Record - Minimising the Financial Cost and Maximising the Economic Opportunities of Euro Exit

7/31/2019 Record - Minimising the Financial Cost and Maximising the Economic Opportunities of Euro Exit

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May 2012

WOLFSON ECONOMICS PRIZE 2012

Minimising the financial cost, and maximising the economic

opportunities, of Euro Exit

If member states leave the Economic and Monetary Union, what is the best way for theeconomic process to be managed to provide the soundest foundation for the future growth

and prosperity of the current membership?

Neil Record


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Table of Contents

Introduction....................................................................................................................4

Background....................................................................................................................4

Planning for a departure.................................................................................................6

Secrecy ? ................................................................................................................................ 6

Unplanned Exit.................................................................................................................................6

Planning without secrecy..................................................................................................................7

Planning in secret ........................................................... .................................................................. 8

Exit planning - relationship between Member States and the EU institutions....................... 9

Exit types ............................................................................................................................... 9

Key considerations in planning an Exit .......................................................................10

Task Force Charter............................................................................................................... 10

Planning is essential the Task Force must be formed (and its existence denied).............. 11

The Task Forces key considerations...........................................................................12

Exit the run-up .................................................................................................................. 12

First priority preventing a European, and therefore global, banking collapse .................. 12

Winners and losers............................................................................................................... 13

Euro banknotes identifiable by country-issuer .............................................................. ..............14

Minimising windfall gains and losses.................................................................................. 16

Redenomination uncertainty ................................................................................................ 18

Exit without Euro abandonment .......................................................................................... 19

A single countrys exit the advent of intra-Euro currency risk......................................... 21

Hedging Intra-Euro currency risk...................................................................................................21

Why should the Task Force recommend the abandonment of the Euro ? ........................... 22

New ECU basket for termination or run-off valuation ............................................................... ....24

Mechanics of the new ECU............................................................................................................25

The ECB a major systemic risk ........................................................................................ 27

Why does the ECB/ESCB have such a large balance sheet ?.........................................................29

Target2 ................................................................................................................................. 30

ECB on Exit ......................................................................................................................... 33

European Financial Stability Facility (EFSF)...................................................................... 34

European Investment Bank (EIB)........................................................................................ 35

National Central Banks........................................................................................................ 35

Conduct of monetary policy ........................................................ ................................................... 35


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Lender of last resort........................................................................................................................36

Exit/transition timetable...............................................................................................36

Task Force activation........................................................................................................... 37

Immediate aftermath the first week .................................................................................. 39

Notes and coins ............................................................. ................................................................. 41

Alternative methods to handle notes and coins ............................................................. .................41

Rapid introduction of new notes.....................................................................................................42

Bank and savings accounts.............................................................................................................42

Mortgages.......................................................................................................................................43

Credit card debt, corporate and personal loans...............................................................................43

Pensions and insurance contracts....................................................................................................44

The individuals perspective ................................................................................................ 44The business perspective...................................................................................................... 45

Multinational companies ................................................................ ................................................ 45

Exporting & importing businesses .............................................................. ................................... 46

Local businesses...................................................... ............................................................... ........46

Constitutional and legal questions ....................................................................................... 46

A German-only back-up plan............................................................................................... 47

Short-term disaster planning and avoidance ........................................................................ 48

Future political, economic and financial health...........................................................50

What does success look like for the announcement phase ?...........................................................50

Stability, growth and future prospects............................................................................................51

Argentina........................................................................................................................................51

Argentinean and Greek parallels ............................................................... ..................................... 53

Fiscal discipline ................................................................................................................... 54

Southern Countries, inflation and the future........................................................................ 55

Northern Countries post-Exit ............................................................................................... 56

Trade and the EU ................................................................................................................. 56

Post-Exit exchange rates ...................................................................................................... 56

New Europe ......................................................................................................................... 57

Summary and Conclusion............................................................................................57


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Introduction

This essay will consider the wide-ranging implications of the putative exit from the Euro of

one or more current member states. It proposes a plan to minimise the inevitable disruption

and maximise the chances of future growth and prosperity.

It will not consider the likelihood of this event (since the essay title has made this the pre-

existing condition). It will look in detail at the timelines that an exit might exhibit; critically,

and in detail, at the implications on the financial infrastructure of such an event; at the legal

questions and the ambiguities that will inevitably arise, and at the economic and financial

implications in the immediate aftermath.

It will briefly consider what a post-exit world might look like for a country that has departed.

However, it will not present a detailed longer-horizon analysis of the post-exit economies

(since it is certain to be so wide of the mark !), except where some economic analysis along

well-established lines appears relevant to the central question.

Background

Almost every contemporary reader will be familiar with the background to this essays central

question. However, for future readers, or those small number who are unfamiliar with the

background, I will summarise a very brief history of Europes Economic and Monetary Union

(EMU) up to the end of 2011.

EMU was first formally countenanced in the Single European Act of 1986, and set out in

more detail in the Delors Report of 1989. The path to EMU was formally agreed at the

Maastricht Summit in 1991 (signed, after some delay, in 1993), at which three stages (I, II &

III) were planned, stages I & II heralding convergence to ultimate monetary union (stage III).

Maastricht was signed by all the twelve member states at the time, although the UK and

Denmark negotiated separate EMU opt-outs. Three further new member states joined in

1995, and they signed up to EMU by default since the EUs constitution is the sum of its

pre-existing Treaties. Maastricht imposed four criteria for member states entering stage III

(full ERM membership i.e. adopting a currency initially called the ECU but later (1995)

called the Euro). These were:

1. Inflation no higher than 1.5% p.a. above the average of the lowest three countries2. Fiscal Prudence Annual Government deficits not to exceed 3% of GDP;

outstanding Government debt not to exceed 60% of GDP

3. Exchange Rate Member states to have had two years membership of theExchange Rate Mechanism (and no devaluations in the period)

4. Long-term Interest Rate Member states to have long-term interest rates no higherthan 2% above the average of the three lowest inflation countries (i.e. those in (1)

above).

Writing in mid-2012, these criteria look rather quaint now. Interestingly, the first, third and

fourth criteria have been largely forgotten; but the second the fiscal prudence criterion

formally referred to in the Maastricht Treaty as the Excessive Deficit Procedure, has lived onrather notoriously.


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The various negotiations that took place between December 1995, when the new currencys

name was changed from the ECU (in the Maastricht Treaty) to the Euro, and May 1998,

when the initial membership and exchange rates to the Euro were decided and announced, are

important because they sowed the seeds of the Euros current travails.

The decision made on 3 May 1998 to admit eleven1 states to membership was an importantsignal which was largely ignored. The market was genuinely unsure before the 3 May

meeting whether Italy, who missed the outstanding debt criterion of 60% by a mile (with over

100% debt to GDP ratio), would be allowed to join. The decision to admit Italy, and blatantly

flout the rules, turned out to be an accurate pointer to subsequent decisions on admission, and

indeed to the policing of existing members. The fig leaf was instructive Italy was admitted

because its ratio of outstanding government debt to GDP was sufficiently diminishing and

approaching the reference value at a satisfactory pace2. On any objective measure, there was

no evidence in 1998 of sufficient diminution and approaching the reference value of Italys

outstanding debt3.

On 1 January 2001, just two years after the foundation of the Euro, Greece was admitted.

There was little fanfare, and the official report which lifted the excessive deficit procedure for

Greece4 allowed a great deal of optimism. By the reports own admission, Greeces

outstanding Government debt was 104.5% of GDP in 1999 (following 106.3% in 1998). It

later turned out that Greece had falsified both these figures, and also the Government deficit

figures5. But even so, had these figures been correct, it would have taken Greece 25 years to

reach the 60% debt reference level if the reduction had continued at the same pace !

There have been five more new Euro members since 2001 Slovenia (2007), Cyprus & Malta

(2008), Slovakia (2009) and Estonia (2011), making a total of 17. All the recent joiners are

very small from an economic perspective.

