The recent elections in Greece and France suggest the Euro drama is entering a new phase. Financial austerity piled on top of crushing unemployment is fomenting widespread discontent with the standing governments. The stay-the-course crowd still claims that this pain will lead to structural reforms and that leaving the Euro would be catastrophic for the exiting country. Others believe the Euro has created a gold-like currency standard that’s not sustainable for the struggling members of the currency union.
A recent paper by the Variant Perception group provides a fascinating historical perspective on currency breakups and devaluations in addition to a review of the current Eurozone situation. By their count 69 countries have exited currency areas in the last 100 years and rather than catastrophe the overwhelming result was that they were much better off just a few years after the transition.
By reviewing the historical patterns the writers came up with a typical recipe for an exit:
- Over a weekend / bank holiday declare that there is a new currency in force in the country. All accounts held in the country are converted to the new currency, typically at a 1:1 ratio. For example, if Spain used this approach all Euro holdings in the country would be converted over to new Pesetas.
- The government defaults on its debt or unilaterally redenominates all of its debt in the new currency.
- Paper currency is stamped to indicate that it is legal tender in the new currency. As soon as possible new bank notes are printed and the old notes are no longer accepted
- Currency controls are put in place to restrict the flow of capital outside the country.
These changes have immediate effects:
- The exchange rate between the new currency and the old drops to a value that significantly devalues the new currency
- Companies with large debts outside the country take huge losses that often bankrupt them unless they get support from the government
- Export oriented companies get an almost immediate boost as the local currently devalues / inflates—making their products more competitive.
- Freed from external monetary constraints, governments can boost stimulus spending, bootstrapping their economies—and further devalue their new currency.
- Foreign Banks that hold large amounts of the country’s debt take massive losses.
- Savers that haven’t managed to get their currency based assets out of the country suffer an immediate loss in buying power compared to stable currencies.
The dissolution of the USSR and the breakup of Czechoslovakia in the early 1990s were fairly recent currency transitions, but they predate the highly interconnected financial networks of today. The software impact of switching from the Euro to a local currency is probably daunting, but software is not a fundamental barrier. Since surprise is an important part of a currency transition it seems very unlikely that updated software would be ready when the change is announced. Instead, networks would probably be shutdown to prevent electronic funds transfer and functionality restored a piece at a time.
From an investment standpoint the dissolution of the Euro reminds me of the USA mortgage bubble. It seemed pretty obvious that it was unsustainable, but timing the bust was difficult. Many people were years early with their moves.
It’s a no-brainer that Eurozone companies should hedge their exposure to a Euro breakup. The Variant Perception paper suggests that companies in the weaker countries are already shifting their deposits to safe countries like Germany. Shifting debt from foreign countries to local holders might be tough, but hedging that debt against a big move like a currency exit might not be too expensive.
It’s just a matter of time before the Eurozone governments admit they have created a monster that needs to be at least partially dismantled. The quick economic recoveries that followed recent defaults and devaluations (e.g., Asia 1997, Russia 1998, Argentina 2002) show that currency exits provide a fresh start—not the catastrophes that some predict.
It’s time to cook up some new currencies.
Sunday, May 27th, 2012 | Vance Harwood