Also: think about the governing law of your government bond when a currency union is collapsing. Willem Buiter of Citigroup on Tuesday, exploding a certain meme:
A Greek exit is indeed often viewed as ‘euro-positive’ in the narrow sense of likely to be associated with a strengthening of the effective exchange rate of the euro – mainly because it eliminates the prospect that a sovereign default in Greece would entail the risk of part-monetisation of Greek government debt by the ECB.
We agree that Greece’s exit from the euro area would likely be ‘euro-positive’ in the narrow sense just given. We fear, however, that it would be a financial and economic disaster not only for Greece, but also for 16 continuing euro area member states, and that it would also have severe economic and political implications for the whole of the EU and the wider global economy.
Basically it’s about demonstration (or domino) effects as markets test the rest of the periphery. We don’t doubt that the euro would appreciate if Greece was sacrificed, but the logic of the trade entails that everyone bar Germany should leave in order to keep the euro strengthening in value. Maybe throw in a few trade surplus nations but certainly don’t bother risking a eurozone with Italy still inside over the long term. It’s a destructive logic. Actually if you’ll permit us to add to Buiter’s argument here…
In fact markets might re-price the periphery in advance of Greece leaving, during the months it would take to negotiate a formal exit via a treaty amendment. Releasing Greece’s FX reserves for defending the Neo-Drachma from the Eurosystem (again, not provided for under current treaties) would deal a further blow to the credibility of original terms of euro monetary union as “permanent” and “irreversible” Community law. “The permanent currency union would have been revealed to be a snowball on a hot stove,” Buiter says in his Tuesday note.
(And thinking that Greece is the only problem and its departure will solve everything is very, very, very dangerous)
But anyway, Buiter is also very good on the technicalities of how Greece could finance itself in Neo-Drachma after a euro exit, probably following the repudiation of official loans excepting the IMF. (It’s a given at this point that private debt will be massively written down whether Greece stays in or out of the euro.) The answer from Buiter is that Greece will struggle:
Assume the Greek authorities end up (very optimistically) having to find a further 5 percent of GDP worth of financing. This could be done by borrowing or by monetary financing. Borrowing in ND-denominated debt would likely be very costly. Nominal interest rates would be high because of high anticipated inflation – inflation that would indeed be likely to materialise. Real interest rates would also be high. Although the Greek sovereign’s ability to service newly issued debt would be greatly enhanced following its repudiation of most of its outstanding debt, the default would raise doubts about its future willingness to service its debt. Default risk premia and liquidity premia (the market for ND-denominated Greek debt would be thin) would raise the cost of borrowing in ND-denominated debt. Even if the Greek authorities were to borrow under foreign law by issuing debt denominated in US dollars or euro, default risk premia and liquidity premia would likely be prohibitive for at least the first few quarters following the kind of confrontational or non-consensual debt default we would expect if Greece were pushed out of the euro area.
Again, that’s not to say that Greece won’t be forced into it in any case, but the “technical” aspects of a euro exit, such as financing neo-drachma debt, bear thinking about — considering how bad this could get.
Buiter’s most interesting point comes last though:
As soon as Greece has exited, we expect the markets will focus on the country or countries most likely to exit next from the euro area. Any non-captive/financially sophisticated owner of a deposit account in that country (or in those countries) will withdraw his deposits from banks in countries deemed at risk – even a small risk – of exit. Any non-captive depositor who fears a non-zero risk of the future introduction of a New Escudo, a New Punt, a New Peseta or a New Lira (to name but the most obvious candidates) would withdraw his deposits from the countries involved at the drop of a hat and deposit them in the handful of countries likely to remain in the euro area no matter what – Germany, Luxembourg, the Netherlands, Austria and Finland. The ‘broad periphery’ and ‘soft core’ countries deemed at any risk of exit could of course start issuing deposits under English or New York law in an attempt to stop a deposit run, but even that might not be sufficient. Who wants to have their deposit tied up in litigation for months or years?
Apart from bank runs in every country deemed, by markets and investors, to be even remotely at risk of exit from the euro area, there would be de facto funding strikes by external investors and lenders for borrowers from these countries. Again, putting under foreign law (most likely English or New York) all cross-border (or perhaps even all domestic) financial contracts and instruments could at most mitigate this but would not cure it.
The point about flight to English-law bonds is a very good one, because weirdly it is already happening in Greece for different reasons. An English-law bond maturing in 2012 is currently priced at around 80, compared to Greek-law debt also maturing in 2012 priced at around 59, for example. This is mostly because of the way in which the current bond swap (which will also convert Greek-law bonds into English law) has affected the market. Holdouts in Greek-law bonds face considerable risks of a legal change to the terms of their bonds, whereas English-law holders are insulated from this risk. English-law holders receive greater protections against other creditors being secured above them as well.
Foreign-law bonds haven’t really been seen as being additionally attractive for protecting against re-denomination risk. Until now, maybe?