1 The missing four being the UK & and Denmark with an opt-out; Sweden who didnt qualify and Greece, who

didnt qualify by reason of its excessive government deficit and debt. Swedens failure to qualify was by reason of

its non-membership of the ERM, and was in effect an opt-out exercised by Sweden.2 Maastricht Treaty; Article 104c; extract from 2(b)3 Italian debt as % of GDP: 1995: 120.9%; 1996: 120.2%; 1997: 117.4%; 1998: 114.2%; Source: Eurostat, General

Government Gross Debt as % of GDP (Maastricht definition).42000/33/EC: Council Decision of 17 December 1999 abrogating the Decision on the existence of an excessivedeficit in Greece.5 Although the word falsification was never used in Eurostats 2004 report (Report by Eurostat on the revision of

the Greek government deficit and debt figures, 22 November 2004), the evidence on revisions, and the selective

and inconsistent use of accounting conventions makes a damning case. As an example, this report shows that by2004, Greece (at the behest of the EU) had revised its outstanding debt for 1998 and 1999 to 112.4% and 112.3%

of GDP respectively.


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Planning for a departure

Secrecy ?

There are only three types of departure possible:

Completely unplanned Planned without secrecy (i.e. in public) Planned in secret

At one level any Eurozone exit is, by definition, unplanned. EMUs architects designed a

system in which exit was neither possible nor conceivable. Hence the subject of this essay is

dealing with the unpicking of a system which was not designed to be unpicked.

That being said, the apparently different routes above are a continuum rather than fully

distinct. Clearly it is almost inevitable that at least one person in a senior official position in a

departing country will have thought about the actions needed by that country in the event of a

departure from the Eurozone6. If that person is a senior Treasury official in a Eurozone

member state, does a departure of that country constitute a completely unplanned exit ? What

about these thoughts having been committed to paper by this official alone ? What if thoughts

have been committed to paper by a small group of officials, even working informally ?

Hence the caveat about the difficulty of distinct categorisation.

But for practical purposes, it does matter whether there is some time for planning or not, and

indeed in the very short term, the difference between a planned and an unplanned exit is likely

to be fundamental to the path of the crisis and probably the ultimate outcome.

Unplanned Exit

Unplanned exit is likely to be the result of a major and unstoppable financial or political

crisis7 which erupts quickly despite the continued protestations of the main players that

increasing fiscal integration remains the direction of policy.

A completely unplanned exit is likely to have really serious consequences for both the

population of the departing country, and for the remainder of the Eurozone. If multiple

countries leave without planning, then the chaos is likely to be disproportionately greater.

In the most extreme of unplanned exits, say in a military coup, one could imagine waking up

one morning in Greece to a news announcement that the Government of the day has beenreplaced by a military junta; that all borders have been temporarily closed, and that a curfew

has been imposed. You are told that the Governor of the Greek central bank has been

replaced by a nominee of the junta, and he has announced that, with immediate effect, the

new currency of the country is the (new) Drachma. The announcement may continue that the

6 Perhaps just by reading the short-listed entries to the Wolfson Prize !7

For example, the surprise election of an avowedly Exitist party to power in one member State; the completefailure of a sovereign to be able to borrow in the markets or from a multilateral funder; a military coup or popular

uprising in, say, Greece.


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official conversion rate of the Drachma to the Euro is, say, 3.4075 Drachma per Euro 8. All

contractual commitments, debt, assets, money, pensions, indeed everything within Greece that

had been denominated in Euros would now be denominated in Drachma.

With no planning, and no ability (or desire) to consult their Eurozone partners, one can

imagine the chaos that would ensue.

The most obvious desire would be for Greek residents to try to get their Euro banknotes out of

Greece, since if they could do so, they could preserve the notes purchasing power. The

likely result of this would be an unwillingness to bring their notes out into open circulation,

since presumably the junta would also issue a decree that the moment a Euro banknote was

tendered to a shop or bank, the shop or bank would be obliged to overstamp, or maybe

confiscate, the note.

Much worse from an international financial solvency perspective is that a unilateral

redenomination of sovereign liabilities would punch large holes in the balance sheets of the

European Central Bank (ECB), the European Financial Stability Facility (EFSF), and therump of the Eurozone private sector banking system which still owns Greek sovereign debt.

Similar damage would be inflicted on any non-Greek Eurozone banks with loans to the Greek

private sector.

The swapped Greek Sovereign bonds issued under the March 2012 swap agreement are

written under English law, so redenomination could not be effected without a specific

repudiation of the debt contract. Under the conditions outlined, I do not imagine that a

revolutionary Greek Government would regard that as much of a hindrance.

I paint a particularly bleak picture here (and there are many less bleak possibilities), but not, I

believe, a totally implausible one.

Planning without secrecy

So is it in theory possible to plan for an exit of one of more countries without secrecy (i.e. in

public) ? I believe not, and this is why:

The Euros very nature is predicated on its indivisibility. Individuals, companies and banks

within Eurozone member states were content to treat each Euro equally, wherever it was

located, only because there was perceived to be no risk of arbitrary devaluation of one

regions or countrys Euro.

At the time of writing (May 2012), this perception has begun to change, and I will explore theimpact of this change later. However, if officials and politicians within the Eurozone embark

on an open discussion about plans for a Euro departure (however remote they claim the risk to

be), the perception of equal treatment of all Euros will be lost, and potentially unlimited

capital flight will ensue, particularly when the current cost and difficulty of capital flight is

zero or close to zero. For those readers unfamiliar with what wholesale capital flight means, I

will be exploring it later in the essay.

8 The entry rate of the Drachma when it joined the Euro in 2001 was 340.75 Drachma (GRD) to the Euro. I

(arbitrarily) choose 3.4075 as being equal to 100 old Drachma.


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Planning in secret

Once you eliminate the impossible, whatever remains, no matter how improbable, must be

the truth. Sir Arthur Conon Doyle.

Sherlock Holmess famous quote has intuitive appeal because, like the scientific method, it

relies on observation and reasoning to discover the truth, untrammelled by preconception or

prejudice.

In the previous two paragraphs I have attempted to illustrate the undesirability of an

unplanned exit, and the impossibility of a public exit-planning process. What remains -

planning in secret - is by Holmesian logic the only available alternative.

I have been asked whether it is really possible for material plans for an exit to be put in place

in secret. My accurate answer to that is that I cant know. But I do know that the incentives

for one or more Governments to do so are so high that I suspect that they will succeed in

doing so. There are innumerable parallels for major projects successfully planned in secret,

although most of the examples that readily come to mind are military: the location of D-day

landings; the Manhattan Projects development of the atomic bomb; Iraqs invasion of Kuwait

and Argentinas invasion of the Falklands.

All of these projects were large scale in terms of men and material, much physically larger

than the planning processes required for a Euro exit. But if I were Prime Minister of the

Hellenic Republic, or Chancellor of the Federal Republic of Germany, or indeed the leader of

any of the Eurozone member states, I would have already commissioned a very small task

force, probably led by a member of the secret intelligence service, and staffed with a small

number of highly-regarded and fully vetted individuals drawn from the economics profession,

the National Central Bank, the financial regulator and the commercial and investment bankingcommunity. I would invite them to contribute to the compilation of a Euro exit plan on the

basis that the entire work, and its existence, was a matter of national security, and that a

breach of the secrecy would be a criminal offence and, in effect, a treasonable act. This is the

basis on which secret military plans are made, and it would likewise be the basis on which

secret Euro exit plans would be made.

Military Parallels

There is quite a close parallel with another secret contingency planning activity which many

developed countries undertook since the second World War post-nuclear holocaust

planning. The event was almost too terrible to contemplate (certainly in a different league toEuro exit or breakdown !) and a much more remote likelihood than Euro exit, but despite this

many Governments (rightly) believed that it was their civic duty to lay detailed plans for this

remote and terrible contingency. However, being seen to be planning for the event was

widely believed by authorities to be likely to sow alarm and despondency among the

population, and so planning, even physical construction of facilities, was kept secret. Since

more than twenty years have passed since the end of the cold war, and the very significant

lessening of the risk of a nuclear exchange, some of these plans have now surfaced, and from

those that have, it is evident that a great deal of money and manpower has been devoted over

many years to developing and updating these plans in almost total secrecy.


