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Πέμπτη, 6 Οκτωβρίου 2011

Leaving the euro: What’s in the box? Mario I. Blejer Eduardo Levy Yeyati 21 July 2010

Rumours of Eurozone break-up are mounting. This column argues that exiting a strong currency for a weak one poses almost unthinkable challenges, from the redenomination of contracts and the imposition of bank restrictions to the restructuring of external debt and limiting of capital mobility. Lessons from Argentina illustrate just how radical the changes would need to be.

The turmoil in Europe is not abating. True, some calm has returned to the markets after the initial storm, but tenacious misgivings about the euro project in general are growing, driven by disenchantment with the policy responses and a realisation of the magnitude of the problem.

Something that was unthinkable six months ago is happening today. There are, still few indeed, but undeniable mounting calls for euro exit – and not only from euro sceptics across the Atlantic (see Feldstein 2010, Financial Times 2010, and Baldwin 2010 for a summary of the debate on Vox.)

While faint exit pleads could be heard in Germany, as a way to avoid bearing the cost of the bailout, the louder calls are coming from the economies under pressure and looking to regain competitiveness, with Greece in front of a potentially larger number of countries willing or forced to give up the single-currency project.

Switching from a strong to a weak currency

But the process of launching a new, weaker, national currency to substitute a stronger one as legal tender is, to be sure, a very complex one. What do we know about this process? Eichengreen (2007) provides an analysis of this event but when it comes to hard facts the answer is simple. We know virtually nothing.

Indeed, it is unclear whether those toying with this type of solution have analysed the preconditions and consequences of such a move since there is not much precedent for an episode of this kind in recent economic history.

Abandoning a battered currency in favour of a stronger one (“dollarisation” in the jargon) has been more frequent, and is probably easier in comparison (see for example Levy Yeyati and Sturzenegger 2002). Creating or reintroducing a national currency with the deliberate intention to weaken it relative to the existing one (and to all other world currencies, for that matter) is an altogether different and much more complicated endeavour, particularly if this has to be done in times of distress and mistrust of domestic policies.

Argentina 2002

The closest, although certainly not identical, precedent to this course of action is Argentine’s exit from a currency board arrangement to float a weakening peso in 2002, an event that has important common aspects with the case in point. While still far, in many respects, from a “new drachma” or a “new peseta”, the episode nonetheless offers some interesting pointers as to what the whole affair involves.

At the risk of generalising and omitting, the Argentine lessons can be summarised under four categories. If a country is willing to seriously entertain the idea of introducing a new, weaker, currency (which for simplicity we could call the peso), it needs to be willing to deal with:

the “peso-ification” of contracts,
the imposition of heavy restrictions to commercial bank operations,
an external debt restructuring, and
the use of capital and exchange controls – at least temporarily.

Crucially, all of these four types of tribulations, which come on top of the potential inflationary consequences that follow any normal devaluation, need to be tackled jointly and up front, as they are likely to be anticipated by agents and markets.

Exit costs can only grow larger if the decision process is protracted and marred by improvisation and half-baked patches.
Below we briefly discuss why these four issues are an almost inescapable consequence of leaving the strong currency:
Peso-ification or redenomination of contracts

The new currency needs to create its own transactional demand and requires a legal framework that makes it the sole legal tender and unit of account. This requires the forced redenomination of all contracts in the economy. Regarding prices and wages – as well as other flows of funds – the redenomination may not create very serious disruptions.

The redenomination of accumulated stocks, however, particularly those arising from domestic financial contracts, becomes an extremely thorny issue.
On the one hand, if the new currency succeeds in achieving a real devaluation (i.e., this if the pass-through of the nominal devaluation to inflation is reasonably low), the forced peso-ification of financial contracts results in heavy and asymmetrical balance sheet effects.

In particular, the losses experienced by domestic euro debtors would more than offset the gains from a more competitive economy and make the whole euro exit strategy self defeating (see Frankel 2005).

