12 January 2012

Jens Nordvig: Planning for the worst is the best way to save the eurozone

In this FT article, Nordvig writes that even though there was no plan for a eurozone break-up when the EMU was created, ironically, spelling out guidelines for a eurozone break-up may – at this stage in the crisis – even help to reduce the risk of the break-up itself.

Those who pretend a eurozone break-up is not a possibility are ignoring reality. Various forms of eurozone disintegration are possible, ranging from a very limited break-up (involving one or a few small countries), to a full-blown break-up (which would see the euro cease to exist). Most would agree that a Greek exit is a very real possibility. But break-up risk is not only a Greece-specific issue. The fact that Italian five-year credit default swap contracts imply a roughly 30 per cent probability of an Italian default, highlights the possibility of a full-blown break-up scenario.

At this point, Europe needs to spell out a contingency plan for a eurozone break-up. Since fears about a break-up are already present and affecting investors’ flows, the cost-benefit analysis of announcing such contingency plans is very different to what it would have been in 1999. At this juncture, contingency plans would help to reduce uncertainty, rather than add to it.

The plan must offer guidance on orderly redenomination of euro-denominated assets and obligations in a break-up scenario. Such guidance is crucial in connection with a full-blown break-up scenario, in which the euro would no longer exist as a currency. This scenario involves a host of very complex redenomination issues. In particular, a very large number of assets and obligations are subject to English law (not the laws of the eurozone countries), and it is highly uncertain how the redenomination process would work for such instruments.

The logical and fair way to redenominate would be to introduce a new European Currency Unit (ECU-2). This would be a basket currency linked to the new national currencies created after a break-up – akin to the original ECU basket. Current European Central Bank capital weights could be used to define the currency weights in the basket.

The value of the new ECU would be mechanically linked to the performance of the new currencies of previous eurozone countries, and the redenomination process would mirror how ECU-denominated instruments were redenominated into euro in 1999. Introducing a new ECU would help to facilitate an orderly redenomination of a host of instruments such as debt issued in euros under English law, euro-denominated loans extended by global banks, and euro-denominated swaps and foreign exchange forward contracts. It would hardly make the break-up an easy process, but it would help the redenomination process by making it less inefficient and arbitrary.

Full article (FT subscription required)

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