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Small Task Force

At a practical level, I do not think that a Euro exit task force need be large, nor do I think that

compiling an effective plan is a particularly big task when measured by national capabilities.

Perhaps twenty of the right professionals (together with support staff) employed for six

months would in my opinion be able to prepare a pretty comprehensive set of plans for thepoliticians of the day, and perhaps five to keep it up-to-date. The only possible physical

activity contemplated would be the prior printing and storing of banknotes, although

alternatives to this do exist9, and I describe one later in the essay.

By contrast, I do not think it would be possible for the EU or any of its institutions to conduct

such a planning exercise. Such an exercise would be one of self-destruction, and therefore I

believe, fundamentally difficult to execute, particularly in secret.

Exit planning - relationship between Member States and the EU institutions

I have suggested that planning for Euro exit must be conducted at national level. This bringsme to the question of the extent to which there is communication between member states, and

between member states and EU institutions on this topic.

I believe there is some chance of international co-operation amongst member states, but I

think that the requirement for absolute secrecy is so high that the co-operation is likely to be

minimal, and probably only bilateral. I also think that there is no chance that member states

will communicate their plans, or indeed their plans existence, to any EU institutions on the

grounds that their secrecy can then no longer be guaranteed.

Exit types

There are a surprisingly large number of alternative types of exit possible, and although the

purpose of this essay is not to guess which one will emerge, it certainly is to examine which

ones are most likely to lead to long-term financial and economic stability. I set out below

what I perceive as the full likely set of possible exit types (note that there are in theory many

more permutations possible, but I ignore them as materially similar to those listed):

1. Group leaves out of the top (super Euro); Euro intact below2. Group leaves out of the top (super Euro); fragmentation below (Euro abandoned)3. Fragmentation out of the top; Euro intact below4. Fragmentation out of the top; new group (Mediterranean Euro) below (Euro

abandoned)

5. Group leaves out of the bottom (Mediterranean Euro); Euro intact above6. Fragmentation out of the bottom; Euro intact above7. Fragmentation out of both top and bottom; Euro intact in the middle8. Full fragmentation (Euro abandoned)

9

And indeed it is possible that member states have stored old national currency notes and coins. At the re-unification of Germany in 1990, East German coins were melted down, but most of the notes were stored for 11

years in underground tunnels until a minor opportunistic theft in 2002 precipitated their destruction.


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Note that fragmentation in this context means that one or more countries resume the use of

their own National Currency. In the essay, from this point onwards I will use Exit to mean

any of the above unless otherwise specified.

Interestingly, most Press and other comment has hitherto focused on 6) above. I will discuss

this in much more detail later as I discuss the financial and other implications of Exit.

Key considerations in planning an Exit

How a national Exit Task Force goes about its work depends crucially, in my opinion, on the

member state concerned. I think that one member state Germany has a completely

different position with regard to the Eurozone compared to all the others. Germany is the

largest economy in the Eurozone by some margin; it has by far the largest trade surplus within

the EU, and it and the Bundesbank have become at the date of writing (May 2012) the

effective funder and guarantor of the Eurosystem.

While the other sixteen Eurozone member states should be busy preparing national exit

contingency plans for their own countries, I believe that Germany should be busy preparing a

Eurozone-wide proposal. It may be that the implications for the Eurozone of a potential exit

are so profound that Germany feels obliged to consult France on this topic. I think Germany

is unlikely to consult more widely in the planning stage, as to do so would sharply raise the

risk of a breakdown in secrecy.

However, in view of the critical importance of Germany to the Eurozones existence, from

now on, I am going to concentrate on the national plans that Germany might draw up.

Task Force Charter

When Germanys Exit Task Force gets to work, it needs to have been given a policy

framework (Task Force Charter) to guide its practical proposals. Sadly, this Charter will

not be available for prior discussion, and the EU will have to depend on the sagacity of the

Charter designers for the post-Euro order. On this will turn the success or otherwise of the

future path of the EU, and, as in war, one key individual (or very small group) may emerge to

show inspirational leadership in this context. But at the Charter design stage, it will all be

secret.

I set out below the key goals that I believe the Charter could seek to achieve:

1. Maintenance of liberal democracies in all Eurozone member States.2. The continued existence of the EU10 as a voice in the world, and as a force for binding

the nations of Europe by trade and mutual interest.

3. The continuation of a European free trade area, without capital controls, within thewhole of the current EU (not just Eurozone) membership and EFTA.

4. Future economic and financial health of all Eurozone11 (and indeed EU) memberStates as far as is possible. This will require:

10

I suggest later that a name change (to New Europe, say) might be appropriate to signal the fundamental changethat Euro Exit would bring. This would be the fourth name the others (in order) were European Economic

Community; European Community; European Union.


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a. An Exit transition period which succeeds in preserving the integrity of thefinancial system in each Eurozone Member State. Which will in turn require:

i. as much certainty as possible in determining the currency ofdenomination of all financial instruments and contracts post-Exit, and

ii. the minimisation of windfall gains and losses, particularly in thebanking system.

b. An economic framework which provides aligned economic incentives for thefuture for both member state Governments and their people.

c. A new European economic and financial order which is widely perceived tobe sustainable and resilient in the long-term. It is essential particularly that

the markets do not continue to bet on further crises.

Headings 1) to 3) above are political principles which I believe would resonate with the

founding fathers of the European Economic Community in the 1957 Treaty of Rome. I willnot discuss them further in this essay I will take them to be in some sense self-evident and

capable of commanding wide support. However heading 4) is the practical matter where all

the energy of the Task Force in planning and policy will need to be concentrated. The

remainder of this essay will concentrate on this heading.

Planning is essential the Task Force must be formed (and its existence denied)

In the preceding sections I have argued the following:

1. Eurozone Exit in some form is possible.2. If such a risk exists, whatever the desire on the part of the core Eurozone members for

further integration within the Eurozone, then some contingency planning must be

made.

3. The consequences of a completely unplanned Exit are likely to be catastrophic, andeven a full understanding of how catastrophic can only be made in the context of a

secret Task Force.

Hence, this essays first concrete recommendation is that:

Recommendation 1: Germany (possibly together with France) establishes a secret Task

Force, with a Charter to design proposals for planning and managing

possible Eurozone Exit. Ideally France would join to give legitimacy

but secrecy and speed is essential, so only a token joint operation

may be possible12.

11

I.e. the current 17-member Eurozone membership as per the essay title.12 Writing in May 2012 just after the election of M. Hollande to the French Presidency, it now seems less likely

that France and Germany would find it easy to co-operate on the task force I suggest.


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The Task Forces key considerations

Exit the run-up

The first and overriding requirement of the Task Force is secrecy. I have already discussed

the overwhelming desirability of secrecy, and the likelihood of it being maintained.

The risk of secrecy breaking rises with time, hence the next requirement for the Task Force is

speed. Speed is in any case essential since many current Eurozone member States (and their

banks) require large amounts of financing or refinancing on a continuous basis. This brings

me to my next recommendation:

Recommendation 2: Whatever the results of the Task Forces deliberations, firm plans and

proposals should be in place as soon as possible using all means at

the Task Forces disposal.

It may be that the Task Forces plans (and indeed the existence of the Task Force) never see

the light of day. It may be that the plans only need to be brought to the Council of Ministers

in 2015. It may be that they are needed immediately. Whatever the outcome, unless really

rapid planning is completed immediately, then the EU (and the world) is at risk of a major

financial collapse.

First priority preventing a European, and therefore global, banking collapse

The Eurozone has created a series of unique problems for the management of an Exit. At the

forefront of these is the Eurozone banking system, and its banks balance sheets which are

currently denominated in Euros. No risk-weighting has been made (nor indeed permitted to

be made) for currency risk within Euro-denominated assets. The problem is muchcompounded by the design of the Euro, which in effect denies that assets, liabilities or

associated derivative instruments have country domicile. A founding principle of the single

currency was that the country of domicile was irrelevant, and indeed often undefined. It is

this single act of policy (the welding shut of the emergency exits) that has put the whole

banking system at such risk. Lets look at a stylised example: a Bank in a potentially strong

country, like Germany.

