Options for Europe – Part 80

The title is my current working title for a book I am finalising over the next few months on the Eurozone. If all goes well (and it should) it will be published in both Italian and English by very well-known publishers. The publication date for the Italian edition is tentatively late April to early May 2014.

You can access the entire sequence of blogs in this series through the – Euro book Category.

I cannot guarantee the sequence of daily additions will make sense overall because at times I will go back and fill in bits (that I needed library access or whatever for). But you should be able to pick up the thread over time although the full edited version will only be available in the final book (obviously).

Part III – Options for Europe

Chapter 23 Abandon the Euro ­ Costs, threats and opportunities




Re-denomination rather than default?

On June 6, 2011, German Finance Minister Wolfgang Schäuble wrote a letter to the ECB, the IMF and his Ecofin finance ministers, which expressed doubt that Greece could meet the terms of the bailout conditions in place and return “to the capital markets within 2012” (Reuters, 2011). He knew the IMF would oppose further funding in these circumstances but predicted that without “another disbursement of funds before mid-July, we face the real risk fo the first unorderly default within the euro zone”. He then judged that “any additional financial support for Greece has to involve a fair burden sharing between taxpayers and private investors”, which introduced the idea of the PSI (private sector involvement) at the highest levels. He called for a “substantial contribution of bondholders to the support effort”, which should be achieved ” through a bond swap leading to a prolongation of the outstanding Greek sovereign bonds by seven years” (Reuters, 2011). This set in place what would become a major default by the Greek government on its privately-held debt liabilities all managed by the Troika.

The Greek government bond debt held by the ECB (its largest creditor), the national central banks (also large creditors) and the European Investment Bank (a smaller creditor) were excluded from the haircut. Various tricky legal mechanisms were put in place to ensure the default was not subject to further legal challenges (for example, to cope with debt issued under English law). The details of the PSI need not concern us here but suffice to say, the “present value of the haircut of the Greek debt exchange was in the range of 59-65 percent” (Zettelmeyer, 2013: 19). The question is why is a forced restructuring of public debt to the detriment of the investor preferable to a negotiated withdrawal with the liabilities being redenominated and possibly losing value due to depreciation? The PSI was a Troika-managed and imposed loss for private investors who had presumably acted in good faith. A forced ‘haircut’ gives the financial community no option – the loss is imposed upon them and the accompanying austerity that is imposed on the nation defaulting increases the likelihood of further defaults in the future. Everyone loses and the losses magnify over time.

By way of contrast, the losses from redenomination only arise if the new currency depreciates significantly. This provides the holders of the redenominated assets an incentive to work to ensure the depreciation is contained and there is confidence in the new currency. For example, in the case of Greece, the 2012 PSI meant the vast majority of Greek government debt was held by official institutions – ECB, other national central banks and such. While the ECB could write all the debt off without consequence if it chose too, it could also offer the new Greek central bank (should it be Greece that exited) an unlimited euro-drachma swap line, which would help to buffer the depreciation. In the extreme case, the ECB could manage a peg on behalf of the exiting nation until growth resumes and confidence in the currency returns. However, as we discuss below, the depreciated currency provides a more effective way to increase a nation’s international competitiveness, than the present method of ‘internal devaluation’, which ensure there will be long periods of economic stagnation and hardship. The economic choice becomes one of determining which of the two alternatives is best for the nation.

There are many reasons why exit and redenomination is a superior path when compared to remaining with the euro-zone with debt default. Scott (2012: 41) concluded that the opposition to exit “cannot be allowed to obscure the economic reality that redenomination is at least a marginally better solution than restructuring – and in certain circumstances, a markedly better solution (emphasis in original)”. First, the nation gains full access to its fiscal and monetary policies and can stimulate growth immediately. Structural adjustments and managing large private debt exposures are more easily accomplished in a growth environment. Second, redenomination alters nothing with respect to contracts except the unit of account (the currency). There is no need for lengthy renegotiations and delays in payment flows. Third, Scott argued convincingly that redenomination avoids the problem of “holdout creditors” (p.4). Fourth, redenomination doesn’t advantage any creditor over another – they all face the same adjustment. There would be no ‘super priority creditors’.

