Economics

Six steps to leaving the Euro

Europe is into the final countdown. With everyday it looks more certain that the Eurozone will break up and the world will enter some very rough and unchartered waters.

Britain’s George Osbourne admitted yesterday (26 November 2011) that the UK had started contingency planning several months ago for the a euro break up. Let’s hope other countries and their banks also have good plans. Unlike the accidental on-the-go policy-making we have seen so far, this is not a break up to go into blindly.

While there have been many throwaway comments that ‘Greece will have to leave the euro’, I haven’t seen a lot on how a break up might transpire so I thought it would be worth starting a discussion on it. To start with however here are some good articles that do tackle the question of what a country leaving the eurozone will mean.

Polly Curtis’s discussion in The Guardian
Tom Judd in the European Voice who thinks the new currency would be pegged to the Euro to begin with
Julian Phillips in Financial Sense looks at the fallout in detail

Europe after Euro break up

Let’s set out what the post break up picture might look like, then think about the ways the break up could happen.

In a few years from now its seems most likely to me that we will have the following situation.

1. A reduced Eurozone consisting of Germany, the Benelux countries, Austria, and provided the current cancer is contained, France. These countries are either sufficiently strong or have such political will behind the euro project that they cannot leave.
2. Smaller countries as yet not seriously affected by the crisis such as Finland, Estonia, Slovenia, Slovakia and Cypress may also be holding in, but alternatively may have taken the window of opportunity to withdraw voluntarily
3. Ireland may have just held in but could also have found the opportunity to devalue its currency and set its own interest rates too tempting
4. Greece, Italy, Spain and Portugal will each be running their own currencies

Six steps to euro break up

1. Overnight announcement with immediate effect

People in Greece or Italy will wake up one morning to hear that the country has left the Euro. The balances in bank accounts registered within those countries are now denominated in Drachma or Lira. On day 1 the new currency has a 1 to 1 conversion to the Euro.

2. Cross border transaction restrictions

Electronic transfers from accounts in the country that has exited to other countries will be immediately restricted. Not only is this to avoid very rapid currency devaluation, but is also a practical consideration. Banks need time to code up the new currency; transactions that previously involved no currency exchange will now need it. In the first few days after the exit, there may be next to no payments out of the country until the banks can get their IT changed. One by one banks will announce they can make those transactions and payments will start to flow. If I were running a bank now I would be making preparations for the rapid introduction of a new currency.

Businesses owed money from across the new currency border will see their cash flows choked while the banking system responds.

3. Cash withdrawl restrictions

While changing the nominal currency of a bank account can be done electronically, changing a bank note is a physical change and takes time. To prevent a run on banks and to stop the country’s money supply being lost, cash withdrawl restrictions of a hundred or so ‘euros’ per bank account per day could be imposed until the cash supply is physically converted to the new currency.

4. Bank note stamping

How do you quickly convert a country’s bank notes?

As a precedent we might look to the break up of Czechoslovakia in January 1993. In March 1993 I was travelling through the two countries and found that while the same bank notes were in circulation, the two versions of the former Czechoslovakian crown had different adhesive stamps on them. There was a slight difference in value, and the coins remained unaltered and interchangeable.

I expect a similar process would take place. In the first few weeks, a cash withdrawl would give you plain euros, and not lira or drachma. We would expect to see queues of people taking out their maximum allowance in euro notes each day until the machines started delivering notes with stamps on them.

How big a task is it? I’ve seen several estimates for the value of cash in circulation, and it seems that only 1/40th of a modern currency’s money supply is in cash. Of that, a large proportion is held by banks. Bank notes held by ordinary Greeks or Italians outside of banks would be lost by the country’s money supply and would stay as Euros. Bank notes held by banks could be converted.

How long would it take? I visited Slovakia in March 1993, three months after a currency separation that was planned. By then all the notes had been converted. I would expect an unplanned bank note stamping process would last around two months.

5. Cross border loans defaults or renegotiations

Cross border loans and contracts represent the biggest challenge in the break up. Although every contract annd loan will need to be dealt with separately, in general its likely to be tough for businesses in the country that is leaving the euro.

If a Greek company owes a German bank a million euros, it will still owe a million euros after Greece’s exit. And because the new drachma will inevitably devalue, the Greek company will have to pay more drachma than euro to repay the loan, unless it is renegotiated. We are likely to see many loan defaults as a result.

Looking at it the other way around, if a German company owes a Greek bank a million euros, it is likely that the bank will still want a million euros back. That would be worth more in drachma afterall.

6. Print new notes, mint new coins

Banknotes with stamps are only a temporary solution and coins still need to be changed. Bank note printing company De La Rue is reportedly gearing up to benefit from the emergence of new currencies. However, it is likely to take several years to fully change the country’s physical cash supply.

One country will leave first, then after observing the fallout, others will follow. There will be no formal timetable however as the initial announcement needs to be a surprise else it will be precipitated by runs on banks.

Six steps is rather simplistic, but I’d welcome other people’s comments on how break up could happen.

Tagged Europe, Eurozone