The balance sheet is expressed in National Currency [i.e. Euro pre-Exit, and Deutsche Mark

(Swift code: DEM) post-Exit]. For convenience lets assume that the EUR/DEM

conversion exchange rate at redenomination is 1:1; and that following Exit, the DEM rises

30% against whats left of the Euro; and that the Euro survives without Germany. We will

revisit all these assumptions later.


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Table 1

Example of German Bank Balance Sheet

National Legal Tender Currency, bn

ABC Bank, AG

Pre-Exit (EUR) Post-Exit (DEM)

Assets

Loans to German residents 50 50

Loans to non-German residents 50 35*

Liabilities

Deposits 70 70

Term debt 25 25~

Equity Capital 5 (10)

Assume that all German residents debt is converted to DEM

* Assume that the continuation of the Euro means that Euro-denominated debt owed by non-Germans

remains in Euros. These loans include non-German sovereign debt and non-German mortgages. Assume that all deposits in German branches are redenominated into DEM, irrespective of the

domicile of the depositor (which would be difficult to ascertain). I assume this is a largely domestic

bank, hence there are no depositors in non-German branches or outside the Eurozone.~

Assume that German law requires that Euro-denominated debt issued by German resident companies

and banks is fully redenominated in DEM

The upshot of this is that ABC Bank is insolvent, and the extent of its solvency or otherwise is

crucially dependent on the redenomination treatment of the various components of its balance

sheet.

To the extent that this treatment is under Germanys control, the uncertainty can be contained

or eliminated. Indeed, it is likely that all entities operating within Germany, or under German

Law, will suffer forced redenomination of all their debt, and also their assets as far as they are

under German control. And herein lies the problem. A German bank owning, say, French

Government bonds, will not be able to have them redenominated into DEM. They will

remain in Euros, or indeed themselves be redenominated into French Francs (Swift code

FRF) if further fragmentation takes place. So as a general rule, it seems likely that much or

most of the liability side of banks balance sheets will be redenominated at Exit, but that only

the domestic element of the asset side will be.

Winners and losers

If underlying Euro-denominated asset values are not changing, and the example German Bank

above becomes insolvent, then who, if anyone, gains ?

There are two classes of winner. The first is bank customers.


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At the time of writing, it is possible for a Greek13 resident person to travel to Germany, open

an account there at the German branch of a German bank, and deposit any amount of Euros he

can lay his hands on. He might even have increased his mortgage in Greece on his Greek

home if he can to give himself some extra liquidity. In doing this, the Greek resident is

buying a free option. There is little or no cost in doing this; no downside, and potentially avery large upside.

If the bank chooses not to accept his deposit (unlikely if it is legally obtained), our Greek can

simply decide to hoard German-issued Euro notes, ideally (just to avoid any possible

exchange controls and subsequent illegality in moving cash across borders) stored in a safe

deposit box in Frankfurt.

Euro banknotes identifiable by country-issuer

It is worth noting, to the surprise of many commentators, that Euro notes are not formally

issued by the ECB, but by each member State National Central Bank. Each Euro note is

accordingly marked with a prefix letter according to its issuer14 as follows:

13 I propose to use Greece as my example for a weak Eurozone country, and although at the time of writing (May

2012) Greece is the most vulnerable of the Eurozone member states, I would like it understood that when I use

Greece I am referring to any weak Eurozone country with a large external (balance of payments) deficit together

with a large fiscal deficit and outstanding public debt. Sadly, many member states satisfy these criteria.14 Euro banknotes are printed in many locations, including non-Eurozone countries (like the UK). All

commentators (including the author) regard the location of the printer as irrelevant to a notes value. The ECB

retains overall control over banknote issuance, but it authorises individual National Central Banks (NCBs) to

actually issue banknotes. The identity of the issuing NCB is marked on each banknote. Whether or not these areformally a liability of each NCB, or collectively of the whole Eurosystem of Central Banks (ESCB), is not entirely

clear, since without a Euro exit, the question is irrelevant (and the Euro was designed without exit provisions).


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Table 2

Serial Number Prefixes for Euro banknotes

Country of Issue

Country of Issue Serial Number Prefix

Estonia D

Slovakia E

Malta F

Cyprus G

Slovenia H

Finland L

Portugal M

Austria N

Netherlands P

Italy S

Ireland T

France U

Spain V

Germany X

Greece Y

Belgium Z

So a Greek (or indeed any non-German resident) could sort through his or her notes as they

acquire them, and pass all non-X prefix notes on to shops or back to the bank, and retain all X

prefix notes, perhaps in the safe deposit box in Germany. This is as close to a free financial

option as any individual will ever be faced with, since the chance of loss is nil (the cost of

holding X prefix notes is the same as holding any other prefix banknote), and even

compared to a bank account, the lost interest is negligible. The opportunity of gain (even if

the probability is small) is very substantial indeed. Similarly with moving wholesale amountsof money via the banking system.

The other winners are likely to be the banking systems of weaker currency countries.

Lets take the same size Bank as in Table 1, but analyse it as if it were domiciled in Greece.

Lets assume that the Euro survives, and that in Greece there is a new currency, the Drachma

(Swift code GRD), for which the official conversion rate in this example is 1:1 (just for

convenience). Assume the GRD falls by 60% against the Euro in the market on the first day

of trading.


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Table 3

Example of Greek Domestic Bank Balance Sheet

National Legal Tender Currency, bn

Bank, AE

Pre-Exit (EUR) Post-Exit (GRD)

Assets

Loans to Greek residents 50 50

Loans to non-Greek residents 50 125*

Liabilities

Deposits 70 70

Term debt 25 25~

Equity Capital 5 80

Assume that all Greek residents debt is converted to GRD.

* Assume that the continuation of the Euro means that Euro-denominated debt owed by non-Greeks

remains in Euros. These loans include non-Greek sovereign debt and non-Greek mortgages. Assume that all deposits in Greek branches are redenominated into GRD, irrespective of the domicile

of the depositor (which would be difficult to ascertain). I assume this is a largely domestic bank,

hence no depositors in non-Greek branches or outside the Eurozone.~

Assume that Greek law requires that Euro-denominated debt issued by Greek resident companies and

banks is fully redenominated in GRD

So we can identify at least two potential winner categories

All non-German individuals and companies in the Eurozone (and indeed any non-Eurozone resident) who has the capacity and ability to exploit the free

redenomination option.

Weaker-country resident Banks, and weaker country sovereigns via debtredenomination.

Minimising windfall gains and losses

It seems evident that one of the Task Forces principal tasks is to minimise windfall gains and

losses, since many of the losses will be in geared financial institutions, and these threaten

financial stability. There is the additional moral imperative that ordinary peoples financial

position is not impaired beyond repair or outside their control to an unreasonable extent.

Clearly, it will not be possible to protect fully every group, just as Governments cannot, for

example, fully protect classes such as savers from the effects of inflation.

Let us take the two principal classes of windfall winners identified above.


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17

Southern depositors in northern states (and debtors in southern domiciles)o There is now (May 2012) increasing evidence of capital flight from southern

Eurozone states. In late 2011 and early 2012, the ECB narrowly averted a

major banking liquidity crisis by extending unlimited funding at very low

interest rates to all Eurozone banks. I will discuss the implication of thisLong-Term Refinancing Operation (LTRO15) funding in the ECB section

below. Interestingly, there is little evidence to date of bank note hoarding16.

o It is now evident that a hitherto little-understood form of southern-countryfinancing (Target2) may also lead to windfall gains for weak countries at exit,

and windfall losses for the ECBs owners in proportion to their adjusted

capital key17.

Weaker-country resident Bankso Reducing weaker-country resident bank windfall gains is the reciprocal of

trying to minimise stronger-country resident bank losses.

o There is little that can practically be done to alter the core transfer of value,and this is because generally18 the currency denomination of the debtor or

debt issuer is under the control of the Government of the departing State. A

departing State cannot influence the denomination of an asset issued outside

its borders and not under its legal control.

