The risk of one or more countries leaving the euro – or indeed the euro breaking up into national currencies or new smaller currency blocks – is no longer something to casually dismiss. The volume of PIMCO client questions on this topic attests to this. The possibility is also no longer politically unthinkable. French President Nicolas Sarkozy and German Chancellor Angela Merkel contemplated the previously unimaginable last November when they said, “The question is whether Greece remains in the eurozone.”
So even if the euro survives this crisis intact, scenario planning is indispensable for investors. Indeed, even if no country actually leaves the euro, investors need to think about the implications, because the market will price in this uncertainty as the euro debt crisis evolves. As 19th century British Prime Minister Benjamin Disraeli famously said, “I am prepared for the worst but hope for the best.”
How might a country exit the single currency?In brief, it all depends on political, not legal, decisions. The Lisbon Treaty governing the European Union makes no provision for leaving the single currency but does allow for a country to negotiate its exit from the EU. (A reminder/primer: The EU is the single market of 27 European countries allowing free movements of goods and services and jobs. The eurozone consists of 17 EU countries that have agreed to share the single currency and have a common central bank, the European Central Bank, or ECB.) In short, this means that a country could leave the eurozone unilaterally by simply breaking EU treaties, or it could leave with the agreement and potential support of other EU partners. The first course of action is likely to have more severe economic spillovers, while the second is likely to involve protracted political negotiations.
The most likely spark for a euro-exit will be local social and political unrest driven by prolonged recession. Although a country cannot legally be forced out of the eurozone, EU policymakers could also adopt policies that made it very difficult for a country to stay.
There are many different breakup scenarios. At one extreme Greece, possibly joined in time by Ireland and Portugal (the other EU/IMF program countries), could leave the euro and revert to their own national currencies. At the other extreme, the euro may cease to exist and all 17 euro countries could revert to their own national currencies. In between is the possibility of a severely trimmed down eurozone, for example a “Northern Bloc” consisting of countries with very similar economic characteristics and without Spain and Italy. Not to be dismissed is the possibility that the northern European countries leave the euro themselves. As a general rule, the larger the size of the departing economies, the greater the market and economic dislocation we should expect.
The Lisbon Treaty suggests that a country leaving the eurozone should also leave the EU, but this is not obviously the case. If a country left the EU, the economic costs would be great because it stands to lose associated trade privileges, capital and labour mobility and, in many cases, EU transfers. However, euro-exit is likely to be a political, not legal, decision. As such, it is possible that a euro exit could be negotiated while retaining EU membership.
All these political changes may take some time to occur. But the signposts that will help us reassess the probability of a euro exit by any country are: greater domestic political advocates for such an outcome, continued economic stagnation with high and rising unemployment, continued social unrest, continued capital flight and growing unwillingness of other eurozone governments to provide financial support for the policy status quo.
What happens next to my bonds?The departing state is likely to issue a new law redenominating all domestic contracts into local currency at a fixed exchange rate. Investors therefore need to be aware of their bonds’ governing law. Bonds issued under domestic law would probably be redenominated into local currency and investors would now face additional currency risk.
Capital controls and severe financial repression are additional risks investors should expect to face. Given their weaker balance sheets, we’d expect capital to quickly flow out of the peripheral economies in anticipation of a large currency devaluation. Inevitably, governments will try to avert bank failures by imposing deposit and capital controls. The only way to address this would be by holding higher-than-usual liquidity cushions outside of the country at risk of leaving the eurozone.
But having a bond issued under English or New York governing law does not unambiguously address these risks. If the bond documentation gives jurisdiction to local rather than foreign courts, the bond could be redenominated. Foreign courts may also judge whether there is a “presumption” that the payment would be made in euros or in the currency of the departing state. If the euro is not clearly stated as the “currency of payment,” courts could use the “place of payment” to determine whether the bond should be redenominated into the currency of the departing state.
Finally, if a euro-exit is politically negotiated it may be accompanied by an EU directive that compels all EU courts to give primacy to local redenomination law.
Investors’ positions become even more unfavourable if the calamitous event comes to be and the euro ceases to exist. At this point the euro would cease to be legal tender in Europe, and investors probably would have little option but to redenominate into the local currency at the rate of the government’s choosing.
The only way to help mitigate these risks is to hold fewer assets in the country at risk of euro exit. In cases where this does not make sense – for example, because valuations are attractive while the perceived risk of euro exit is very low – investors should think about diversifying the location of their liquid assets as well as holding higher-than-usual liquidity buffers.
Implicit foreign currency risk across the euro-government marketIf one country leaves the eurozone it sets a precedent that other eurozone countries, faced with this or some future crisis, could follow. The eurozone formally morphs from a single currency into a fixed exchange rate regime where exchange rates are no longer “irrevocably fixed.” This sentiment effect means that as the risk of one country leaving the euro increases, it increases the implicit foreign currency risk of not only its own debt, but also the debt of others sharing the euro. This rising risk would likely be reflected in higher bond yields on euro-denominated debt.
This foreign currency risk is significant even for economies not nearly as imbalanced as Iceland and Argentina were. Indeed, the pound sterling fell 22% against the euro as its banking crises unfolded during 2008-09. Even relatively stable European economies have significant foreign currency volatility; the Swedish kroner appreciated by only 0.5% against the euro in 2011, yet it had average annualized daily volatility of 8.3%.
More losers than winners in EuropeForeign currency risk is a zero-sum game: One currency falls at the expense of another’s rise. However, the peculiarities of euro-redenomination mean that most countries would probably see higher bond yields on their euro-denominated debt.
In addition to accelerated capital flight from the periphery, capital will probably begin to leave the eurozone as a whole. Economies with relatively small current account deficits (such as France) or small and hence less liquid markets (such as Austria and Finland) could become more vulnerable to capital flight and experience rising bond yields.
As the anchor of the system, German bunds should benefit from intra-eurozone capital flight. It seems reasonable to expect these intra-euro capital flows, together with domestic repatriation of other foreign assets, to offset any foreign repatriation of capital out of Germany. In short, bund yields will probably fall if euro breakup risks increase.
The chart (Figure 1) shows that this process has been unfolding over the past 18 months. As the crisis engulfed more countries, their yields started to rise while Germany’s fell or remained unchanged. This happened in Italy this summer and in France this autumn. The result is that the average eurozone sovereign yield (weighted by GDP and excluding Greece, Ireland and Portugal) is little changed compared to end 2010. This is despite a much weaker economic environment that has delivered lower yields in non-eurozone sovereigns with no better economic fundamentals but greater policy certainty, such as the UK (red line in Figure 1).
Capital flight out of the eurozone would likely weaken the euro against most other major currencies. The redeployment of this capital should also lower developed sovereign bond yields outside of the eurozone, especially those countries with deeper liquid markets such as the US and the UK. Investing in non-euro developed bond markets therefore offers a degree of protection against euro breakup risks both via potential currency appreciation against the euro and via capital gains from lower yields.
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Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Covered bonds are generally affected by changing interest rates and credit spread; there is no guarantee that covered bonds will be free from counterparty default. Diversification does not ensure against loss. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, or are suitable for all investors, and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
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