SS Euro - sinking the unsinkable
This is the risk they won't talk about in Brussels, Bonn or Paris - that monetary union, once entered into, goes horribly wrong, scuppering the SS Euro. Prudent financial management demands that the risk of failure, exit by one country or dissolution should be considered. Research suggests it isn't negligible and that its consequences for financial contracts and exposures will be devastating. David Shirreff reports.
In 1912 shipbuilders Harland & Wolff had somehow convinced the public that their latest creation the Titanic was unsinkable. Today, the architects of European economic and monetary union (Emu) are spreading the same propaganda about the SS Euro, scorning any thought of lifeboats or muster stations. The Maastricht Treaty, which sets the ground rules for entering Emu, has no provision for the exit of one or multiple countries; nor does the stability and growth pact, signed last year, which attempts to keep countries within the Maastricht criteria once they have joined, contain the ultimate sanction of expulsion.
The lack of an exit strategy is a problem for Emu, says Robin Marshall, head of research at Chase in London. "Because of the lack of an adjustment mechanism, the system may not be robust enough to survive."
Conferences and roadshows by Emu participants have been shy of examining what might go wrong. In the future euro-land such questions are regarded as disloyal. But since the middle of last year, like samizdat (the underground publications during the Soviet empire), a growing literature of dissent has emerged which dares to ask the question "what if".
This is a sensible risk-management question. A lot of effort these days is put into stress-testing portfolios and subjecting them to low-probability events that could have extreme results. The break-up or partial failure of Emu is such an event, and the risk of it happening is low but not zero.
The dissent is divided into two schools, says Mary Pieterse-Bloem, euro bond strategist at Paribas in London. "The bottom-up approach says that financial markets believe Emu is a hoax, and they are looking for what will bust the system. The top-down approach - which is more sensible - is that there will be economic and political tensions [that threaten to break the system] and these will be expressed in the financial markets." In other words: 1) hedge funds and others are looking for the big trade that will blow Emu apart; 2) economists and serious analysts are asking how might fundamental forces blow Emu's lid off.
"It's like a kettle with the safety valve welded down," says Neil Record, chairman of Record Treasury Management. An article in his quarterly publication on "The consequences of Emu's failure", outlines how markets might price the likelihood of a bust-up, and the mess that might ensue. "It has scared some of my US investor clients," says Record. "They're worried about holding assets in Italy."
Why Italy? Italy is just one hypothetical example. According to a popular bust-up hypothesis, a risk premium will develop on Italian assets after the third stage of Emu, from January 4 1999, because of fears that Italy (but it could equally be Ireland, Spain or Finland) may be forced by high unemployment and political weakness to leave Emu and create a new currency for itself. Those fears would drive up the rates at which Italian banks and Italian entities could borrow, regardless of the fact that there is supposed to be one euro-wide repo rate set by the European Central Bank (ECB). The Italian risk premium could skew interest rates and the forward rate for the Italian lira (which will still exist as a component of the euro until July 2002). The ultimate fear is that, when a country leaves Emu and creates a new currency, it redenominates its sovereign debt and perhaps that of private-sector entities in the new and probably weaker currency, wiping off value with a political act.
If the risk of this happening is not zero, then there is a price for it, which the riskier countries in Emu will have to pay - call it a credit spread, or a risk premium. Record suggests this premium should be quite high, given that, according to popular surveys, the perceived risk of an Emu break-up is quite high. An investor survey by Paribas last December had 39% of respondents seeing the risk of an Emu break-up ahead, 17% of them putting the date before 2002 and 22% after. "Say the risk of secession by a country is 5% a year," says Record, "and secession would wipe 20% off that country's financial assets. Then a risk premium of 1% a year isn't unreasonable."
Beware the euro-war
The premium may not be 1%, but nearly everyone agrees there will be credit spreads between the euro nations' government bonds. That represents the risk of default. However, default by a euro nation would involve much more than its debt being impaired. It would be a nightmare of global proportions - the equivalent of a third European war.
Why? Because a euro country which decides to exercise its sovereign right to print money doesn't have a domestic currency to reform. The euro is more like a foreign currency, controlled by a foreign central bank, the ECB. But a seceding country would be unlikely to regard all onshore money as a foreign currency. It would probably redenominate at least the bulk of its domestic money stock in its new currency. Would that affect all euro assets within, say, Italian borders? Or all euro assets held by Italian banks worldwide? Would it include deposits by non-Italians, or euro assets held in Italy by pan-European companies for operations all over Europe? Very quickly we see confusion, panic and the need to impose exchange controls; worse: huge litigation over seizure of assets and the frustration of contracts.