In practice, therefore, the Task Force needs to make informed estimates of the likely scale of

windfall gains and losses of all systemically important Banks in the Eurozone (in practice, in

the EU).

The Task Force should then prepare each Government for the possible support needed for

each bank (strong country banks), and perhaps encourage Governments to tax the windfall

gains of the weak country banks. In the perfect world (unlikely in the fraught nature of these

events), Governments from weaker countries might agree to transfer some of these windfall

gains to stronger country Governments to help the latter support their own banking systems.

Given that stronger countries have (almost by definition) stronger Governmental balance

sheets, it is almost inconceivable in the real world that such transfers should be agreed and

take place.

15 An ECB operation which has loaned about 1 trillion (at May 2012) to over 500 European banks for a 3-year

term at an interest rate of 1% p.a. The loans are secured with collateral, mainly southern sovereign debt.16 The ECB publishes Euro note circulation statistics, which show little movement (up to February 2012) in the

value of overall note issuance. http://www.ecb.int/stats/euro/circulation/html/index.en.html17 Each member state in the Eurozone has a capital key which is the proportion of the ECBs capital to which it has

subscribed. However, because non-Eurozone EU member states have essentially not subscribed their capital key

proportions, and are not liable for ECB losses, the reality is that Eurozone member states liability is likely to be in

proportion to their capital key adjusted for non-Eurozone non-subscribers. For example, Germany (the largest

shareholder) has a capital key of 18.9373%, and an adjusted capital key of 27.0647% as at 28 December 2011. For

more information on ECB capital keys, see http://www.ecb.int/ecb/orga/capital/html/index.en.html. [27.0647% =

Germanys paid-up ECB capital (1,722,155,360.77) / Total paid-up ECB capital (6,363,107,289.36)].18

The position of Greek Sovereign Debt has recently changed, as the bonds issued in March 2012 as part of theenforced Greek bond swap (i.e. default) are drawn up under English law rather than Greek law. This significantly

complicates the application oflex monetae in a redenomination of Greek sovereign debt in a possible Greek exit.


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In practice, many large, stronger-country banks (based mainly in Germany, the Netherlands,

France and Austria) will become insolvent without Governmental assistance. It should be

made abundantly clear in the Exit announcement that the Governments and National Central

Banks of their respective countries are standing fully behind each of these Banks. This should

fall short of a full guarantee (i.e. not go the 2008 Irish route), but give depositors andinterbank markets the confidence that the entities will continue to fulfil their obligations.

Support like this was administered to many of the worlds largest banks in 2008 by (mainly)

the US, the UK and Switzerland.

Bank bond holders (as distinct from depositors) were largely bailed out in 2008. I suspect

that they may have to bear a large measure of the losses this time round along with bank

equity holders. The role of the National Central Banks (NCBs) in this crisis is not to protect

the value of these investments, but to guarantee the integrity of the banking system. Much

work on banking solvency has been undertaken since 2008, and new instruments (bail-in

bonds, contingent convertible bonds), new bonus practices (clawback, deferral and payment

in shares) and higher Tier 1 capital should somewhat ameliorate what will be very serious

damage to bank balance sheets. Once the immediate crisis is over, then clearly urgent thought

should be given to ensuring that banks that received support should be able to resume

standing unaided in the private sector as soon as is practicable.

Redenomination uncertainty

If it were done when 'tis done, then 'twere well it were done quickly. William Shakespeare,

Macbeth.

I turn now to one of the most intractable transition problems namely the question of the

redenomination or otherwise of commercial and financial contracts of all kinds which appearto be stateless, or where the legal system under which they are agreed to be judged is not a

Eurozone member.

Examples of instruments exhibiting this uncertainty are:

Forward foreign exchange contracts with the Euro as one leg, undertaken under non-Eurozone law

o Even forward foreign exchange contracts with the Euro as one leg,undertaken under Eurozone law might be problematic if the location of the

Euro leg is uncertain.

Euro-denominated interest rate and currency swaps undertaken under non-Eurozonelaw.

Euro-denominated debt issued by Eurozone corporations outside the Eurozone, andnot under Eurozone law.

Euro deposits in banks domiciled outside the Eurozone, irrespective of the residencyof the depositor (another point of contention).

Euro denominated commercial contracts (e.g. long-term supply contracts, etc.),particularly where at least one party is located outside the Eurozone, and not under

Eurozone law.


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I could go on, but it is clear that just the foregoing runs into potential transfers of value of at

least hundreds of billions of Euros. The Task Force needs to ensure that denomination

disputes do not become a catalyst to damage fatally both the relevant financial systems, but

also the ability of commercial companies to operate in a stable framework.

After much thought, I have come to the conclusion that the only way to prevent ruinouslitigation (particularly relevant in the UK and US, under whose legal systems a large

proportion of the worlds financial instruments operate), is to announce the complete

abandonment of the Euro on the first Exit. I believe that the Task Force may well come to a

similar conclusion.

This may sound like the tail wagging the dog the Task Force having to preside over the

termination of the Euro project simply to find a mechanism to unblock litigation over

denomination uncertainty. But there is another, equally cogent, reason for supporting this

route.

If there is just one Exit from the Euro, then the Euro project is over.

The concept of the single currency was predicated on the impossibility of Exit that it was

irrevocable, and immune to the vagaries of market sentiment. For the Task Force to be called

to put its proposals to the Council of Ministers is a final recognition that this premise was

flawed. There is no half-way house on this, and indeed I set out below in some detail

alternatives to complete Euro abandonment. The conclusions of that discussion will

emphasise the necessity of this radical route.

Exit without Euro abandonment

Many commentators would argue that today (May 2012) while a Eurozone Exit is apossibility (even a likelihood), if it is contained to, say, just Greece, then the Euro would be

perfectly capable of surviving.

At one level, this is true. Outstanding Greek Sovereign debt is about 266bn19, which while a

very large amount for a small country (123% of Greek GDP), is not a large amount in the

context of a Eurozone with annual GDP of 9.4trn20. Additionally, some 50bn or so of

private Greek debt is held in the German and French banking systems. Since most Eurozone

banks have already taken or recognised around a 70% write-down on Greek sovereign debt,

redenomination on its own should not punch a too-large-to-mend hole in European bank

balance sheets.

So why such a drastic recommendation (Euro abandonment) for such a small Exit ?

The recommendation is because, as I stated above, any Exit demonstrates to the market that

Exit is possible. Currently (May 2012) there remains a strong strand of belief (although

19 Source: Eurostat Greek Sovereign debt at end 2011 = 356bn (=165% GDP). Since then, in March 2012,

Greece has reduced its debt by about 100bn net by defaulting on bonds held by the private sector by the

mechanism of enforcing a debt swap on very disadvantageous terms. Hence the May 2012 position is about356bn + 10bn (half year deficit) - 100bn (default) = 266bn.20 Source: Eurostat 2011 Estimated 17-member Eurozone GDP at current prices


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concentrated particularly in Eurozone countries) that Exit is impossible21. This belief would

be shattered, and once that happened, almost all of the advantages that a single currency had

over an exchange rate mechanism would evaporate. Elsewhere in this essay, I spell out some

of the pressure points where this loss of certainty would be felt.

The history of the European Exchange Rate mechanism (ERM) within the EuropeanMonetary System (EMS) is instructive in this regard. The ERM (a 1979 successor to the

moribund European snake) survived a series of mini-crises [usually resulting in a

revaluation of the DEM, and devaluations of the FRF and the Italian Lire (Swift code ITL)]

for over a decade. However, when the Pound Sterling joined the ERM in October 1990, the

scale of Sterling in the FX markets, and its relative independence from European economic

cycles, created instability which encouraged a speculative attack, culminating in the exit of

the Pound, ITL and the Swedish Krona in September 1992. But by now the market had

recognised that it had the power to break even quite well established and sustainable links. In

the summer of 1993 there was an unprecedented speculative attack on the DEM/FRF parity,

which resulted in a crisis which effectively ended the ERM experiment. In August 1993, new

bilateral bands of 15% replaced the former bands of 2.25%. These bands were so wide that

they allowed a free-float of the currencies that remained within the system. From that point

onwards, the ERM effectively ceased to exist as a currency stabilisation mechanism.

