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Foreign Exchange

How could Greece leave the euro?

In a three-part series, EuromoneyFXNews will provide an in-depth analysis, first published by sister-publication, International Financial Law Review, of how a country's exit from the Economic and Monetary Union (EMU) would transpire and the relevant legal constraints that would govern the sequence of events.

EMU exit no longer taboo

 
Greek finance minister, Venizelos and
prime minister, Papademaos
One of the biggest concerns in the FX market is if, and when, Greece could exit the euro – though the legal limitations on such a departure have been little discussed. If a country were to break away from the EMU in defiance of such limitations, it would likely open up vast arbitrage opportunities between its laws and EU treaties, thus dooming such an effort. Indeed, any exiting member should carefully observe its treaty obligations to have any realistic hope of stabilizing its economy.

The euro was created based on EU treaties, which contain explicit criteria as to the entry into the EMU but are silent as to withdrawal. The silence is peculiar since the new Lisbon Treaty provides a withdrawal mechanism from EU.

There were reportedly three reasons for the silence, according to Phoebus Athanassiou in a European Central Bank (ECB) working paper in 2009: first, it was to dispel doubts on members' commitment to the project; second, providing a mechanism for withdrawal might have increased its likelihood; and third, providing such a mechanism would have involved the daunting task of spelling out the procedures and consequences of withdrawal.

Indeed, until recently, European officialdom refused to contemplate withdrawal. It was not until after the then Greek prime minister George Papandreou called for a referendum on the second Greece rescue package in November did the French president, and the German chancellor, finally utter the unspeakable.

If such a referendum were to be held, they declared, the single question should be if Greece wants to keep the euro as its currency.

Difficulties of an exit

In his 2007 article, Barry Eichengreen, the Berkeley economist and former International Monetary Fund policy adviser, argued that any move to exit the euro would require time and preparation, and that the preparation itself could cause devastating bank runs.

While it might seem straightforward for a country to pass a law stating that the state and other employers will henceforth pay workers and pensioners in a new currency, with wages and other incomes redenominated, mortgages and credit-card debts of residents would need to be redenominated as well. Failure to do so would otherwise mean currency depreciation would have adverse balance-sheet effects for households, leading to widespread bankruptcies.

However, with mortgages and other bank assets redenominated, bank deposits and other bank balance sheet items would also need to be redenominated to avoid destabilizing the financial sector. With government revenues now in the new currency, government liabilities would also have to be redenominated to prevent balance-sheet effects from damaging the government's financial position.

Doing so in a democracy will require public consultations. Anticipating that domestic deposits would be redenominated into the new currency, which would undoubtedly depreciate against the euro, savers would swiftly shift their deposits to other eurozone or Swiss banks.

In the worst-case scenario, a system-wide bank run would follow. Investors anticipating that their sovereign bonds would be redenominated would try to sell, leading to huge losses for investors and financial institutions that hold such bonds, further contributing the cycle of financial panics and write-downs.

If the precipitating factor was parliamentary debate over abandoning euro, the ECB might not provide extensive lender-of-last-resort support. And if the government were already in a tenuous fiscal position, it would not be able to borrow to rescue the banks. Instead, the government’s only option would be to respond with a bank holiday, limiting bank withdrawals, at least temporarily.

The likelihood that planning to exit the euro would devastate its own financial system is a good reason as to why a country should not intentionally exit. Still, it does not preclude the possibility that a severe crisis can force a country toward that path.

On Monday, EuromoneyFXNews will discuss what the likely trigger of a break-up would be, the economic consequences and the legal issues relevant after an EMU departure.

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