If one or more Southern European countries were to leave the eurozone, it would most definitely result in a substantial devaluation of the re-introduced local currency and it would almost certainly lead to a (non-quantifiable) default on its sovereign debt all of which suggest that the country in question may not be able to access international capital markets for some considerable time to come.
Again, history does not support this thesis. Even the worst abusers of creditor trust have been able to return to international capital markets relatively quickly following a default. In the capital markets it is not so much about what happened in the past but more so what is likely to happen going forward. If creditors judge that Spain, Greece, Italy or Portugal would be in a stronger position to service their debts following the reincarnation of the old currency 50% below the old parity level, loans will be made.
Only in the last couple of days has Cristobal Montoro, the budget minister of the Spanish government, admitted that Spain no longer has access to international capital markets (see here). This is happening to a country with one of the lowest debt-to-GDP ratios in the eurozone and at a time where Spain is doing pretty much everything the austerity hawks have been asking for. It is all about perception.
And the perception is that Spanish banks need fresh capital more than ever. If you ask the Spanish government how much is required to recapitalise the Spanish banking industry, they will throw a number of around ā¬40 billion at you. If you ask the same question to the research team at RBS who recently did an in-depth analysis of the Spanish banks, the number required is more like ā¬350-400 billion!
Since I apparently have a history of confusing my readers (!), let me make it crystal clear that I donāt think a Spanish euro exit is on the cards at the moment. The Spanish really want the euro to work; however, as with most other things in life, the Spanish will continue to conduct a simple cost/benefit analysis and, at the speed events unfold at the moment, the benefits associated with an exit could soon outweigh the costs.
The recipe for exit In order to implement a successful exit from a currency union, some strict rules must be followed. Some governments are undoubtedly already preparing contingency plans, so this is the kind of action plan you should be prepared for (greatly inspired by Jonathan Tepper at Variant Perception). Please note that the list below is not a complete list of required steps. I have only focused on the main action points. Many smaller and more administrative items have been intentionally left out.
1. The announcement will almost certainly come over a weekend with banks staying closed for at least a few days into the following week, allowing the government and the banks time to prepare for the new currency.
2. Capital controls will be implemented instantly although they will be temporary in nature. Note that the more capital that has left the country prior to the exit announcement, the faster the capital controls will be lifted again.
3. The new currency should begin to trade as soon as the banks re-open for business so that the desired devaluation can take effect immediately.
4. All interest payments on public debt will probably be suspended with immediate effect; however, the government would be wise not to make any declarations as to what haircut to expect on sovereign debt. Let the dust settle first but expect the IMF to be paid back in full. It is important to stay on good terms with your influential friends!
5. Expect a nationalisation of all systemically important banks that require financial aid. Expect shareholders to be wiped out; bond holders should expect a significant haircut. The banks need sorting out once and for all. Remember, they are the root problem.
6. Expect drastic labour market reforms to be introduced sooner rather than later. There is a window of public sympathy that the government must take advantage of, but the window will close again relatively quickly. The devaluation will improve the competitive advantage almost instantaneously, but the labour market reforms will secure that the advantages gained shall not be lost again over time.
7. One last āwild cardā (and this is Willem Buiterās idea ā not mine): The government should consider an elimination of all physical money and move to electronic money only. This carries two significant benefits. With such a move, the interest rate floor has effectively been removed and rates can be set at whatever (negative) level shall be required to stimulate investments and consumption. Imagine overnight rates at -3% with no coins and notes available to hide under your mattress. What do you think that will do to investments and consumption? The problem is that it might only work in conjunction with strict capital controls or if we all move to a moneyless society at the same time. Even more importantly, in the tax shy Southern Europe, tax revenues will improve markedly as a result of the reduction of the black market economy. We have all the technology available today to make such a move. Any takers?
The mother of all bull markets If structured correctly, a eurozone exit is not the Armageddon it is so often portrayed to be. When the perma bears realise that, and as they begin to see the benefits bestowed upon the first mover, the mother of all equity bull markets will be unleashed in Europe. As I have frequently pointed out in recent months (see for example here), European equities are extraordinarily attractively priced at levels not experienced since the dark days of the early 1980s. We are just waiting for the catalyst, but remember one thing ā banks will not be the place to be.
Niels C. Jensen
6 June 2012
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1. Source: http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/9309669/The-week-that-Europe-stopped-pretending.html
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