The debate about a Eurozone breakup is evolving. In the spring of 2012, political tension in Greece meant that the debate focused on ‘Grexit’. In the summer of this year, the focus shifted to Spain’s funding difficulties, especially the redenomination risk on Spanish assets. Then the ECB stepped in. Its Outright Monetary Transactions programme has since reduced sovereign funding costs in the periphery. Subsequently, the Eurozone breakup debate has again shifted focus and now concentrates on the possibility of strong countries - such as Germany and Finland - leaving the Eurozone (Soros 2012, De Grauwe 2012, Tett 2012).
Is there a consensus?
There is still limited consensus on the implications of various forms of breakup and on the preferred path for the Eurozone. European policymakers remain stubbornly adamant that the Euro is irrevocable. Meanwhile, academic economists and market strategists continue to disagree about both the merits of keeping the Eurozone together and about the costs of any breakup scenario.
Figure 1 Timing, size and level of development in past currency union break-ups
Note: Size of bubbles reflects GDP as a share (%) of world GDP at the time of break-up. GDP per capita at the time of break-up is measured in 2005 dollars, and we have included a full-blown Eurozone break-up, a limited break-up involving only GIIPS countries, and a unilateral Greek exit in 2012-15 for illustrative purposes. Due to data restrictions, Austria is the only country included from the Austro-Hungarian break-up. Source: Author’s calculations, Penn World Tables, World Bank, Peterson Institute for International Economics, CIA World Factbook.
No historical precedent
Despite several years of debate, little progress towards reaching an informed consensus has been achieved. But why? And what can be done to more objectively evaluate the implications of various breakup scenarios?
If we look back through history far enough, there are plenty of examples of currency unions that have broken apart1. Despite such evidence, there really is no historical precedent for the breakup of a currency union as unique as the Eurozone. This is because:
- The Eurozone is large in economic terms. Its size differs from past currency unions that have split, typically involving much smaller countries. The Eurozone accounts for roughly 20% of global GDP; Greece, Italy, Ireland, Portugal and Spain alone accounting for 6.7%. By comparison, the Soviet Union’s ‘ruble zone’ - a recently disintegrated currency union - accounted for only 2.5% of global GDP.
- Eurozone financial markets and institutions play a disproportionately large role in the global financial system. Indeed, Eurozone banks account for 35% of global bank assets and for 34% of global cross-border lending. No currency union breakup in history comes close in relation to its importance for the global financial system.
- Eurozone countries are substantially wealthier than other countries that have experienced a breakup in the past. Figure 1 shows that, within our sample, Eurozone countries are around five times wealthier in terms of real GDP per capita than the average country. This creates vulnerability that is linked to high leverage (debt levels). But it may also create a source of resilience because loss of real income may not lead to political instability as easily as it does in lower income countries.
- The euro serves a unique role both as a reserve asset and as a currency widely used in international capital markets. The euro’s truly international features raise new problems that were not features of earlier periods of currency union disintegration.
Data shortages pose analytical obstacles
Basic macroeconomic datasets - such as net foreign asset positions and cross-border banking statistics - are really useful if we wish to analyse the implications of currency union breakups. Yet current official data sources tell us nothing about the legal jurisdiction of the assets and liabilities in question. Unhappily, this missing dimension in the data makes it difficult to quantify the effects associated with breakup.
It seems that there is now a broad consensus that the legal jurisdiction of a financial instrument is a crucial feature of any redenomination process (Proctor 2010, 2011)2. For example, Spain is able to redenominate local law government bonds into new local currency in a Eurozone exit scenario. However, bonds issued in euros by the Spanish government and by Spanish corporations under international jurisdictions are likely to remain in euros regardless of what new Spanish currency laws say.
What would happen to external assets and liabilities?
The effects from a Eurozone breakup on macro-level balance sheets will be determined by the relevant external assets and liabilities. These external assets and liabilities are defined as those cross-border positions where the legal jurisdiction of underlying financial contracts is foreign to the country in question.
We have attempted to construct a breakdown of euro-denominated assets and liabilities by legal jurisdiction based on an aggregation of contract-level data (Nordvig and Firoozye 2012) and have compiled a database that can help quantify the relevant external assets and liabilities in a breakup. As is predictable, the euro’s international dimensions are far from a minor issue; there are currently around €20 trillion of euro-denominated contracts in existence outside the jurisdiction of individual Eurozone countries3.
That said, additional work needs to be done to precisely quantify relevant exposures and their macroeconomic implications. Statistical agencies and regulators could bridge the remaining gaps in the data, thereby making more accurate cost benefit analyses possible. Politically, this may prove difficult.
