Exit from the Euro Area: Uncertainties and Risks

I write a weekly column on the Forbes French website. I will now translate them into English. You can find the original column here in French.
You will find below my yesterday’s column on risks associated with an exit from the Euro Area

The presidential and general election dates are fast approaching in France and the issues at stake are becoming clearer. One question that keeps coming back to the fore is France’s exit from the Eurozone. Commentators focus most particularly on what would happen in the immediate aftermath, once the country formally exits the currency union, and they are quite right to do so, as a number of very relevant questions need to be raised.

The first question is how France would exit the European Monetary Union in practical terms and what the legal procedure would be. In the case of the UK’s withdrawal from the EU, a much more simple exit as there is no currency involved, we are already getting caught up in speculation.

Then comes the issue of the monetary regime that would be used. Would the next currency be floating or would it be pegged to the euro? Can the Eurozone continue to operate effectively if France is no longer a part of it? What would happen in Europe if the Eurozone can no longer function…would the European Union still be viable in this case?

Independently of this question on the Eurozone, there is also the matter of the status of public debt. Ratings agencies have indicated that if the currently euro-denominated public debt were redenominated in another currency, then there would be a breach of contract and hence public debt default. This is a matter of huge importance: if the new currency were to depreciate, then France would have to reimburse its debt with a depreciated currency. It is worth remembering that during the Asian crisis at the end of the 1990s, reimbursing dollar-denominated debt had a devastating effect on Asian counties as their currencies were depreciating against the greenback. This could potentially be a fairly similar scenario.

A further question is the functioning of the French central bank, the Banque de France, and its relationship with the ECB. There is also the matter of monetary financing of the public deficit by the Banque de France. This very facility was at the root of German hyperinflation.

All these questions are fundamental and require very clear and precise answers. For the moment, we have no clear framework and hence no way of reducing the uncertainty on France’s potential monetary system if it were to leave the Eurozone.

And this area of uncertainty is particularly problematic. One of the major roles for a currency is that it bridges the present to the future…. if the future is deemed to be highly uncertain, then economic players will act accordingly.

In this respect, it is interesting to look at what happened during the last two major monetary crises. The first was in Argentina, which defaulted on its debt in 2001, the second was in Greece, with the crisis lasting up until the agreement in July 2015.
In our first example, the Argentinian peso was operating in a framework that was no longer functional. Parity with the dollar was no longer sustainable and a new monetary framework was required. In the Greek example, the fundamental question was a withdrawal from the Eurozone.
In both cases, behavior witnessed during periods of uncertainty was the same.
The first reaction was massive capital outflows. The Argentinian population opened bank accounts in Miami and transferred their funds there. Meanwhile, Greek citizens opened euro bank accounts in other countries in the Eurozone in order to transfer their holdings.

The rationale behind this behavior is simple: the person holding the funds does not know what will happen in the new monetary context and is concerned that the currency would be devalued, savings would then lose a large proportion of their value and so the individual seeks to safeguard savings in a solid currency.

This type of behavior is damaging for the economy’s internal momentum as citizens focus on savings and restrict spending and investment, triggering a significant economic downturn: this is what we witnessed in Argentina and Greece. So not only is there monetary uncertainty in this situation, there is also economic uncertainty.

This type of banking panic is bad news for the banking system. It disrupts banks’ overall situation, as they are forced to pull out of a whole series of investments to stay afloat. These banks will also need to find short-term liquidity on the markets, but would other banks in the rest of the Eurozone want to lend to French banks, even on a short-term basis?
It is worth noting that we have already witnessed this type of situation… in 2008/2009 and the aftermath. Eurozone banks lost confidence and no longer wanted to lend, and only massive intervention from the ECB defused the situation, as the central bank took on the role of the money markets. In the UK, the Bank of England broke with its usual policy and nationalized Northern Rock as the bank was no longer able to obtain inter-bank funding.

French banks are still under ECB supervision, and we note that at the time this is all taking place, there has been no institutional change, the Banque de France is still part of the European System of Central Banks. So the ECB would have to take drastic restrictive measures to put French banks on life support (remember Greece), in order to avoid contagion to the rest of the Eurozone.
Capital flight would thus endanger the entire economic situation and the entire banking system in France.

The second source of instability, and which was also witnessed before any institutional change in our two examples above, is investor withdrawal from local public debt.
In 2001, with currency adjustment looking inevitable, non-Argentine investors withdrew from  Argentinian debt. In our Greek example, the situation was slightly more complex as Greece is part of the Eurozone. Private investors sold up and public investors had to carry Greek debt.
In both cases, interest rates soared. 60% of French public debt is held by non-residents: can we expect them to display goodwill? Certainly not! These investments in French debt are their investors’ savings. In the face of such uncertainty, they are more likely to want to invest in other vehicles outside France and this could mean real funding difficulties for the French government. It would also be disastrous for corporates due to much higher interest rates, as well as the fact that these companies have traditionally issued debt to foreign investors. Would these international issuers remain confident in their French investments?
Default, as raised by ratings agencies, would have some very lasting effects. Argentina did not issue debt on the international markets for 15 years after its currency crisis. For a country like France, which is highly depending on non-resident investors, this situation would be critical. There would be a radical internal adjustment, as was the case for Argentina and Greece.

However, the real problem lies in the fact that these events may unfold not as a result of the election results, but rather on the basis of the various economic players’ expectations of the election results. So opinion polls will have an even more important role to play as they may dictate the strength, or increase the fragility, of the banking sector. Looking beyond the banking sector, the danger is that this situation could dent French economic momentum for a very long time.

It would be so much more effective just to avoid taking this risk and avoid fuelling this uncertainty.


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