The lesson of this period (and indeed going back further to the 1971-73 collapse of the

Bretton Woods fixed parity system), is that if markets believe, with corroborating evidence,

that they have the power to break systems of controlled exchange rates, then they have an

incentive to do so. This applied in 1971-73; it applied in 1992-93, and it would apply to the

Euro the moment the corroborating evidence (e.g. a Greek Exit) appeared.

After that, history tells us that a full Euro break-up, with all the series of crises that that would

imply, would ultimately be inevitable. If the supporters of the Euro project do pass the point

of no return which in my opinion is the first Exit and they do not give up the project, then

the economic and financial, not to mention political, losses may be many times greater (and

certainly unknowable) than would be the case with an early capitulation.

There is only one sustainable counter-argument to this line of reasoning. That would be an

enduring political union formed around whatever shape the single currency took at the time,

and which was much more than simple fiscal discipline or even fiscal integration. It would

have to be the creation of a new country, with a single democratic (or other) system of power

and governance, and with a common and widespread desire, culture and will to be onecountry. The US is a good model for this case although it only achieved country status as

we understand it after a vicious and destructive civil war nearly a hundred years after its

formation as an independent state.

Lets look in a little more detail at the market implications of a single countrys exit.

21

As I see it, the Bundesbanks Target2 claims do not constitute a risk in themselves because I believe the ideathat monetary union may fall apart is quite absurd. Dr Jens Weidmann, President of the Deutsche Bundesbank,

Open Letter, 13 March 2012.


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A single countrys exit the advent of intra-Euro currency risk

As we have already seen in 2010 and 2011, markets are constantly probing and re-evaluating

the probabilities and scale of alternative outcomes, and managing their investment and

derivative positions accordingly. To date, most of the market pricing of Euro stress has been

concentrated in the sovereign debt markets. But this represents just one of two risks withinthe Euro the risk of sovereign default. The other risk the risk of redenomination has so

far not found direct expression in the markets.

In February 2012, the Financial Times ran an article22 which explored the development of

hedging instruments to protect investors and others against the direct exchange rate risk of a

redenomination (i.e. exit) within the Euro. The article reported on a newly developing foreign

currency hedging contract, which rather than protecting investors against fluctuations of

defined currencies (say US Dollar versus Euro), would instead protect investors against the

risk of redenomination by referring not to the US Dollar and the Euro but to the legal

tender from time-to-time of the USA and the legal tender from time-to-time of (say)Germany. By explicitly linking a hedging (i.e. forward foreign exchange contract) to a

specific countrys currency, rather than naming the currency, it would be a simple matter (in

the legal and financial sense) to create an active two-way market in intra-Euro currency risk.

How is this relevant ? The answer is because if one country leaves the Euro, then it will

generate real and present fear that other countries are potentially vulnerable to exit, and that

therefore all Euros are not the same. One could call this the Geographisation of the Euro, so

that a German Euro is perceived as different from a Spanish Euro or Greek Euro. Under

these circumstances, all remaining monetary assets that are moveable to northern countries

will be (since, as I have already mentioned, the cost of doing so is close to zero), and indeed

investors and debtors (particularly banks) will want to explore the cost of hedging themselves

against the next countrys exit for those assets and liabilities which are immoveable. This is

where hedging contracts come in.

Hedging Intra-Euro currency risk

How would you price a voluntary contract which promised to deliver you, in exactly six

months time, 100 units of the legal tender of Germany from time to time in return for Xunits

of the legal tender of Greece from time to time23 ? This is a contract in which you buy

German Euros forward, and sell Greek Euros.

I suspect the following pricing model may hold sway: if the market perceives the likelydepreciation of the new Drachma, if it arrives, would be, say, 60% versus the Euro (i.e. it

would be worth only 40% of its current international value against the Euro), and that the risk

22 Investors seek hedge against euro split, by Alice Ross, FT, 20 February 201223 The mechanics of the contract are such that it would not matter whether Greece chose a new Drachma at 1:1

with the Euro, or 340.75 to the Euro (the 2001 entry rate). On an act of redenomination, the contract terms,

originally set at a 1:1 exchange rate (because today a German Euro is worth the same in the market as a Greek

Euro) would be adjusted by the official redenomination exchange rate, so that if Greece went back to the old

Drachma, then a 1:1 contract would become a 1:340.75 contract, i.e. if the contract is entered into at 1:1, the

contract buyer is delivered 100 Euros in six months, and would have to deliver 34,075 Drachma. If the Drachma

was trading in the market at, say, 900 per Euro, then the contract buyer would only have to spend 37.9(=34,075/900) to buy the Drachma they were contracted to deliver, and so would make a 62.1 profit, because he

would receive 100 under the contract terms.


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of this happening at any time in the next six months is, say, 10%, thenXwould be set by the

market at (0.9 x 100) + (0.1 x 40) = 94. So under these expectations, willing buyers and

sellers could exchange six month forward legal tender contracts between Germany and

Greece at something like 94 cents24 in the Euro for the Greek Euro. Under this pricing, the

market expects the German Euro buyer to lose money (6) 90% of the time, and to make 6010% of the time.

But if this market develops, which I argue it would after a single countrys exit25, then lenders

will no longer be prepared to lend to creditworthy Greek domestic borrowers at normal Euro

interest rates. Since they can lend (say mortgages) to German borrowers instead at, say, 3%

p.a., and then buy Greek Euros legal tender contracts at 94 cents in the Euro (or less), the

implied interest rate that they are charging for taking Greek redenomination risk is 12.4% p.a.

(= 1.06 * 1.06)26, and to this they would add the German interest rate to fully price Greek

lending. This is a Greek interest rate of 15.4% p.a., even though the Greek borrower is fully

creditworthy it is not a credit premium it is a currency risk premium. Arbitrage will

ensure that Greek LIBOR rates will have to move near to this level.

A full set of differing interest rates could arise, fundamentally destroying the concept of a

single monetary policy without giving the southern states the benefit of a more competitive

exchange rate. A side effect of such a market response, rather bizarrely, might be that it could

provide an effective mechanism to re-privatise the funding of deficit southern states i.e.

provide a mechanism to reverse the inexorable rise of Target2 funding. I will return to

Target2 funding later.

Why should the Task Force recommend the abandonment of the Euro ?

If the Euro continues in existence, then there will be billions of Euros of contracts, of debt andof other instruments operating under non-Eurozone law, which will continue, in the legal

sense, to be fulfillable and therefore required to be fulfilled.

Most of these will have been undertaken ultimately by entities within the Eurozone or its

trading or investing partners for the purposes of normal commercial, financial and investment

activity. If these contracts continue to exist, then they are most likely to become divorced

from their original purpose.

Lets take as an example, say, the departure of Italy from the Eurozone, but the continuation

of the Euro within other Eurozone states. An Italian pension fund holds currency forward

contracts to currency-hedge its US assets. These contracts would be to sell US Dollarsforward, and buy Euros forward at a fixed exchange rate. If that pension fund finds that all its

24 94 cents does not include a risk-premium for the weaker currency just the statistically expected outcome. So

maybe it would trade at 90 cents, to give the buyer a risk premium (i.e. an expected positive return).25 If the departing country is Greece, then the contracts described would apply to other countries at risk of exit, not

to Greece, which would then have its own currency. The Greek example is just designed to be illustrative of the

concept.26 If there is no redenomination, then the Greek Euro buyer is paid 6 Euros after six months, and then has 106

Euros to hedge, rather than 100. He therefore buys a further contract for the final six months of the years for 106

German Euros, which equates to 99.64 Greek Euros. If there is no redenomination in the second six months, then

he will be paid a further 106-99.64 = 6.36. So he will have 12.4 in addition to his interest rate. If, by contrast,there is a redenomination, then he will lose exactly the same amount on the legal tender contract that he would

have lost had he simply lent to a Greek borrower.


