Fixing Eurozone with the return of the European Currency Unit (ECUxit)
The victory of Syriza in the Greek parliamentary elections has led Eurozone on the verge of a breakup, once again. Hard austerity measures have been applied in the crisis countries in order to try to limit the growth of joint and several financing liabilities and guarantees of the Eurozone countries via the European Financial Stability Facility (EFSF), European Stability Mechanism (ESM) and the European Central Bank (ECB). This has led to a major political revolt in Greece, whose 2015 government is seeking to reduce austerity.
The conditions of austerity attached to the bailout loans of EFSF, ECB and the International Monetary Fund (IMF), in a country that cannot devaluate its currency, inevitably lead to steep falls in output and sharp rises in unemployment. IMF has provided emergency loans to countries in crisis since 1952. In its programs debt restructurings and changes in nominal exchange rate regimes have been commonly used to stabilize the detrimental effects of austerity. Within a common currency area only debt restructuring is possible, but for mainly political reasons, only Greece’s privately held debt has been restructured in 2012 among the crisis countries of the Eurozone.
However, even if the debts of crisis countries of the Eurozone would be restructured, it would not correct their large gaps in competitiveness compared with Germany. Also, when the next economic shock will hit the Eurozone, many countries will be struggling despite of their current external funding position. The shared EU and Eurozone debt mechanisms, with advanced financial engineering via high level guarantee structures such as EFSF and ESM do not directly address the fundamental problem of the solvency of some of the problem countries, although they do help with the immediate liquidity issues. The program of quantitative easing (QE) started by the ECB in March 2015 also does nothing to solve the deep structural issues separating countries in the Eurozone. It does, however, improve the average competitiveness of the Eurozone countries against other currency areas via its effect of weakening euro, and move the market credit risk of sovereign debt up to a level of 33% to each national central bank’s balance sheet. It has also been the major reason why the Greek distress has not spilled out to other PIIGS countries.
The only stable solution for the long-term problems of the Eurozone would be a transfer union, where countries thriving under the common currency, like Germany, would compensate to countries suffering under the common currency . Because there seems to be no political will for this within the Eurozone, the only remaining solution is a partial or a total breakup of the euro. However, uncontrolled breakup is likely to be messy and costly. Fortunately, there is a way to break the Eurozone in a controlled manner by addressing the definition of euro itself.
ECUXIT – Fixing Eurozone without a conventional break up
The current Eurozone discussion typically focuses on keeping Eurozone intact and discussing the harmful effects of euro break up. Conceptually, two stable types of Euro break-up are possible: a very limited break-up and a full-blown break-up. The first scenario sees one or a few small Eurozone countries and their currencies leaving the EMU (Greece and Cyprus being the primary candidates). The second is a full-blown ‘big bang’ break-up, which would see the Euro cease to exist in its current form. The third alternative, a sequential, ‘onion peeling type’ break-up process appears to be an unstable or at the very least a risky scenario; the exit and corresponding likely default of a large Eurozone country would likely trigger write offs in the core Eurozone banking systems and could lead to a terminal instability of the entire Eurozone financing system. It is also likely that even a partial EMU break up is not stable, due to it likely leading to strong expectation of a sequential continued country-by-country and currency-by-currency unwinding of the EMU.
Instead of a break up, we argue for ECU EXIT or ECUXIT. It is a permanent solution which redefines Euro, but keeps the rest of the current EMU system as intact as possible, at least for a transitional period. This redefinition would need to be a decisive and comprehensive, yet not necessarily irreversible. It would re-establish Euro as a basket currency, consisting of all 19 Eurozone countries’ national currencies, weighed with the adjusted European Central Bank (ECB) capital key. This change would take simultaneously place in all Eurozone countries and their global trading partners and, critically, can be announced in advance of its implementation. The solution, thus, is to establish second version of the European Currency Unit, that is, ECU-2.
The implementation mechanics of ECUXIT
The so-called Lex Monetae or “the law of money” principle allows sovereign nations to have the international right to determine their own legal currency, legal tender. On this basis, a single country leaving the EMU would have the right to switch to a new local currency. However, the redefinition cannot be forced to be retroactively binding for all existing contracts. It is likely that only contracts set up under the domestic law could be forced to be redefined, and even these would likely be legally challenged, where it would be advantageous to have the dispute handled by domestic courts. International contracts with dispute mechanisms outside the domestic jurisdiction would be even harder to be unilaterally redefined. The problem could also be reverse if the domestic currency would be stronger than the remaining definition for Euro – investors might want to force redefinition of contracts from Euro to the local currency with a legal process.