Redenomination is simple depending on which jurisdiction is being considered. Within a nation’s own legal system, under the principle of Lex Monetae, a government could determine that all contractual liabilities currently specified in euros would now be valued in the new currency. The legal matters relating to this are not straightforward but are not likely to prevent it (see Thieffry, 2005; Proctor, 2006; Scott, 1998, 2012). In the case of liabilities, whose legal status lies outside of the national legal system the situation becomes murkier. This uncertainty is less likely to burden public debt, which is mostly issued under national law (Capital Economics, 2012; Scott, 2012). Further, for a nation borrowing in its own currency, depreciation presents no real problems because the government can always service their liabilities and the value of the debt in the local currency remains unchanged. For foreigners who hold this debt, the depreciation means that the value of the bonds in their currency falls. For a euro-nation, the debt is already effectively denominated in a foreign currency – that is, one they do not issue and cannot control. The euro-nation thus faces insolvency risk if it cannot generate enough euros to service its debt obligations. Exiting the EMU and restoring its own currency does not alleviate this problem. Furthermore, the value of its outstanding euro-denominated debt rises for the exiting nation once the currency depreciates. The local currency equivalent of the public debt to GDP ratio would rise, perhaps, quite substantially, which could trigger further falls in the confidence people have in the currency. It is thus essential that the government only issues debt (if at all) in the new currency with no convertibility guarantees and redenominates all outstanding debt accordingly.

However, in the case of private debt obligations the legal issues are likely to be thorny, which is why some commentators recommend taking a ‘laissez faire’ approach and leaving these obligations outside the redenomination net (Capital Economics, 2012). According to this argument, apart from the avoidance of legal issues, the evidence from the Asian financial crisis and the Russian default is that the private sector was “able to resolve these issues without governments becoming heavily involved” (p.41).

However, given that all local wages and prices would be paid in the new currency, it would become difficult for a household to service a euro liability. All bank deposits could remain outside the redenomination net but they would soon be exhausted and the debtor would then have to convert local currency into euros at the going price to facilitate payments. Widespread bankruptcies would be inevitable, which would then place severe strains on the banks. Capital Economics (2012) recognises this ‘systemic’ risk as justifying government-decreed redenomination. They also see scope for multilateral negotiations between governments to legislate to recognise the redenomination.

Scott (2012) also suggests that an international approach should be adopted in these cases, similar to the way the euro was brought into being, whereby all major jurisdictions recognised that the euro would become the payment currency. While the probability of loss through exchange rate fluctuations was minimal in that transition, the point is that when confronted with a total loss (default) or somewhat of a loss (depreciation), there would be an incentive to minimise the loss. These incentives should be enough to induce a process of Treaty change, which as a result of the more streamlined processes introduced in the Treaty of Lisbon would not take that long should there be a general view that it was in the best interests of all for these negotiated settlements to be allowed. That would clearly be a preferable route to take than unilateral exit.

Scott (2012) also raises the issue of vulture funds (or holdout creditors), which hunt around and purchase non-performing public debt and then sue if there is default. Various legal precedents have been established whereby courts rule that ‘commercial activity’ usurps sovereign immunity. Then the issue is to get the funds. The Economist (2011) noted that “(g)etting the country to cough up is another matter. Unlike companies, countries cannot officially go bust so their creditors don’t have the benefit of a clear insolvency framework”. Accordingly, the plaintiffs may “have rights but may not have remedies.” In the current proceedings against the Government of Argentina, the vulture funds have hit a dead-end because the a large proportion of the government’s off-shore reserves are deposited in with the Bank of International Settlements, which Swiss Federal Supreme Court (Schweizerisches Bundesgericht) ruled in 2010 has immunity from any claims for embargoes (Schweizerisches Bundesgericht, 2010, para 4.3). However, there are still avenues that these profit-seeking funds can pursue and these might be disruptive for extensive economic connections between European nations. Scott (2012: 43) concludes that “redenomination provides the clear advantage of making holdouts simply impossible” because the ‘haircut’ via depreciation does not constitute any legal claim. With the international approach outlined above redenomination is vastly superior to outright default.

