon as possible using all means at the Task Force’s disposal.
The Task Force would propose to the Council of Ministers that the Euro should cease to exist on the day of the Exit announcement, to be replaced by new National Currencies. The ECB would be closed and its functions terminated with immediate effect. All its functions to be transferred to the relevant National Central Banks (NCBs). Its balance sheet to be shared out pro-rata to NCBs by reference to the ECB adjusted capital key and (for banknotes), NCB banknote issue. Assign where legally possible (i.e. within Eurozone jurisdiction) currency redenomination to depend on (a) the country of domicile of the debtor (not the creditor) and, (b) ideally, based on immoveable geographic reference points. This will prevent as far as is practicable Eurozone individuals’ panic moving of assets or liabilities to achieve more favourable redenomination treatment. Stateless assets, debts and derivatives should be valued and closed using a new ECU. Continued membership of the EU to require that each member state does not impose tariffs or restrictions to trade on any other member state, including requiring open and free-market currency markets in both current and capital account in unlimited amounts for all EU citizens.
With these recommendations (and the others in the main body of the essay) enacted, and with a credible and fully thought-out plan as recommended, I believe it is possible for the Exit of one member (which in this plan implies the complete abandonment of the Euro) to be a turning point in the cycle of crises which have characterised the Euro in the past few years. Indeed I do think it is possible, despite the momentous scale of the event itself, that Exit could mark the start of a new and vibrant period in Europe’s history.
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