02 April 2012

Das/Roubini: A divorce settlement for the eurozone

Splitting up can be better than staying in a bad marriage, write Arnab Das and Nouriel Roubini in the FT. The eurozone should devise plans for orderly exit sooner rather than later, because delaying often makes break-up more costly.

Das/Roubini propose the following amicable divorce settlement (here abridged).

Countries leaving the eurozone must rebalance away from growth led by debt, towards export- and income-led growth. Members of a “rump” eurozone should rebalance toward domestic demand. The EU free trade arrangement is critical to this end. Ideally, five distressed peripherals – Portugal, Ireland, Italy, Greece and Spain – would exit, negotiating bridge financing.

Currency realignment would aid this adjustment. It is far better to restore competitiveness through devaluation than by changing relative prices with a fixed nominal exchange rate, which implies protracted debt deflation, potentially ending in disorderly defaults and exits in any case, or sustained inflation above target in surplus countries.

This strategy would ensure exiting countries’ viability and the euro’s credibility. It would maintain the EU customs union to the benefit of all Member States; and set a monetary framework for the rump ECB and exiting national central banks.

A transitional monetary framework would effectively reverse the exchange rate mechanism that led to the euro: FX targeting by exiting national central banks, with ECB support to avert currency collapse, capital flight and a resultant surge in inflation. 

After the transition, independent national central banks and the ECB would implement congruent inflation targets, averting protectionism in the wider EU by restraining competitive devaluation. Exiting countries would be small, open economies relative to the rump eurozone, where FX movements would quickly pass into inflation, inducing them to avoid maxi-devaluations that could provoke wage price spirals.

Unlike other currency regime changes, FX corridors would not be threatened by the inadequate FX reserves of exiting countries. The ECB would buy the new currencies at the floor of the trading band, to mitigate losses from currency collapses and disorderly defaults. 

A clear, consistent legal framework for exit is crucial. We would redenominate all contracts made under domestic laws into the new currencies at the time of exit. We would retain euro denomination for contracts made under foreign law, subject to the territorial connection of the contract or obligor, in line with consensus legal opinion.

Exiting countries should accelerate the “domestication” of external debts before the transition to minimise balance sheet mismatches. Imbalances in the payments system would be redenominated by negotiation and netted between the ECB and national central banks. 

Banks and financial markets pose the gravest immediate threats to the exit strategy. Pursuing domestication prior to exit would reduce credit losses and currency risk. The ECB’s currency support would allow time for hedging and repayment of euro-denominated obligations.

Full article (FT subscription required)

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