In contrast, the basket Euro redefinition is from a juridical point of unambiguous and avoids the Lex Monetae problem by re-establishing national currencies for all 19 Eurozone countries, but allows only one Euro definition that applies across the whole of the EMU. The redefinition will also avoid most of the EU legal problems stemming from the fact that the EU does has not defined unambiguous legal withdrawal processes for EU Member States leaving either the EU or the EMU. However, conceptually the redefinition of Euro could be achieved with two possible ways:
- The EU, under the Lisbon Treaty, has a standard mechanism for agreeing Treaty changes, described under Article 48 TEU. This would likely require parliamentary approvals in all EU countries, or the very least in all Eurozone countries. However, since the plan contained herein has a relatively strong pre-announcement safety, the anticipated slow national approval process of several months may still be manageable without a major market disruption.
- Another route would utilise the enhanced co-operation procedure of the EU contained in articles 43 and 45 TEU. This would allow the Eurozone countries to decide on the Euro redefinition without involving the decision making of non-Euro EU countries such as the UK and Sweden. The Eurozone governments used this route to enact local laws for excessive budget deficit controls known as Fiscal Compact in 2012.
The Eurozone can agree that, e.g. 2.9.2015, is the date when the 19 national Eurozone currencies will come back and nations will only issue their own currency (the “Break Date” or “Big Bang”). All Euro issuance by ECB will stop on that day, and ECB will transfer their repurchase and other bank liquidity programs to national central banks, based on the home country of the banks. The procedure is similar to the one applied by the ECB QE of 2015.
The Euros will be valid currency indefinitely or at least for a several year transitional period. The new definition of Euro will make it an ECB Capital Key weighted basket currency, like IMF’s Special Drawing Rights or European Currency Unit (“ECU”) preceding Euro. Possibly Euro, defined as the sum of the 18 currencies, will continue indefinitely as a convenient trading currency. Euro notes and coins would also not need to be removed from circulation, so tourists would not need to get worried. The right to print new euro notes, if any, would remain at ECB after the Break Date. National central banks would have the sole right to issue their own currencies, but with consultation and cooperation with the other Eurozone countries and ECB to prevent excesses.
In the system, ECB can calculate and publish the value of Euro as the weighted sum of 19 Eurozone currencies against other world currencies such as Dollar and Yen. ECB can also administer the conversion of Euros to 19 domestic currencies at demand, or in reverse, can accept 18 currency fractions and convert them to one Euro. This would reduce the need of national central banks to hold foreign reserves in each of the other 19 Eurozone currencies, bringing the system cost savings.
Unwinding the TARGET2 balances is tricky, but like any Euro assets and liabilities, these can be deemed to be repayable in the basket Euro. At latest on the Break Date, the requirement of the national central banks to participate in TARGET2 would be removed. However, the joint and several nature of the balance guarantees according to the adjusted ECB capital key would still remain in place for the accumulated balances. Alternatively, all TARGET2 balances could be deemed to be against the ECB and deficit balances would need to be repaid fully to ECB, which would then pay the amounts to the surplus central banks.
Implications for international contracts, sovereign debt and global corporations
The Euro basket would solve the Lex Monetae problem arising from potentially sequential EMU departures. In a sequential departure, investors will have a real risk that one Euro received under e.g. the Greek law could turn out to be settled in Drachma instead of Euros. The security of receiving Euros under a strong internationally acknowledged law, such as the English law, would reduce but not eliminate this risk. Under the Euro basket redefinition, all courts, regardless of their country or juridical systems, would have no ambiguity of what Euro means, since there is only one definition, namely the weighted sum of 18 Eurozone countries national currencies. The only legal challenge to this redefinition could come from an investor who would want to receive settlement in a new domestic currency instead of Euro basket. This case could be pre-empted in the plan by declaring such redefinition of Euro to be against European law.