On the other hand, the peso-ification of bank deposits and credits could have a massive redistributive impact (benefiting net bank debtors and hurting net deposit holders) and could bring up violent social and political reactions.

It would also immediately trigger a bank run, as depositors run to protect their savings by switching them back into hard currency. Indeed a bank run may be unavoidable and precede the exit, as the Argentine case illustrates.

The Argentinean bank run started in early 2001, nine months before the abandonment of the currency board arrangement. This is because the mere expectation of an exit is enough to fuel a deposit run, as well as a credit crunch, in anticipation of the inevitable peso-ification (see Levy Yeyati et al. 2010).

A deposit freeze

To counter the deposit run and to avoid massive bank failures until the economy is out of the woods, a temporary deposit freeze would be needed. Crucially, to minimise the damage, the freeze needs to be selective, excluding sight and savings deposits needed for everyday transactions.

Argentina, again, is a good example – albeit negative. The gate dropping on all deposit withdrawals in November 2001 (the so-called “corralito”) was a misguided choice that caused a liquidity crunch that only contributed to the downward spiral in economic activity and market sentiment.

This misguided policy was the immediate cause of the government collapse. By contrast, the deposit restructuring in January 2002, that peso-ified and froze only term deposits, slowed down the run thereby preserving the payments system.

Needless to say, these options were (as they always are) desperate measures to cope with a terminal crisis, and suffered from many shortcomings that are inevitable when policy is made in a crisis. But even the most careful preparations may not prevent the financial panic surrounding an anticipated conversion.
An external debt restructuring

This is the flipside of the peso-ification of domestic financial contracts. External debt under international law cannot be redenominated by the government but, following the peso-ification of state revenues and expenditures, it becomes very difficult to service on its original terms. Therefore international debt relief could come through a negotiated debt exchange.

Importantly, however, such a restructuring is not restricted to the sovereign. Corporate euro debtors would suffer the same balance-sheet shock and, with the government unable to fund a bailout, would be forced to renegotiate their liabilities.

In Argentina that was a painful and protracted but essentially successful process. Firms restructured their debts under the umbrella provided by the combination of sovereign default and capital controls that inhibited debt servicing abroad. In this way, bankruptcies were avoided but the access to international markets by the corporate sector remained impaired for many years. Besides this distinction, however, the main lesson from the Argentine experience is that it is unrealistic to conceive a euro exit without a debt default.

Capital and exchange-rate controls

Euros (and other reserve currencies) will be precious in the event of a euro exit. Financial uncertainty fuels capital flight just at the time when the country needs to fund a narrowing but still sizeable current-account deficit. This scarcity of euros will probably be exacerbated by a loss of access to international capital markets.

As a result, traditional restrictive measures such as the obligation to surrender export proceeds to the central bank, often coupled with capital outflow and exchange-rate controls, are necessary. All of these measures were launched in Argentina in early 2002 and contributed to stabilise the transition.

In fact, it may not be possible to enforce the redenomination of contracts nor the deposit freeze without capital controls; without them all settlements would immediately move abroad. Again, the lesson here is that conceiving a euro exit while maintaining full convertibility is probably wishful thinking.

The euro difference: Harder than a currency board arrangement

Argentina’s abandonment of its hard peg has some similarities but also marked differences with the current situation regarding euro exit. Leaving the currency board arrangement was actually simpler than the introduction of a new currency in that the currency board arrangement never eliminated the use of the local currency for transaction purposes, the basis of the demand for money.

In Argentina, the devaluation caught people with pesos in their wallets, and the need for liquidity supported a steady demand for pesos all through the first quarter of 2002 when it depreciated by 300% (see De la Torre et al. 2003). By contrast, a “new drachma” or a “new peseta” would need to create from scratch a demand for a currency born weaker by design. Could it work?

Everything is possible but, as noted, there are no real precedents and, just judging from the costs involved in redistributing wealth through the redenomination of contracts, imposing bank restrictions, restructuring external debt, and limiting capital mobility, it is certainly not the easiest way out.

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