Imagining hypothetical split €-periphery exchange rates

HSBC’s macro currency strategy team has a vision.

A vision of how the euro might have performed had it been split into two currencies back in 2009.

Using the performance of the Swiss franc as an input, the vision goes like this:

The behaviour of the EUR and CHF over the past 18 months and the tightening of monetary conditions in Switzerland have interesting implications for the Eurozone. Imagine that the EUR had been split into two currencies in 2009, call them EUR-core (EUC) and EUR-periphery (EUP) where EUC members were those that had no significant public sector funding problems. Given the close association between the behaviour of the Swiss economy and the German economy (chart 7), it would not be unreasonable to suggest that EUC-CHF would have remained fairly stable.

Assuming EUC-CHF had remained at 2009 EURCHF levels (1.50) this would imply a current EUC-USD of 1.83 (about 28% higher than EUR). This would also mean EUC-JPY of 144 and EUCGBP of 1.13.

As to how the EUP (EUR-periphery) would have fared in the same period (and how one goes about working out its exchange rate), HSBC says:

What would be the value of EUP-USD? There are several possible ways of estimating this. The two simplest are shown in table 8. The first column assumes that the current EUR is just a simple average of the values of the hypothetical EUC and EUP. This would mean EUP-USD of about parity. If the EUR is a weighted average of EUC and EUP then, based on approximate GDP weights this would mean EUP-USD of about 0.65.

Et voila — one set of current EUP current exchange rates:

Now, while all this might strike you as fanciful theory, there are, say HSBC, some interesting lessons to be learned.

Had such a split been engineered, area exports would probably have performed much better in the periphery. Inflation in the EUC area, meanwhile, would probably have been very subdued and the EUC central bank would not have felt the need to raise rates. In the EUP, inflation would have been higher, but it would have been crosschecked via real incomes. The EUP central bank would probably have been reluctant to raise rates.

As to bonds:

EUC area holder of EUP bonds would, of course, have suffered a big currency loss (assuming they were not hedged) in the same way EUR holders of gilts did in 2007/08.

The direct impact on the likes of Germany and Greece, meanwhile, would have been as follows:

Relative competitive positions in the Eurozone would have been very different. Chart 9…

…shows the BIS real effective exchange rates for Greece, Switzerland and Germany. With higher domestic inflation, Greece’s REER has moved steadily higher, but Germany’s has fallen implying a stronger competitive position. With a split EUR or a situation where the peripheral Eurozone deflated internally, Germany’s REER would have been higher and the Greek REER would have been significantly lower. Although the financial cost of the sovereign debt problems may be high for the core countries, they have gained a competitiveness boost from having a currency much less strong than it otherwise could have been.

All in all, concludes HSBC, things could have been very different for the eurozone indeed.

Related links:
What’s a Swiss central bank to do? – FT Alphaville
More on fiscal union as the ultimate solution – FT Alphaville
The Eurozone ‘Convergence Carry Unwind’ – FT Alphaville

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