Retaliation would follow - seizure of Italian assets abroad. Countries have gone to war for less.
All this, remarkably, is not guarded against in any European Union literature. The subject is taboo, as if talking about it might encourage it to happen. As Record warns in his article: "Overt recognition of Emu's possible mortality may compromise its effectiveness and hasten its demise." Contingency planning "may need to be conducted in private", he suggests. And maybe this is what the European Commission and member governments are doing. But don't bet on it. The terrible orthodoxy prevailing in Brussels and Paris practically rules it out. Others, such as investors in the euro area, might like to do some contingency planning anyway.
For those who aren't afraid to stare disaster in the face, here are 10 icebergs that might sink the SS Euro:
1. A speculative attack before or after December 31 1998
Many economists reject the idea that the 11 national euro currencies can be speculated against after January 4 1999. It would be like speculating in £5 notes against the price of £10 notes, they say. Even after May 3 this year, when target bilateral exchange rates between the 11 candidate currencies are announced, there is little chance of speculation provided the national central banks keep their nerve, these economists opine. Why? Because intervention to support one member currency against another will ultimately cost the European System of Central Banks nothing, provided Emu goes ahead as planned.
Forward exchange rates and bond futures suggest that the market regards Emu, at the central rates in the exchange rate mechanism (ERM), as a done deal. Any slight deviation reflects uncertainty about short-term interest rates which must converge by January 4. The prevailing 9 basis point or 10bp spread between 10-year Ecu bonds and 10-year French or German government bonds reflects uncertainty about those currencies in the Ecu basket - sterling, Danish krone and drachma - which won't join the euro. Big volatility in sterling, which comprises around 13% of the basket, could have about a tenth of the same effect on Ecu interest rates and the external value of the Ecu until it is changed one-for-one into euro on January 4.
That isn't of great concern to most borrowers or investors. Few buyers or issuers of Ecu bonds - and Ecu/euro bonds have been issued in billions this year - bother to hedge out the residual sterling exposure, which they should if they want a smooth transition from Ecu asset to euro asset. "A US investor is taking foreign-currency risk anyway, so he doesn't care," says Bloem at Paribas. But a euro-land based investor, such as a Dutch pension fund, might be buying Ecu bonds as part of its future domestic portfolio in euros "so it doesn't want the residual currency risk", says Bloem. It can hedge out the exposure altogether by selling the Ecu forward, or it can hedge 13% by selling sterling and buying back guilders, she explains. Paola Lamedica another bond strategist at Paribas shows in a research article (published in February) that Dutch, German and French investors will see a higher yield pick-up if they hedge an Ecu/euro bond than Italians, British and Danish, because of the spread relative to bonds in their own currencies.
Issuers of Ecu bonds don't need to worry too much about the Ecu/euro basis risk unless they are matching this liability with assets in Ecu basket currencies, including sterling. The arbitrage between the Ecu basket and the so-called private Ecu, which was a good game when the two diverged by several percent, is uninteresting at the moment and, according to most analysts, is likely to remain so until Ecu/euro conversion.
However, one cannot dismiss the possibility that some big speculative trades, coinciding with any serious uncertainty about commitment to Emu, could have a devastating effect up to December 31.
After that the game is slightly different. The national denominations become fractions of the euro, like 10p and 50p pieces. That's the theory.
In practice there will still be money markets, bonds and probably futures denominated in national currencies until 2002. Although the ECB intends to set one repo rate for the euro there will be many factors that add a differential to money market rates. Among these will be the credit rating of the dealing bank, the liquidity of the national denomination, supply and demand effects on various national denominations, and residual anxieties about which national currency is most likely to leave the union. These are not exchange rate differentials, because the ECB and national central banks are committed to a single exchange rate between the national currency denominations. But credit spread or risk premium will become much more important, not least because intermediaries and traders looking for a turn have a big incentive to play up differentials. If spreads don't exist they will have to be invented.
Loss of confidence in the finances of one Emu member would be reflected in the yield spread on its bonds and a deposit premium paid by its banking system, like the premium paid by Japanese banks for Eurodollar deposits. Does this mean that lira-denominated deposits will yield more than Deutschmark-denominated deposits? Possibly. If so, surely lira forward rates will differ from Deutschmark forward rates, a de facto exchange rate differential.
Emu can survive such an anomaly. It may mean that the supply of Deutschmarks replaces the supply of Italian lire, but there should be no effect on the total money supply of euro-land. "In the end speculators can't drive Emu apart, only politicians," says Bernard Walschots, vice-president, financial markets research, at Rabobank. But speculation will nevertheless be a test of resources and even the supply of Deutschmark notes and coins. Without care it could lead to a squeeze on Italian banks and the entire Italian economy. The upshot might be a move to replace national notes and coins and retail transactions with the euro more rapidly than planned. But under the no bail-out principle of the Maastricht Treaty that wouldn't save a country being dragged down a spiral of no-confidence.