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pension obligations, and all its domestic assets, are redenominated into a new Lire under the

Lex Monetae27 principle, then its currency hedge becomes economically disconnected with the

underlying risk, and therefore potentially very damaging. However, if (notwithstanding the

recommendation in this essay) the Euro continues, then it would be impossible for the pension

fund to renege on its obligations towards these contracts without default. This scenario wouldbe played out in countless different ways, many of them within highly geared financial

institutions (banks, etc), whose inability to perform the contracts satisfactorily would again be

highly damaging.

It is not only derivative contracts that would continue to run if the Euro continued to exist it

would be all debt obligations operating under non-Eurozone law. It is very difficult to

quantify what proportion of Eurozone debt (commercial, bank and sovereign) has non-

Eurozone jurisdiction, but we already know that Greek Sovereign debt issued under non-

Greek law traded at a higher price than Greek Sovereign debt issued under Greek law28. This

implies that the market had already started pricing-in the probability of redenomination

separately from the probability of default.

I recommend that the Task Force proposes the abandonment of the Euro because the

alternative is to permit rolling contagion and crises over many years, and because

abandonment would force the legal frustration of all outstanding Euro contracts, which would

itself allow stateless Euro obligations and contracts to be treated in a common way as far as is

possible.

I envisage that immediately following the Exit announcement, frustrated Euro contracts, with

no natural domicile, could with the agreement of the parties be valued and terminated using a

European Currency Unit (ECU) calculation similar to the basis for entry into the Euro29.

Since the Euro would no longer be deliverable, it seems possible that (at the behest of the EU)

both the US and the UK (and other relevant, supportive jurisdictions) could enact legislation

that allowed their courts to value outstanding contracts using a newly defined ECU basket

representing the value of the defunct Euro, and if delivery was the only option, to deliver the

basket. I suggest that actual delivery of national currencies would mostly be inappropriate,

and that contracts would typically be valued and terminated with a payment-for-difference

one way or the other.

27Lex Monetae is the principle that a country may determine its own currency, and hence no party may default on

a contract if a government alters its national currency, using a particular conversion rate, so long as they settle in

that currency. Amounts specified in the contract will simply be redenominated to the new currency by using the

specified conversion rate.28 Nomura estimated in December 2011 that, for example, foreign-law Greek sovereign debt accounts for about

16 billion out of a total of 300 billion of total Greek sovereign debt. That value has (in March 2012) been

hugely inflated by the issue of Greek sovereign bonds under the enforced Greek debt swap which are under

English law jurisdiction.29

At the moment of creation of the Euro, 1st

January 1999, the ECU ceased to exist, converting to the Euro at 1:1.At that moment, its value was a weighted basket of fixed amounts of 12 EU currencies, 9 of which joined the Euro

on 1 January 1999. The others were UK, Denmark and Greece (which joined the Euro in January 2001).


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New ECU basket for termination or run-off valuation

The Euros constituents have expanded since its foundation in 1999. Only 10 current

Eurozone member states currencies were represented in the ECU that was abandoned at the

end of 1998.

The Task Force needs to design a fair currency basket instrument, that would command the

support of the banking and business community, and which would provide termination and

run-off value to the myriad of derivatives and other stateless Euro contracts, debt and assets

outstanding at the time of writing.

My suggestion is that the obvious weights should be the adjusted ECB capital key which

determines the effective shareholding (and loss-bearing) weights of the ECB. I set out the

current (May 2012) Adjusted Capital Key weights in Table 4 below:

Table 4

Euro area NCBs contribution to the ECBs capitalA B C = (B/ Total B)

NCBCapital key

%Paid-up capital ()

Adjusted

Capital Key %

Banque Nationale de Belgique 2.4256 220,583,718.02 3.4666%

Deutsche Bundesbank 18.9373 1,722,155,360.77 27.0647%

Eesti Pank (Estonia) 0.179 16,278,234.47 0.2558%

Central Bank of Ireland 1.1107 101,006,899.58 1.5874%

Bank of Greece 1.9649 178,687,725.72 2.8082%

Banco de Espaa 8.304 755,164,575.51 11.8679%

Banque de France 14.2212 1,293,273,899.48 20.3246%

Banca d'Italia 12.4966 1,136,439,021.48 17.8598%

Central Bank of Cyprus 0.1369 12,449,666.48 0.1957%

Banque centrale du Luxembourg 0.1747 15,887,193.09 0.2497%

Central Bank of Malta 0.0632 5,747,398.98 0.0903%

De Nederlandsche Bank 3.9882 362,686,339.12 5.6998%

Oesterreichische Nationalbank 1.9417 176,577,921.04 2.7750%

Banco de Portugal 1.7504 159,181,126.31 2.5016%

Banka Slovenije 0.3288 29,901,025.10 0.4699%Nrodn banka Slovenska 0.6934 63,057,697.10 0.9910%

Suomen Pankki Finlands Bank 1.2539 114,029,487.14 1.7920%

Total

69.9705 6,363,107,289.36 100.0000%

Source: ECB

If these weights are applied to new national currencies at official conversion (i.e.

redenomination rates), and converted into amounts of each currency as per the original ECU

methodology, then the weights at market rates would change automatically as the market re-

prices the new national currencies. This would be very likely to raise the German weight, and

lower the weights of the southern states. But with this mechanism, there would be a proxy

for the post-Euro value of the Euro.


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Mechanics of the new ECU

In Table 5 overleaf, I set out how a new ECU might be calculated, and how changes in market

values of the new national currencies would feed through to the valuation of the ECU versus a

reference currency (say the US Dollar).

I assume for the purposes of this example that new national currencies are the same both in

name and in official (redenomination) exchange rate (see Column A in Table 5) as their

predecessor currencies at Euro entry. This need not be the case, but countries that chose

differently (say Greece choosing to knock two digits off its conversion value) would not

undermine the principles set out here.

The table shows how the ECB Adjusted Capital Key (Column B) could be used to determine

the amount of each new currency in one ECU (Column C).

I have assumed that on the Exit day, the USD/EUR rate is 1.25. This allows us to calculate

international (i.e. US Dollar) values of all the new national currencies (Column D) at official

ECU rates (i.e. the redenomination rates).

The first day of trading post-Exit, each of the new national currencies will be priced by the

market versus the US Dollar. I have made some (arbitrary) assumptions about the likely

appreciation or depreciation of each new currency (Columns E & F), subject to the constraint

that on this occasion I assume the market will leave the ECU value close to $1.25 (Total

Column G). From the market valuation of the ECUs constituents following exit, we can

recalculate the new weights of national currencies in the ECU in this example, the Deutsche

Marks weight rises from 27.1% (the Adjusted Capital Key) to 36.5%.

The international value of the ECU would not necessarily stay at $1.25 it would vary

according to the independent market pricing of each new national currency versus the US

Dollar. But with this mechanism, there could be a transparent and fully independent market-

based resolution and run-off pricing mechanism for all stateless Euros.


