Monday, May 21, 2012

Life after the euro

Costs of a potential reduction in the size of the Eurozone are expected to be enormous to nations who choose to exit. To demonstrate the point, Capital Economics ran a scenario of devaluing domestic government bonds by 50% and depreciating the new currency by 40%. Switching out of euro will immediately make the government insolvent because it can not manage local currency receipts and euro liabilities. That's the reason for the 50% drop in government bonds in this scenario. The chart below shows the impact on each of the the nations' banking system as a percentage of the GDP.

Source: Capital Economics

This tells us that the only way such an exit is even possible is by restructuring the euro liabilities by re-denominating them into the domestic currency. Such restructuring would be akin to default, but at that point trying to make claims against these nations in foreign courst may be futile. Once bank liabilities are re-denominated into the domestic currency, the national central bank would need to go through the same exercise, converting its liabilities (TARGET2, deposits, etc.) into the new currency - otherwise the national central bank would also immediately become insolvent. This change in liability denomination of the national central bank will cause great pain for the remaining Eurosystem institutions. The question is what would happen to the exiting nation?

Capital Economics' view is that such an exit will benefit the nations who leave the common currency. As an example they use Iceland and Argentina. Clearly Argentina is now facing some severe problems, in part due to its government's idiotic policies. But at the time of the devaluation (after decoupling from the US dollar), Argentina's economy improved considerably. 
Capital Economics: - A lower exchange rate would also prompt domestic residents to substitute away from foreign goods to cheaper domestically produced products. After the plunge in the krona in 2008, Icelandic import volumes fell by 45%, far sharper than the fall in domestic demand. In Argentina imports fell almost as sharply after the substantial devaluation in 2002. What’s more, a sharp devaluation may boost business sentiment and asset prices.

...once the dust settles and growth prospects in Europe begin to improve, markets are likely to rebound, particularly in those economies that exit the euro-zone. The euro could strengthen too.


This analysis obviously assumes stable global growth that helped Argentina recover quickly - which would not necessarily be the case going forward. But it does demonstrate that there maybe "life after the euro".

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