Eurexit – is leaving the Eurozone an option?
Paolo Belardinelli // 13 March 2017
The upcoming months will be decisive for the future of the Euro. The French election, to be held on April 23rd (first round, followed by a probable run-off on May 7th), are probably the most critical events in the near future. Were Marine Le Pen, the leader of the Front National, to win, France would say farewell to the Euro. If Le Pen does not succeed, other threats to the continued existence of the Euro will come from Italy, where right-wing parties (Lega Nord and Fratelli d’Italia) have a return to monetary sovereignty as one of the main points of their platform; moreover, the 5 Star Movement is in favor of a referendum on the single currency.
The demise of the Euro could well mean the end of the European Union, as membership of the Eurozone is not optional for Member States. The only exceptions were provided for the UK and Denmark. For all the other countries, joining the Euro is the natural consequence of being part of the EU, provided they meet 5 criteria:
– public deficit/GDP ratio not higher than 3%;
– public debt/GDP ratio not higher than 60% (although Italy and Belgium were exempt from this one);
– inflation rate not more than 1.5 percentage points above the rate of the three best performing countries;
– long-term interest rate not exceeding 2 percentage points of the average rate of the same three countries;
– permanence in the last two years in the European Monetary System without fluctuations of the national currency.
Member States are required to meet these criteria in order to remain part of the European Union and then being admitted to the Monetary Union. So it would seem no country would be allowed to leave the Eurozone without the simultaneous departure from the EU.
Thus, the only way a country could leave the Euro would be to invoke Article 50 of the Treaty of Lisbon, as the United Kingdom is poised to do. Article 50 provides for a voluntary and unilateral withdrawal mechanism of a Union country.
If a Eurozone country decides to leave by activating Article 50, negotiations would begin to clarify the way out, but some consequences would be immediate and related specifically to the prospect of exit from the Euro. For some countries these are likely to be more painful than for others. Italy, for example, with a public debt of some €2.218 trillion, would face a big challenge.
Making predictions is always a reckless exercise, likely to be wrong most of the time. Nonetheless, it may be a fruitful exercise, by providing the opportunity to reflect on the consequences of various possible choices.
First, government bonds would be converted into a new currency, presumably a New Lira. Unlinked from the euro, the value of those securities would collapse, with serious capital losses for the holders.
65% of Italian public debt is held by Italian actors, including banks (20%), insurance companies (17%), the Bank of Italy (11%), mutual funds (3%), private households (6%) and other domestic agents (8%), while the remaining 35% is held by foreign institutions, among them the ECB (9%) and foreign investors (26%).
Let us imagine 3 different scenarios, entailing a currency depreciation of 10%, 20%, and 30% respectively.
First scenario: 10% depreciation.
With an expected depreciation of 10%, a security bearing a face value of €100 would have a purchasing power of around €91 (100/1.1) after conversion, with a net loss of € 9 for its holder.
The net loss for families, which now directly hold bonds worth some €133 billion (and indirectly, through mutual funds, another €67 billion) would amount to €18 billion. Nonetheless, the households’ net loss would not be limited to this; they would also absorb part of the banks’ and insurance companies’ losses. The latter, holding roughly €821 billion of public debt, would suffer a loss of €74 billion. Finally, foreign operators, holding €577 billion of debt, would suffer a loss of around €52 billion.
Second scenario: 20% depreciation.
The same security, with an expected depreciation of 20%, would have a purchasing power of around €83 (100/1.2) after conversion, with a net loss of €17 for its holder.
The net loss for households would amount to €33 billion: €22 billion directly and €11 billion through mutual funds.
Banks and insurance companies would suffer a loss of €137 billion.
Foreign operators would suffer a loss of around €97 billion.
Third scenario: 30% depreciation.
In the last scenario, with an expected depreciation of 30% a security bearing a face value of € 100 would have a purchasing power of around €77 (100/1.3) after conversion, with a net loss of €23 for its holder.
The net loss for the families would amount to €46 billion: €31 billion directly and €15 billion through mutual funds.
Banks and insurance companies would suffer a loss of €189 billion.
Foreign operators would suffer a loss of around €133 billion.
Another important aspect to consider would be the immediate termination of any purchasing program by the ECB on Italian securities. Consider that, according to the Bank of Italy’s report Finanza Pubblica: Fabbisogno e Debito, the share of Italian debt purchased by the ECB almost doubled in less than a year, rising from just under 5% in December 2015 to approximately 9% in November 2016. The consequences of a drastic stop of the securities purchasing program would have an immediate impact on government bond yields and, again, on their value, worsening the fall.
During the two years of negotiations provided for by Article 50, who would buy Italian bonds? With the foreseeable fall of the value of securities and the simultaneous rise in yields, the Treasury will be forced to offer higher rates of return on public debt.
The fall in interest rates following the Maastricht Treaty had been a blessing to the Italian public finances. Notwithstanding the dramatic increase of the Italian public debt, from €1.24 trillion in 1995 to €2.22 trillion in 2016, the total interest expenditure decreased from €100 billion to €66 billion in the same period. Italy has never really taken advantage of lower lending costs to decrease the tax burden. The government simply shifted public spending on other expenditure items.
The rising rates of return would be a very serious problem for the Government coffers. Our debt/GDP ratio has reached 133%. Every increase of just one point in the debt’s cost would soon translate in a worsening of 1.3 points in the deficit/GDP ratio. The market would probably start to doubt about the Italian debt solvency.
Were the Italian Treasury unable to finance its operations, the resources needed to pay salaries, pensions, or healthcare would be lacking. Any revenue would mostly be allocated to the repayment of old debt, if not rolled over by the market. If we consider that in 2017 Italian government securities for about € 220 billion are coming to maturity, the Government might well opt to stop repaying the debt and use all available resources to pay salaries, pensions, or health. In other words, we would already have reached the default on the debt, which is nothing but an enormous hidden tax on those people who lent money to the state. Among these, Italian families hold approximately €200 billion of public debt that may not be returned to them. Better think about it twice.