2. The German constitutional court
Experts in the German constitution judge it unlikely but still possible that the German system will take advantage of the several chances it has to scupper the euro at this late stage. But to do so would be to go against the wishes of the German parliament. And those are likely to stay pro-Emu even if chancellor Helmut Kohl is replaced after the September Bundestag election by social democrat Gerhard Schröder.
Late last month (March) and early this, the Bundesbank council was due to make recommendations on which countries have met the Maastricht criteria. It could object to the inclusion of Italy or Belgium, because of the size of their debt, but on the same strict criterion it would have to object to Germany's own entry. Towards the end of April the Bundestag and the Bundesrat are due to vote on Emu entry. The Bundesrat, the upper house, is the most likely to challenge Emu, but finally it is not expected to block it.
There are several private applications to the constitutional court to block Emu. The most serious is led by former Bundesbank directorate member Wilhelm Nölling. Even if the court accepts any application it will take so long to deliberate (around eight months) that Emu will then be irreversible.
3. The millennium bomb
"This is the real nightmare," says a risk manager at a big European bank. The nightmare will come a year into Emu when every commercial, strategic and civil computer faces the test, to make the right jump to the year 2000. If there is gridlock, and banks face liquidity problems, "who will provide liquidity", asks the risk manager, "since neither national central banks nor the ECB can act as lenders of last resort". This problem, he says, "is definitely not hedgeable. That's why we're looking at it so intensively - it requires a level of process management unknown in banking". Emu is postponable, the millennium is not, but governments are unlikely to postpone Emu for such a reason. "If you postpone it once, that's probably forever," says the banker.
4. Dislocation of competing payments and clearing systems
This is a long shot. Target is the real-time gross settlement system into which the ECB will feed intra-day liquidity. But each country has at least one payment system which will handle euro payments and some of them will compete for cross-border business. The UK has Chaps euro, an offspring of the Chaps sterling payments system; Germany has EAF2 owned by the Landeszentralbank in Hessen, part of the Bundesbank system; the Euro Banking Association (EBA) in Paris has a clearing system already clearing Ecu transactions which will handle euro payments on a netting basis, sweeping the net positions into Target at the end of the day.
There is the possibility of a hiccup in one payment system, leading to hiccups in the others. There is a danger of liquidity problems for individual banks in a real-time gross settlement system such as Chaps euro which is outside the euro area. Such a system has no end provider of liquidity. In a crisis, banks may not be able to complete payments. Real-time gross settlement means that the Target system will be safe, but a liquidity crisis outside it could hit the banks as they fail to find collateral to complete trades.
5. Impotence of the European Central Bank
Most countries are relying on the ECB to inherit the credibility of the Bundesbank. But Germany will have only one vote on the ECB executive board, along with France, Italy and possibly Spain and Finland, and even less influence on the ECB governing council. Council members are expected to put the interests of the collective economy above that of their own country, but they will hardly ignore what's best for their homeland. Hence there will be a dilution of the strict doctrine of monetary stability. Even if there isn't it may prove impossible for the ECB to cap the fiscal and public-borrowing discipline of 11 sovereign governments. It will become apparent that the ECB must either be strengthened with real centralized power from the European Council of Ministers or the European Parliament, or it cannot do its job. The European Council is too weak to do this, and Emu fails.
6. Mass unemployment and Europe-wide recession
Economists find this the most plausible threat to Emu. Because the ECB wants to show it isn't a toothless tiger (as above) it will go for a strong euro and high interest rates, exacerbating already high unemployment and kicking the region back into recession. The best hope for Emu, say Nobel laureate Franco Modigliani and others, is to make it reflationary, almost Keynesian, in approach. Certainly, lack of synchronicity between the various countries' economic cycles will lead to severe economic and political strain in the first years, and that is the most likely reason for an early joint decision to end the experiment.
Analysts at Credit Suisse Private Banking foresee a severe test of political will ahead: "Looking at the political landscape in Europe", they write, "there is little to point towards speedy reforms of the labour market or towards the rapid development of a common legal and social security system. Probably the financial markets will first have to speculate on the collapse of the system to force politics to take action."
7. Asymmetric shocks to one or two countries
The stability and growth pact signed last June in Amsterdam allows a country hit by an annual fall of 2% or more in GDP (less under special circumstance accepted by the EU council of finance ministers) to ease up on the Maastricht criteria and boot itself out of recession. A big enough shock, however, could put a country beyond the pale, or make it politically impossible to continue membership of Emu.