Restoring central bank sovereignty and the relationship with the ECB

An essential but relatively straightforward part of the exit strategy would involve the re-establishment of the sovereign national central bank. First, the existing national central banks already retained most of their prior functions and structure when they entered the so-called Eurosystem. Second, there are already well-defined structures in place between the Eurosystem and the European System of Central Banks (ESCB), which is composed of the ECB and the central banks of all 28 EU Member States. This structure allows nations outside the eurozone to conduct independent monetary policy (that is, set their own interest rates) but still allow for close cooperation through the General Council of the Eurosystem.

The first priority for the central bank would be to introduce a viable payments system to facilitate the new currency. A payments system “refers to arrangements which allow consumers, businesses and other organisations to transfer funds usually held in an account at a financial institution to one another. It includes the payment instruments – cash, cheques and electronic funds transfers which customers use to make payments – and the usually unseen arrangements that ensure that funds move from accounts at one financial institution to another” (RBA, 2014). It also is backed by a legal framework defining operations procedures and standards. There are two types of systems – wholesale (for large transactions) and retail (for consumer-related transactions).

Introducing a robust wholesale payments system would not be a major issue. The central banks already had functional systems in place when they entered the euro-zone. Further, in terms of linking in with the TARGET2 system that is in place in the euro-zone, non-euro nations such as Denmark and Latvia already voluntarily link their national central banks to this system. There are also alternative systems operating in Europe, which also process euro-denominated transactions (for example, the system run by the European Banking Association). The retail system would be even easier given the widespread use of the so-called Single European Payments Area (SEPA), which is a system for simplifying bank transfers in the euros. Even non-EU nations (Iceland, Liechtenstein, Norway, and Switzerland) are members, as are Monaco and San Marino.

Second, the new central bank would have to re-define its relationship with the ECB. The new central bank would now set its own policy interest rate and be responsible for so-called official transactions, which include foreign exchange market interventions. Much of this expertise remains in the national central banks, given the structure of the Eurosystem.

Third, what about the nation’s capital and foreign reserve contribution to the ECB? The so-called ‘capital key’ of the ECB was formed by contributions from the Member States, the first being at the start of Stage Three of Economic and Monetary Union on 1 January 1999. The contributions were based on the size of the population and the economy, reflecting a ‘capacity to pay’. There have been six adjustments to the ECB capital since that time as a result of specified five-yearly updates and also due to new EU accessions. As at January 2014, the total capital of the ECB stood at €10,825,007,069.61. The euro area national central banks (NCBs) had contributed a total of €7,575,155,922.19 or 70 per cent of the total capital (ECB, 2014). The breakdown is shown in Table 23.X.

A nation leaving the euro-zone should expect this contribution to be repaid in full. There are no legal provisions for this in the relevant Treaties but from an operational sense, procedures are already in place whereby funds are transferred back and forward between the national central banks and the ECB. Would the capital loss be damaging to the ECB? Some commentators claim that the ECB would not be able to absorb the losses and would be insolvent without major contributions from the remaining member states. As we learned in the previous chapter, a central bank that issues the currency in which its capital is defined can never ‘go broke’. It is not like a commercial bank that requires capital for solvency. The ECB could function without missing a heartbeat with the accounting books showing negative capital forever. This is why the ECB could easily write off all its holdings of Member State public debt, thus reducing the liabilities of these governments dramatically, without any negative consequences arising in relation to its normal operations.

The actual amount that should be refunded would also depend on whether the nation remained part of the EU or not. Already, EU nations outside the euro-zone such as Bulgaria, Denmark, Poland and several others provide a small amount of capital to support the ECB as part of their membership of the ECSB.

