JPMorgan believes a break-up of the eurozone is “very unlikely”.
But it wants you to be prepared.
The bank launched its “Alternate States” series of research notes on Thursday, which attempt to describe the probable course of improbable events.
There are two ways a breakup could happen, writes JPMorgan. First, a Germany-led northern exodus which leaves the periphery with a rump currency led by France. Second, a periphery-led southern exodus which leaves the north with a rump currency led by Germany.
Either way, it’ll be messy (our emphasis):
For one, exit would take time. There is no legal provision for leaving the euro without leaving the European Union itself, meaning that EMU exit would have to be negotiated multilaterally, then ratified domestically (via parliamentary debate or a referendum). In that time, bank deposits would flow out of a country if its new currency was expected to depreciate, and vice versa. The only way to stop this would be an extended bank holiday or capital controls.
JPM notes how after the break-up of Czechoslovakia, the two countries agreed to maintain a currency union but Slovaks moved money into Czech countries anyway, on the assumption that their new country would devalue. The union lasted all of six weeks.
Then there’s the legal issue: JPM cites this paper to argue that domestic law debts would probably be redemoninated to the new currency whereas those contracted under English law will probably remain denominated in rump euros.
The problem comes from the likely imbalances between the denominations of assets and liabilities, writes JPM:
We are not lawyers, but see two problems here: firms whose assets or cash flows would be redenominated into a new and weaker currency (say), but whose liabilities would remain in euro could be in financial distress, and perhaps insolvent. Moreover, an extended period of uncertainty would result, as litigation sought to determine which contracts should be redenominated.
The obvious solution, therefore, is to put money into assets that will be redenominated into an appreciating currency rather than those that will be demoninated into a depreciating one. The new German mark rather than the new Italian lira, say. Alternatively, one could just buy dollars (or, yes, gold), which JPM expect to eventually appreciate.
There’s another problem, though: differing bank exposures. From the note:
Chart 1 shows Euro area banks’ non-domestic Euro area lending less non-domestic Euro area deposits, as a share of total assets. Within the Euro area, core banks typically have more external loans than external deposits, exposing them to losses if these assets were redenominated into a depreciating currency. Meanwhile, peripheral banks have more external deposits than loans, exposing them to a revaluation of these deposits into an appreciating currency. Peripheral banks would also be most vulnerable to a deposit run, if EMU breakup were contemplated. Together, that argues for a Euro area bank underweight in equity and credit.
All this sovereign turmoil is just what credit default swaps are designed for, right? Well, JPM points to an interesting technicality that’s also worth bearing in mind should the improbable happen and you’re hedging against the reemergence of the Italian lira (our emphasis):
A quirk of CDS contracts is that a change of currency is a restructuring credit event, except if the new currency is the legal tender of a G-7 country (including Italy) or a AAA OECD country. Thus we believe CDS would be triggered if corporate, bank or government bonds were redenominated to Drachma, Punt, Escudo, Peseta or Belgian Franc, but not if they were redenominated to a newly-reintroduced Italian Lira.
Seriously, what does it take to get a credit-event triggered around here?
Related links:
Why A Breakup Of The Eurozone Is Now Likely – Credit Writedowns
When Italy is already priced to wreck the eurozone – FT Alphaville