After (e.g.) 2.9.2015 the national currencies start at 1:1 parity foreign exchange rate in relation to Euro and each other, and then will diverge, unless a country wants to peg their currency to Euro, either one way or within a band. This will change the Euro basket value, but since some currencies appreciate (possibly DEM) and some depreciate (possibly ITL), and some stay at parity (possibly FIM) the Euro basket value probably will not move violently in comparison to current Euro. All Euro sovereign obligations entered until the “Bing Bang” date should be settled in the basket Euro. The sovereign that have issued e.g. an Euro denominated bond could under the new system issue a domestic currency bond and ask ECB to purchase the other 19 Eurozone domestic currencies with it in order to settle the Euro repayment . This will give investors confidence that the value they receive from the sovereign bond issues and other investments will not deviate from one Eurozone country to another, although of course the sovereign repayment and default risks will naturally vary. If let’s say Italy wants to aggressively print ITL, they will devalue their new currency and will also have inflation. They would still have to pay off their old Euro debts at high basket value. They could also choose to default or restructure part of that debt, but at their own risk, without triggering participation from the other Eurozone countries. It would be also more natural for the International Monetary Fund (IMF) to lead the support packages, potentially joined by the newly redefined ECB as the European Monetary Fund. If the ECB conversion mechanism from 19 Eurozone currencies to basket Euros is reliable and automatic, the Eurozone countries and possibly other sovereigns could continue to issue basket Euro bonds even after the Break Date.
The redenomination risk built by the Eurozone fiscal divergence continues to be somewhat problematic for companies in the Eurozone. For example a German automotive company has currently to take into account at least a minor probability that their liabilities face increased debt value due to post-Euro appreciation, compared to e.g. an Italian company with potential free-fall gain from post-Euro devalued debt burden and cost structure. Under the Euro basket currency model, these payoffs are neutralised as asset and liability values are maintained across the Eurozone (although not necessarily against other currencies). The stable payoff model creates no incentive to pay off or switch liabilities and receivables from core to periphery or vice versa.
Derivative contracts under Euro definition would be payable with the Euro basket redefinition. However, interest rates might have to be redefined from Euribor to an appropriate national interest rate. In order to smooth the effect of contracts, a basket weighing of newly established national interest rates with ECB Capital Key could also be considered. ECB could be the official party publishing the calculations for the Euro basket interest rate. A compulsory settlement of any Euro derivates at their mark-to-market value could be another policy option, but could create challenging funding needs for the derivative counterparties.
Benefits and drawbacks of re-established independent currencies
Benefits of the basket Euro include:
- Ability to influence inflation and its impact on debasing the domestic currency debt
- Allow Eurozone countries to start paying salaries (importantly the government salaries), pensions and other entitlements and benefits in the new national currencies.
- Control of interest rates
- Control of exchange rates , capital in- and outflows and potential export benefit from potentially devalued or pegged currency
- Ability to opt out or only partially implement EU fiscal control procedures to be introduced under the so-called Fiscal Compact agreement of EU
- Option to return to common currency area
Some of the disadvantages from re-established national currencies include:
- The basket Euro loses some of its reserve currency status coming from the unambiguous and seemingly irreversible definition of Eurozone single currency
- The new local currencies have no benchmark trading and creating new market in e.g. local currency debt will take time and can be costly
- Banks and companies would need to re-establish systems, procedures and personnel to handle the new currencies and hedge their risks
- Uncertainty and disruption from legal issues, confidence and contract mismatches arising from interpretation of Euro and new local currencies and against the other currencies such as USD.
Euro has become a massive burden to many of nations participating on the common currency. Costs of partial or complete breakup of the Euro are likely to be high both to Europe as a whole as well to individual countries. Breakup of euro would also lead to massive sunk costs of political capital and it would constitute as first steps of European dis-integration after more than 50 years of integration. If euro would be deemed as a failed project (for now), which for many countries it already is, a controlled breakup procedure with an option to return to common currency later would be an optimal solution.
ECUXIT, or the ECU-2 system presented above avoids most of the problems associated with a traditional break up. It was essentially already beta tested in a reverse form in 1999 when ECUs were redefined as euros. ECUXIT will release the large distortions built among the 19 Eurozone countries via parallel currencies, yet keeps the vast volume of common currency contracts, liabilities and assets largely intact and enforceable. In short, ECUXIT is the market-based way to fix the dysfunctional Eurozone.
Sami Miettinen, Tuomas Malinen