What would trigger a Greek euro exit?
In the second part of this three-part series, the International Financial Law Review, a sister publication of EuromoneyFXNews, asks the following question. While the threat of devastating bank runs should act as a huge deterrent for a country to attempt an intentional exit from the euro, what would happen if a sovereign default were to cause bank runs to happen anyway?
This is the question Paul Krugman asked in response to Barry Eichengreen in a New York Times article on April 28, 2010. After all, the creditworthiness of a country’s financial institutions is closely linked to that of the sovereign, since they generally hold large amounts of its bonds or depend on state support for certain vital functions. Thus, a sovereign default would cast doubts on the liquidity or solvency of a country’s financial institutions, and growing doubts as to a country’s tenacity to stay within Economic and Monetary Union (EMU) might also cause depositors to flee from its banks. While the European Central Bank (ECB) might attempt to act as lender-of-last-resort to stem such a crisis, its lending, as required under Article 18.1 of Protocol (No. 3) on the Statute of the European System of Central Banks and of the ECB, must be based on adequate collateral. As a result, there are limits as to what it can do during a full banking crisis, particularly if it were triggered by a sovereign default that would have already devastated bank balance sheets.
If full bank runs erupt, as Krugman points out, the marginal cost of leaving the euro falls, and under such circumstances the decision may in fact be effectively taken out of policymakers’ hands. The only option would be to leave the single currency and reinstate the mandate of national central bank to independently manage the nation’s money supply with an alternative currency.
An urgent need to re-monetize
During a banking crisis, it would be imperative to have banks reopen as soon as possible. Bank closures would represent a vast contraction in a modern economy’s money supply. Eurozone money supply, as measured by the ECB, reflects the different degrees of liquidity—or spendability—that different types of money have.
Narrow money (M1) includes currency banknotes and coins, as well as bank balances that can immediately be converted into currency or used for cashless payments. Intermediate money (M2) comprises narrow money and deposits with a maturity of up to two years and deposits redeemable at a period of notice of up to three months. Broad money (M3) comprises M2 and marketable instruments and money market instruments issued by the financial sector.
Since nearly all of these items – other than currency – are financial institution instruments, with its banks closed or bank withdrawals limited during such crisis, the country’s money supply would quickly shrink to the physical currency at hand.
As Irving Fisher observed in his classical text ‘The Purchasing Power of Money, its Determination and Relation to Credit, Interest and Crises’: MV = PQ, where M is the nation’s total money supply, V is the velocity of money or number of times each dollar is spent during a period, P is the average price of all the goods and services sold during the period, and Q is the quantity of assets, goods and services sold during the period.
Nominal GDP to plunge
In such a crisis, with banks closed or cash withdrawals limited, the money supply, M, will dramatically fall, and the velocity, V, of bills and coins at hand will remain physically limited. The stock of physical bills and coins, indeed, might shrink even further as would-be depositors would now go abroad, and as individuals and businesses choose to horde their cash until the banks reopen. As a result, nominal GDP – the product of P and Q – will quickly plunge, likely endangering public health and safety if the crisis persists.
Under these circumstances, the country urgently needs to obtain sufficient funds to credibly re-open its banks. If aids sufficient to do so were not forthcoming, it might have no choice but to introduce a new currency, say drachma, in a hypothetical Greek banking crisis, for the state and other employers to pay workers and pensioners, and for banks to make available some cash withdrawals.
If Greece were to redenominate wages and other incomes into drachma, it would be, as Eichengreen pointed out, necessary to redenominate the mortgages and credit-card debts of residents into drachma, to prevent currency depreciation from instantly ruining the finances of individual households, leading to even lower spending levels amid a deep recession.
However, with mortgages and other bank assets redenominated, bank deposits and other bank balance sheet items would have to be redenominated as well, lest the banks remain insolvent or lacking sufficient reserves due to mismatched assets and liabilities.
For the same purpose, to the extent that Greek financial institutions have already suffered large losses in the crisis or have obligations governed by foreign laws that cannot be unilaterally redenominated by Greece, Greece would probably invoke its new bank resolution regime Law 4021/2011, which was enacted on September 28, 2011, and was promptly invoked with respect to Proton Bank.
The law grants Bank of Greece discretion when a systematically important bank faces failure to order: (i) a mandatory partial transfer of assets to third parties, or (ii) the establishment of a bridge bank, and the mandatory transfer of selected assets and liabilities from the troubled bank to the bridge bank, with wide power by Bank of Greece to decide which assets and liabilities are to be transferred and the amounts to be realized by the transferor.
The Bank of Greece, thus, may simply choose to leave foreign claims on a Greek bank behind to be adjudicated in its liquidation, while transferring needed assets and liabilities – including the crucial re-denominated domestic deposits – to new good banks to the extent necessary to re-monetize the economy.
On Tuesday, EuromoneyFXNews will publish the final instalment of the International Financial Law Review eurozone-exit series, looking at whether a member state could legally withdraw from the EMU without a parallel withdrawal from the EU itself.