Table 23.X Euro area National Central Bank’s contributions to the ECB’s capital, as at January 2014

National central bank Per cent of Total Paid-up capital (€)
Deutsche Bundesbank 17.9973 1,948,208,997.34
Banque de France 14.1792 1,534,899,402.41
Banca d’Italia 12.3108 1,332,644,970.33
Banco de España 8.8409 957,028,050.02
De Nederlandsche Bank 4.0035 433,379,158.03
Nationale Bank van België/Banque Nationale de Belgique 2.4778 268,222,025.17
Bank of Greece 2.0332 220,094,043.74
Oesterreichische Nationalbank 1.9631 212,505,713.78
Banco de Portugal 1.7434 188,723,173.25
Suomen Pankki – Finlands Bank 1.2564 136,005,388.82
Central Bank of Ireland 1.1607 125,645,857.06
Národná banka Slovenska 0.7725 83,623,179.61
Banka Slovenije 0.3455 37,400,399.43
Latvijas Banka 0.2821 30,537,344.94
Banque centrale du Luxembourg 0.2030 21,974,764.35
Eesti Pank 0.1928 20,870,613.63
Central Bank of Cyprus 0.1513 16,378,235.70
Central Bank of Malta 0.0648 7,014,604.58
Total 69.9783 7,575,155,922.19

Source: ECB, 2014.

On January 1999, the central banks of the Member States transferred 50,000 million euros in foreign reserve assets to the ECB. Those assets now stand in euro-equivalent terms at around 40,553 million euros (see Table 23.X). As in the case of the capital contributions, the new central bank would expect to have these assets refunded.

Table 23.X Euro area National Central Bank’s claims equivalent to the foreign reserve assets transferred to ECB, at January 1, 2014

National central bank Claim equivalent to the foreign reserve assets transferred to the ECB, with effect from
1 January 2014 (€)
Deutsche Bundesbank 10 429 623 057,57
Banque de France 8 216 994 285,69
Banca d’Italia 7 134 236 998,72
Banco de España 5 123 393 758,49
De Nederlandsche Bank 2 320 070 005,55
Nationale Bank van België/Banque Nationale de Belgique 1 435 910 942,87
Bank of Greece 1 178 260 605,79
Oesterreichische Nationalbank 1 137 636 924,67
Banco de Portugal 1 010 318 483,25
Suomen Pankki – Finlands Bank 728 096 903,95
Central Bank of Ireland 672 637 755,83
Národná banka Slovenska 447 671 806,99
Banka Slovenije 200 220 853,48
Latvijas Banka 163 479 892,24
Banque centrale du Luxembourg 117 640 617,24
Eesti Pank 111 729 610,86
Central Bank of Cyprus 87 679 928,02
Central Bank of Malta 37 552 275,85
Total 40 553 154 707,06

Source: Official Journal of the European Union, L16/47, 21.1.2014


Additional references

This list will be progressively compiled.

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Banco Central de la Republica Argentina (2007) ‘Single Free Exchange Market (MULC) Transactions and the Foreign Exchange Balance in the First Quarter of 2007’. www.bcra.gov.ar/pdfs/estadistica/MULC1trim07i.pdf

Buiter, W. (2011) ‘A Greek Exit from the Euro Area: A Disaster for Greece, a Crisis for the World’, Global Economics View, Citigroup, September 13, 2011.

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Proctor, C. (2006) ‘The Future of the Euro – What Happens if a Member State Leaves?’, European Business Law Review, 17, Issue 4, 909-937.

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Scott, H.S. (2012) ‘When the Euro Falls Apart – A Sequel’, Working Paper, Harvard Law School, January.

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Voßkuhle, A. (2012) ‘Über die Demokratie in Europa’, Speech to Rhur Political Forum, Dortmund Concerthall, February 6, 2012 published in Aus Politik und Zeitgeschichte (APuZ), 13/2012, Bundeszentrale für politische Bildung, 3-9.

Wade, R. and Sigurgeirsdottir, S. (2010) ‘Lessons from Iceland’, New Left Review, 65, September-October.

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Wolf, M. (2013) ‘Why the euro crisis is not yet over’, Financial Times, February 19, 2013. http://www.ft.com/intl/cms/s/0/74acaf5c-79f2-11e2-9dad-00144feabdc0.html#axzz30L8DwwS0

Wolf, M. (2014) ‘Managing a Bad Monetary Marriage’, paper presented to iNET Conference, Toronto, Canada, April 2014.

Zettelmeyer, J., Trebesch, C. and Gulati, M. (2013) ‘The Greek Debt Restructuring: An Autopsy’, Working Paper Series, WP13-8, Peterson Institute for International Economics.

(c) Copyright 2014 Bill Mitchell. All Rights Reserved.

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