No one truth about Eurozone breakup
Over the past few years, we have seen a flurry of statements about the near-infinite cost of Eurozone breakup (Eichengreen 2010, Buiter 2011, Åslund 2012). However, conditions change. Statements that were true in the past may no longer apply. The analysis of a Greek exit scenario is a case in point; foreign investors have dramatically reduced their exposure to Greece over the past few years and, in particular, Eurozone banks have only a fraction of the exposure they had in early 20094.
Figure 2 International bank claims on Greece (quarterly)
Source: Nomura, BIS
Additionally, the Eurozone’s backstop infrastructure has been dramatically expanded, providing a better chance of limiting contagion effects in the Eurozone and avoiding an uncontrolled systemic crisis. These changing circumstances are now reflected in officials’ recognition that the cost-benefit analysis of a Greek exit has changed5.
The breakup scenarios now being debated, that involve strong countries exiting, also change the analysis. Problems associated with extreme capital flight that have, in the past, been used to argue that the cost of a breakup would be prohibitively costly, would be smaller in a situation where a strong country leaves. For instance, it is conceivable that a Finnish exit could be managed without devastating disruption to financial markets. Thus, 'avoid breakup by all means' is not a universal truth.
We ought to also consider the costs of the status quo; how much would non-breakup cost? Often, the cost of breakup is analysed in isolation. The cost of the current policy path is not explicitly accounted for. Quantifying the cost of the status quo is a dynamic exercise and most would agree that the current path has been more costly than was predicted a few years ago6. It is not analytically objective to a priori exclude the possibility that the cost associated with non-breakup could exceed the cost of breakup.
Economists still have a lot of work to do. We need a robust cost-benefit analysis that includes specific Eurozone breakup scenarios versus the costs of the current path of gradual Eurozone integration. Many different Eurozone breakup scenarios have been debated but without being able to properly quantify the effects of breakup scenarios, uncertainty still reigns.
Åslund, A (2012), “Why a collapse of the Eurozone must be avoided”, Voxeu.org, 21 August 2012
Buiter, W (2011), “The Terrible Consequences of a Eurozone Collapse”, Financial Times, 8 December.
Eichengreen, B(2010), “The Euro: Love it or leave it?” VoxEU.org, 17 November 2007, reposted 4 May 2010.
De Grauwe, P and Y Ji (2012), “What Germany should fear most is its own fear”, VoxEU.org, 18 September.
Nordvig, J and N Firoozye (2012), “Rethinking the European monetary union”, finalist round of the Wolfson Economics Prize, policyexchange.org.uk, June 2012.
Proctor, C (2010), “The Euro-fragmentation and the financial markets”, Capital Markets Law Journal, October 2010.
Proctor, C (2011), “The Greek Crisis and the Euro – A Tipping Point”, Client Advisory, Edwards Angell Palmer & Dodge, June 2011.
Soros, G (2012), “Why Germany Should Lead or Leave”, Project Syndicate, 8 September.
Tett, G (2012), “A Finnish parallel currency is imaginable”, Financial Times, 25 October.
1 The specific sample we have looked at covers the period since since 1918 and includes 67 instances of currency union breakup. It is not an exhaustive sample, but it includes the most of the important historical instances.
2 Emerging market investors have long been aware of the importance of this legal dimension of their investments (hence their preference for English law bonds). But for developed markets investors, understanding the importance of the legal jurisdiction for bond holdings, loans agreements, cross-border deposits, and derivatives has been a learning process, which only started in earnest in late 2011 when redenomination risk associated with euro-denominated assets started to be taken seriously.
3 This is counting foreign law bonds, international loan agreements, and currency derivatives. We are not counting euro-denominated interest rate derivatives, where exposures are even bigger. The large size of foreign law exposures within the Eurozone implies that balance sheet effects associated with breakup have the potential to be very sizeable and much larger than we have seen in emerging market currency crises in the past.
4 The latest BIS data show consolidated BIS bank exposure to Greece of $72bn, down from a peak of just above $300bn in Q3 2009. Bank exposure is set to drop further to around $40bn in H2 2012 given that a major French bank recently completed the sale of its Greek subsidiary, which had assets around $30bn.
5 For example, German Economy Minister Philipp Rösler said back in July, “Greek exit from the Eurozone has long since lost its horror”.
6 The official unemployment rate is currently above 25% in both Greece and Spain, and set to rise further in coming quarters. Two years ago financial market tension was generally confined to the smaller peripheral countries and growth looked fairly robust in the core of the Eurozone.