8. Expulsion of a delinquent country
There is no such sanction in the stability and growth pact. But fines levied from bad countries and given to the good are like stealing from the poor and giving to the rich. A delinquent country seeing a large percentage of its GDP (0.2% plus a tenth of its deficit excess) going to countries that meet the criteria such as Holland and Luxembourg isn't likely to put up with this for long. It will dig in its heels. It will dare the powers in Frankfurt and Brussels to do something. Either they will relent and bail the country out, which is forbidden under the Treaty, or the naughty country is expelled.
9. Voluntary exit by a country
A country anticipating the above will make up its mind to leave anyway. Or, despite meeting the Maastricht criteria, it will decide it is unsuited to Emu, or that Emu is a mistake, and leave.
10. Mutual agreement to dissolve Emu
Such has been the political and economic investment that this is unlikely to happen for at least a decade. It will have to be proved, empirically and intellectually to the satisfaction of whatever French and German government is in power, that Emu was an experiment which didn't work and which brought more misery than it did prosperity. That will depend on who's writing the history.
An agreed mutual termination of Emu could be staged over several years. The agreed exit of one country could also be phased in gradually. There would be some financial losers, but panic could be avoided.
A sudden exit from Emu, or even the real fear of it, could unleash chaos on the financial markets. In such an eventuality, holders of assets or financial contracts in euros or a national currency subdenomination of the euro, will want to make sure that their assets or contracts can't be affected by redenomination into a new currency by force majeure.
One way of reducing the chances is to make sure the governing law of the contract is outside Emu - for example English law, or even better US law. "Italian issuers may find themselves forced to issue euro bonds offshore to avoid paying a high risk premium," suggests Record of Record Treasury Management. "For London it's a win-win situation," he says. London, unless there's a real risk of it joining Emu, will be the safe haven for euro swap and bond contracts, as it has been for the Euro (offshore) market in dollars and other world currencies. A contract under US law may be even sounder, since US court decisions appear to have global reach (see Euromoney, March 1998, page 38: "Who needs gunboats?") and there's no likelihood of the US joining Emu.
For prudent financial institutions considering the first three years of Emu there is a related dilemma: do they regard positions in, say, lira or Deutschmark as totally fungible with positions in euro? European bank supervisors say that they are fungible, and that there will be no regulatory capital charge for exchange risk between such positions. Counterparties can opt to make payments due either in the denomination specified in the contract or in euro at the official rate. But at least one US investment bank is asking: "Should we allow our customers to opt freely for one or the other, and if we do what liability do we run if Emu blows up?" Most European bankers regard this alleged risk as irrelevant. "We're certainly not going to manage our positions as if they were different currencies," says Dominique George, managing director at JP Morgan in Paris.
JP Morgan economists discuss this point in Event risk under monetary union: "If doubts existed, market participants would be unwilling to net exposures in different denominations which would result in price differences between them - in swap markets different denominations would not trade at zero yield differentials while in bond markets investors would put a premium on issues with certain currency denominations." Whether it would be possible to say which part of the premium is credit risk and which is denomination risk is another matter. Perhaps credit risk models would be able to strip out the two factors, Record suggests.
"It's a systemic risk you can't quantify," says David Mackie, UK economist at JP Morgan in London. "And you've no idea what kind of systemic risk your counterparty would be exposed to."
The JP Morgan paper says that to worry about such a risk, while others ignore it, would be to price oneself out of the market: "The opportunity costs associated with managing denomination risk, combined with the low probability that such an event could happen, make it extremely likely that market participants will view the conversion rates as irrevocable."
But this means that, from the start of Emu, transactions denominated in euro are likely to dominate the institutional market, the paper concludes. Isn't there a danger, however, that risk managers will ignore the issue, simply because to dwell on it would be uncompetitive? How often has this herd mentality led to mispricing in the financial markets?
The secession of a country from Emu, and the creation of a new currency, may be too ghastly to contemplate; but various prudent bankers and lawyers are at least asking a few of the right questions.
Bernard Walschots at Rabobank is working on a stress scenario based on the exit of one country from Emu. "It shouldn't be ruled out that the next generation of politicians in Europe shifts back to a more nationalistic stance," he says. "Indeed, they can be forced to do so by the electorate." In the event of a full or partial Emu collapse he sees three outcomes for the euro: that it ceases to exist; that it reverts to being a basket currency; that it survives as the currency of remaining members. Walschots warns that if there is no common approach supported by the European Council "a central government and its central bank may apply a discretionary rule, thereby creating a national money stock instantly, but more likely than not they will face a mass of law suits following such an illegal or dubious operation".
