There’s been a lot of talk about the possible break-up of the euro, but until now little has been written about the actual mechanics of a euro breakdown (other than it just can’t happen, so let’s not write about it.)
But a few banks have recently dared to speak the unthinkable.
Here’s HSBC, which this week put out a note entitled “How to solve the euro’s problems” in which it made the following points about the mechanics of a euro exit:
Can a country be forced to leave the euro?
There is nothing in the Treaty that can be used to force a country out of the euro or can facilitate it but if a country decides that the degree of austerity and reforms have become impossible to deliver and unilaterally decides to leave, it can’t be prevented. But euro exit would almost definitely mean EU exit and the free movement of labour, capital and trade that it implies as well as access to EU social and cohesion funds.
What would happen to the exiting country?
*The assets and liabilities of the banking system would, most likely, be redenominated at a rate of one-to-one with a view to a quick depreciation
*Capital controls would have to be put in place both because of the still large current account deficit and to limit daily cash withdrawals in order to avert a collapse of the banking system which would no longer have access to ECB liquidity. If a euro exit were in any way anticipated the bank runs would have already happened.
*Default would not eliminate the need for fiscal adjustment as primary balance is still in deficit so overnight even more austerity would have to be delivered than under the Troika plan. Assuming this is politically unfeasible, the central bank would undertake debt monetisation.
* Increased likelihood of defaults by companies now holding FX-debt which would also result in a raft of legal challenges in creditor nations.
*With no nominal anchor, there would most likely be a wage-price spiral (especially if the central bank is printing money) which would quickly eliminate any competitiveness gains unless it undertakes massive structural reforms
*Very hard to reinstate a legacy currency (probably become euro-ised particularly in the tourism sector and the large informal sector)
*Technical hurdles would be huge: legal, computer codes would have to be rewritten, ATM machines reprogrammed etc
*Would have to leave to EU and could face the imposition of trade tariffs from its members
For the rest of the Eurozone
*Huge contagion to other peripheral countries given that a precedent has been set for a country to leave: bond spreads blow out as foreign investors flee, widespread runs on banks which will have also suffered a credit event
*The ECB has to respond to with vast liquidity provision and government bond purchases as the EFSF would not be able to issue debt quickly enough to make the necessary purchases
*ECB and all private sector and official creditors would have to completely write off their debt claims on the exiting country. The IMF would likely be the exception given its preferred creditor status and because its assistance may be sought again soon
*A full-blown credit crunch on a scale that would make 2008 seem mild and economy falls into a deep recession
*Member state governments could seek recourse under British Law for the loans extended under the bailout package
What about Germany leaving?
*FX appreciation: impact on Germany’s export performance. Since the euro was formed, Germany has managed to maintain much more competitiveness than ever before. The recent appreciation of the CHF has shown the damage that having a freely floating hard currency can do to an economy, particularly one with an export-led growth model.
*Would amount to a devaluation of external assets of German households, companies and banks
*Banks would have to be recapitalised because their foreign assets denominated in euros would be worth less
*Germany would have to leave the EU and highly unlikely that the euro could survive the departure of the major economy
Bottom line: the Eurozone was always a political project and has never been an optimal currency area in terms of structure or country membership. Several members states would be in a better situation now if they had never joined but the implications of beak-up would be potentially catastrophic. It now requires a political solution to make it more of an optimal currency area, involving fiscal integration.
The consequences of a euro breakdown or euro exit would be, in a word, horrific. (And that’s for all nations involved in the project.) In that context, saving themselves increasingly means coming together in a “United States of Europe“. No other option ultimately seems tenable.
And if Europeans don’t like the idea of being pressured into the end of their sovereignty — well, let’s just say, the Polish finance minister’s prediction of war in the eurozone is suddenly not so unbelievable.