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Table 5

Possible Construction of the new ECUA B C = A x B D = A / 1.25 E F = D

Country

(National Currency)

NationalCurrency

Entry / Exit

Rate per Euro

ECBAdjusted

Capital Key

CurrencyAmount per

ECU

USD ExchangeRate at official

exit rates

% Change ofNational

Currency

(say)

ExamExit

exchan

U

EuroUSD Rate atExit = (say) 1.25

Belgium (Franc) 40.3399 3.4666% 1.3984 32.2719 0% 32

Germany (Mark) 1.95583 27.0647% 0.5293 1.5647 35% 1

Estonia (Kroon) 15.6466 0.2558% 0.0400 12.5173 -10% 13

Ireland (Punt) 0.787564 1.5874% 0.0125 0.6301 -30% 0

Greece (Drachma) 340.75 2.8082% 9.5689 272.6000 -50% 54

Spain (Peseta) 166.386 11.8679% 19.746 133.1088 -30% 19

France (Franc) 6.55957 20.3246% 1.3332 5.2477 0% 5

Italy (Lira) 1,936.27 17.8598% 345.81 1549.0160 -20% 193

Cyprus (Pound) 0.585274 0.1957% 0.0011 0.4682 -40% 0

Luxembourg (Franc) 40.3399 0.2497% 0.1007 32.2719 0% 32

Malta (Lira) 0.4293 0.0903% 0.0004 0.3434 -25% 0

Netherlands (Guilder) 2.20371 5.6998% 0.1256 1.7630 10% 1

Austria (Schilling) 13.7603 2.7750% 0.3819 11.0082 5% 10

Portugal (Escudo) 200.482 2.5016% 5.0153 160.3856 -35% 24

Slovenia (Tolar) 239.64 0.4699% 1.1261 191.7120 -15% 22

Slovakia (Koruna) 30.126 0.9910% 0.2985 24.1008 -20% 30

Finland (Markka) 5.94573 1.7920% 0.1065 4.7566 5% 4

Total 100.0000% USD valu


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The great advantage of the route of full abandonment is that all Euro contracts would

automatically come to an end, because the disappearance of the Euro would mean legal

frustration of the contract.

While in law there is no concept of Lex Euro-Monetae i.e. allowing the Eurozone to

determine without legal frustration a change in its own currency from the Euro to the newECU, the re-creation of the ECU as a run-off currency would enormously aid the process of

stateless Euro-contract resolution.

The process would need to be conducted as quickly as feasible, especially with the support of

the Governments of the US, UK and others. Other relevant non-Eurozone Governments

likely to assist in a common resolution framework are Switzerland; Singapore; Australia;

Hong Kong; Canada; Sweden, etc.

I now turn my attention to the ECB.

The ECB a major systemic risk

The ECB is a very unusual central bank, in that it does not have a single Government sponsor.

For all major developed countries with their own currencies, the NCBs are, in effect, an arm

of Government, and are treated by the markets as if they were the Government of the relevant

country.

There is good precedent for this. To my knowledge, no developed-country NCB has in

modern times defaulted on its obligations without the sponsoring Government simultaneously

also defaulting on its obligations.

Under normal circumstances, the ECB would not pose a particular threat to the European

financial system. Its main remit is to control European inflation by exercising monetary

policy in effect setting Euro interest rates30.

However, beginning in 2008, the ECB began to provide liquidity in large amounts to banks

in the Eurozone. I put liquidity in quotation marks because liquidity operations are

normally just that unlocking the value of less liquid assets so that banks under liquidity

constraints can always provide the funds that their customers and counterparties require at all

times. This lender of last resort function is a well-established and very valuable part of the

system of management of the integrity of national banking systems. It does not imply any

kind of guarantee to any bank, nor does it prevent insolvent banks failing. It is designed to

smooth liquidity shocks and short-circuit runs on banks. The ECBs behaviour, however, hasled it towards solvency provision as well as liquidity provision.

Since the start proper of the Euro crisis in 2010, the ECB has been providing core funding to

a large number of Eurozone banks who cannot fund themselves except at ruinously high

interest rates, or indeed at all. In effect, southern banks have been shunned by investors; these

banks have turned to the ECB for funding, with the ECB in turn funding itself with deposits

from northern banks flush with cash and with no secure assets to invest in. The scale of the

problem was illustrated just recently when the ECB opened a 3-year funding window (LTRO)

30 The primary objective of the ECBs monetary policy is to maintain price stability. The ECB aims at inflation

rates of below, but close to, 2% over the medium term. Source: ECB.


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to Eurozone banks at very advantageous interest rates31, and in one day 489bn was snapped

up! A second round saw a further 530bn taken up in late February 2012.

The unusual constitution of the ECB, and this large-scale credit provision, has led it into a

very vulnerable position. It has a very small capital base currently 6.4bn. This will rise by

the end of 2012 to 10.7bn, and so this last 4.3bn can currently be seen as a 17-nationsovereign guarantee for this amount. But these amounts are tiny when compared to the

ECBs current balance sheet. Its last reported Accounts (December 2011) showed liabilities

of 224bn. At that date the ECBs capital was 6.4bn this is a 2.8% equity capital ratio,

well below the requirements of the commercial banking system, and with very concentrated

risk indeed.

But the ECBs reported balance sheet is only half (indeed much less than half) of the story.

The ECB is the heart of a larger grouping called the European System of Central Banks

(ESCB also colloquially known at the ECB as the Eurosystem). The ESCB is the

aggregate of the activities of all the 17 NCBs and the ECB, obviously netting off intra-systemtransactions and assets/liabilities (like Target2 see below).

The liabilities on the ESCB balance sheet at 4th May 2012 (which includes at the time of

writing to an unknown extent the ECB proper) stood at 2.96trn32. The liability side of the

balance sheet includes some 1.11trn of cash balances held by the private Eurozone banking

sector (in effect an ECB overdraft with the commercial banking sector sometimes called

high-powered money), as well as 880bn of banknotes in circulation. On the asset side sits

1.12trn of lending to the banking sector, much/most of it collateralised with Eurozone

sovereign debt, and a line entitled other claims on euro area credit institutions in euro, which

has risen strongly recently, and sits at 205bn. I suspect that at least some of the other assets

are non-Euro sovereign debt (the old FX Reserves of the NCBs), although the classifications

are so anodyne in the reporting (Securities of Euro area residents in Euro = 607bn; Other

Assets = 254bn) that we really do not know.

If the ECB had a large Government (like the US) standing behind it, one would not worry

about its solvency, beyond worrying about the solvency of the State itself. But with lending

(even collateralised lending) to the European banking sector on this scale, and unknown

quantities of less-than-perfect-credit sovereign debt, the ECBs capital is evidently totally

inadequate to be a stand-alone entity. We cannot know what the quality mix of the collateral

at the ECB is like, as the ECB has been handed a mandate which enforces its acceptance of

Eurozone sovereign debt as collateral. As we have seen in the past two years, much of thishas been continuously marked down by the market to such an extent that the market is pricing

in a high probability of default for several fringe Eurozone member states and has already

had to cope with default for Greece.

31 Three year Long Term Refinancing Operation (LTRO) at 1% p.a. interest rate. A first tranche was offered on 21

December 2011, 560 banks took up this facility to the tune of 489bn. The second tranche was offered at the same

interest rate on 29 February 2012, and 800 banks took up 530bn. This is, in effect, recycling northern bank

deposits to southern banks to keep them liquid.32 Source: ECB Monthly Bulletin; Monetary Policy Statistics; Table 1.1 Consolidated financial statement of the

Eurosystem; 4 May 2012.


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Why does the ECB/ESCB have such a large balance sheet ?

The ECBs balance sheet is being inflated for a uniquely Eurozone reason partially described

above. But the need for the ECB to bail out the European banking system has partially arisen

through a self-inflicted wound. What wound ?

The wound is the scale of southern (and Irish) sovereign bonds which have been bought by

the European banking system. Under normal circumstances, commercial banks would not

hold longer-dated sovereign bonds. They offer neither the yield needed to be commercially

attractive, nor the interest rate structure to match banks typical liabilities, which are generally

variable (i.e. short-term). By contrast, banks do typically hold Government treasury bills,

which are a fundamental source of liquidity, but which are typically less than one year in

duration. No Government wishing to promote non-inflationary growth would contemplate

financing their deficits solely with sales of treasury bills (or indeed treasury bonds) to the

private banking sector, except temporarily and in exceptional circumstances. The literature

on this printing money - is about as extensive as any in macroeconomics.The orthodoxy would have Governments sell their debt to long-term savers Pension Funds

and Insurance companies - where these securities impeccable credit rating and long duration

matched these institutions liabilities.

But as part of the Eurozone project, Eurozone banks were told, by their national regulators

and by the ECB, that if they chose to hold sovereign bonds, these would be nil-risk-weighted

in the calculation of their capital requirements.

Documents

Record - Minimising the Financial Cost and Maximising the Economic Opportunities of Euro Exit