In a dummy crash of a hypothetical Dutch/German monetary union, Walschots predicts that Dutch sovereign and corporate bonds redenominated in the new Dutch florin, are immediately dumped by the market. Dutch corporates are squeezed and Dutch banks lose their deposits to the German banks. Dutch companies and banks face bankruptcy and the IMF is called in to set up a currency board, which, ironically, links the florin to the Deutschmark. Rabobank is now including an Emu crash among its series of stress scenarios, says Mâcé Mesters, who runs Rabobank's central market risk control.
Under such a scenario "you could have people walking away from contracts," says Martin Brookes, international economist at Goldman Sachs in London. But he adds consolingly: "A factor likely to hold things together is that the alternative is too horrendous to contemplate."
Jean-Daniel Cohen, managing director at Aurel in Paris, is concerned with the uncertain status of the euro. "To me it's an open question," he says, "is the euro the national currency of a country or the currency of the union? We've asked the European Commission and never had a formal answer." John Barty, director of European economics at Deutsche Bank asked the same question to the European Monetary Institute (EMI), forerunner of the ECB: "The answer I got from the EMI was that the euro was going to be a European currency. But if a country was to withdraw, who is going to enforce that?"
A clear answer would settle the question whether a member country's debt in euro is foreign-currency debt or domestic debt, and whether it is legal to redenominate euros in a new domestic currency. Francis Crédot, director of legal affairs at the Chambre Syndicale des Banques Populaires in Paris, and head of the French legal working group on Emu, says he has "no direct answer" to this question. But "it's difficult to consider that all liabilities would stay in euro [if a new currency is created]", he says.
Colin Bamford, chief executive of the Financial Law Panel in London paints a picture of Italy "dumping all its public sector liabilities into the union". But he sees no legal solution: "People talk about it but the conversation never gets anywhere - all you do is frighten yourself."
Marc Dassesse, a partner with US law firm McKenna & Cuneo in Brussels, cites the conundrum of a Belgian bank holding customer deposits in Deutschmarks during the transition period 1999 to 2002: "Pre monetary union, with such a customer account, a Belgian bank would have a countervailing Deutschmark position with a German bank. But post Emu, if the Belgian bank keeps an account denominated in Deutschmarks on its Belgian books, it makes no sense for it to keep a countervailing claim on the German banking system - since Belgian francs and Deutschmarks are just a non-decimal expression of the euro. If Germany or Belgium leaves the euro zone, the Belgian bank or its customer may be at risk. The bank may have a problem repaying the customer in Deutschmarks (which could have risen in value against the euro after leaving monetary union). Its customer may have a problem if the bank insists his Deutschmark account had been in euro all along. A US customer might be tempted to test the bank's reasoning in the New York courts, and may try to go after the US assets of the Belgian bank."
Dassesse reminds us that Belgium and Luxembourg have been in a monetary union for more than 50 years, with a legally fixed parity between the Belgian franc and the Luxembourg franc. Yet, to this day, Luxembourg banks will refuse to open an account in Luxembourg francs for Belgian residents. This is because in 1981 Belgium was forced to devalue, and Luxembourg had no option but to follow. Luxembourg was then determined to have the option to disagree in future. This can only be the case if Luxembourg banks are required to match deposits in Belgian francs on the books of Belgian banks, and liabilities in Belgian francs vis-à-vis Belgian customers not resident in Luxembourg.
Monetary unions have been broken before. Some obvious examples are the republics which broke from the former Soviet Union, the Czech and Slovak republics, Rhodesia declaring unilateral independence in 1965, and Ireland de-linking itself from sterling to join the European Monetary System in 1979. But only in the Soviet case was there a complex network of cross-border assets and liabilities which had to be settled. And in the Soviet case the values, in transferable roubles and barter arrangements, weren't market-sensitive.
Bernard Connolly, strategist with AIG Trading in London, compares the plight of a beleaguered country leaving Emu to that of Indonesia or Malaysia: "You have your debt in foreign currency and your private sector faces bankruptcy. You can only leave Emu successfully if you are strong," he says. "Then you're indebted in a currency that is weak."
Given the core intentions of Emu and expectations that the ECB will act tough it is difficult to imagine the euro being that weak. But it is possible to imagine more and more political measures being taken to centralize and strengthen the status of Emu. Mackie at JP Morgan remembers that America was a loose federation of states before the US constitution was adopted in 1789: "Within 100 years there was a civil war over whether a state could secede or not." If an Emu state thinks it may want to secede some time in the next 100 years, maybe now is the optimal time.