Author: Brian Kettel
“Losing one percentage point of competitiveness a year, if it goes on in time for a number of years, would become a condemnation for Italy and it would be difficult for us to stay in the single currency.” That’s the view of Romano Prodi, president-designate of the European Commission, speaking about Italy’s ability to remain within the unified currency regime, June 1999. “If there were exceptional circumstances and provided it was not done in a way which was hostile to the European Union.” That’s Romano Prodi, president of the European Commission, replying to the question whether existing members of the euro might choose to opt out of the euro, in The Spectator, May 2000.
Under the 1992 Maastricht Treaty, monetary union was intended to be an irreversible and irrevocable process. No mechanism exists in the treaty to allow a participating member state to withdraw. Romano Prodi is clearly not correct to assume that a member state could withdraw from the euro but assuming that legislation was introduced to permit this it is instructive to examine what the implications for the fnancial markets would be should a member state withdraw .
Now the euro has come into existence, the financial markets are faced with a new risk, one of which they have no prior experience, and which has enormous ramifications. This risk, known as legacy risk exposure, is the possibility and consequent implications of the withdrawal of a member state from the single currency. This is quite different from the withdrawal of a member state from the exchange rate mechanism (ERM) of European Monetary System where individual currencies still existed, albeit nominally pegged to each other.
The withdrawal of a member state would not be like an ERM break-up because of two critical differences – banking sector balance sheets and notes and coins. These are not the esoteric points that they may at first seem. Banks operating in eurozone countries are required by EU law to treat all euros as the same, and no exchange rate risk is allowed to be admitted between any two euro-denominated balance sheet items.
Banks cannot in any case sensibly determine the domicile of many of their assets and liabilities, so this is practical advice. Say a bank lends money to a pan-European multinational in euros. Where is the debt? A bank takes euro deposits from a US multinational with world-wide interests across its European branches. Where is the deposit? The implication of this is that one country’s exit would severely damage, and possibly destroy, the balance sheets of all Europe’s major banks. How would this happen?
EC president Romano Prodi, in the Spectator interview, referred to the case of Denmark joining the euro and subsequently leaving it. It makes no difference which country exits the euro but clearly there would be no point in doing so unless the country concerned intended to introduce its own currency with the likelihood that it would then lose value against the euro. In the examples below I choose the case of France leaving the euro and introducing what I call the New Franc. But the example could just as easily have been any of the other 10 euro member states.
To appreciate the implications of a potential Emu (European economic and monetary union) break-up let us assume that the balance sheet of a hypothetical French multinational bank, ParisLyonnais, prior to Emu exit can be represented by Table 1. The balance sheet reflects a healthy bank.
Beware the New Franc
With the looming prospect of France’s exit from Emu, companies, investors, banks and individuals will all begin to take action to protect themselves from what they see as a certainty: that if France exits, a new weaker currency will be introduced. They examine all their euro assets, and judge whether they will remain as euros or get redenominated into New Francs. The parity of the New Franc is likely to start at the old French franc’s original parity with the euro. Having their deposits (the bank’s liabilities) redenominated in weaker New Francs is unacceptable, while having their loans (the bank’s assets) redenominated in weaker New Francs is very acceptable.
Most likely, they will judge that keeping their French-issued euro deposits on French soil is a bad idea. Euro deposits are withdrawn from France and redeposited in London, Frankfurt or New York, with non-French banks. French corporate and government bonds are sold off and replaced with German-issued (or UK, Dutch. . . etc. ) bonds.
This begins to drive down the price of French bonds, pushing up the credit premium on “French” interest rates, and pushing down “German” rates. Bond yields already differ in euroland largely because of different political risks. But now they start to reflect currency risk, as they did prior to the arrival of the euro. Interest rates in euroland are now providing information to the financial markets that the system is under strain.
Inside France, there is a mix of Euro-denominated assets and liabilities, some of which are definitely “French” (French government bonds held by French residents in France), some of which are borderline (multinational euro corporate debt held by French banks), and some are almost certainly non-French (notes and coins – which are a liability of the ECB and which are bearer instruments and so don’t have a domicile). (I am assuming this will happen after July 2002, when euro notes and coins are in circulation and old franc notes and coins have ceased to be legal tender.) The interest rate differential will apply to those instruments deemed most “French”, therefore most liable for redenomination.
But there are almost certainly categories of securities whose risk of redenomination can be reduced or eliminated by being moved – either physically or by a change of the owner’s domicile.
This will create a plethora of arbitrage opportunities with bizarre effects. French residents will take all their money out of bank and savings accounts, and put them into euro accounts abroad, possibly in non-French nominee names. They will squirrel away large quantities of euro notes for their everyday use – much more secure than French bank accounts. They will borrow as much as they can in France, and redeposit the money offshore.
The classic hedging technique of having liabilities denominated in weak currencies and assets denominated in strong currencies will be applied.
There will be a credit explosion in the Emu banking sector as French residents and non-residents alike round-trip German assets and French liabilities. As the trade turns into a run, and then into a frenzied panic, it will become clear that the banking system will collapse (ie. French banks will run out of liquidity) unless action is taken immediately. That action must be an immediate Emu exit and the introduction of the New Franc. Nothing else will halt the flows.
To see the implications of this and to make the arithmetic simple let us assume in this new euroland that half of all the balance-sheet items of ParisLyonnais are held at branches outside France or by non-French residents. What happens to the value of ParisLyonnais’s assets and liabilities either owed to or from these non-French residents? ParisLyonnais will be forced by the French government to re-denominate all its assets and liabilities into New Francs. After all what would be the point of exit otherwise?
Assume a New Franc 20% devaluation from the official conversion rate. ParisLyonnais customers with borrowings in foreign jurisdictions will not complain if they suddenly owe 20% less expressed in euros because their debt has been redenominated. In fact they will demand it. They will argue that they cannot legally be discriminated against purely because of their residence. So in Table 2 the assets fall to 80 even though only 50% are owed either outside France or to non-French borrowers. But every individual and bank in a foreign jurisdiction will rightly complain if their euro-denominated asset, deposited with ParisLyonnais, is unilaterally redenominated, and consequently worth 20% less.
The effect of the devaluation would be to lower the liabilities of ParisLyonnais to 83.7. It must be said that other European governments will oppose this too as they will fear contagion and systematic risk.
The morning after
The next morning it will be seen that, at the discount that the New Franc is trading at, the assets of ParisLyonnais and other French banks are now worth less than their now non- matching liabilities.
With liabilities greater than its assets the entire French banking sector is insolvent unless redenomination can apply in foreign jurisdictions. In other words if the banking sector’s liabilities can also be reduced by the full 20%. The ECB and the BIS tell France that if redenomination applies to non-French jurisdictions that will trigger a world-wide banking collapse. The French government does not agree that it should pick up the full cost of banking sector rescue, and refuses to act as lender of last resort to its own banks.
The banks promptly default, triggering a world-wide banking crisis of previously unseen proportions. It appears that Prodi’s comments that a country could exit from the euro would, if carried to their ultimate conclusion, unleash chaos on the financial markets.
