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Analysis
The dangers of redenomination

The dangers of redenomination

Follow the Target-2 balances

by Stephen Cecchetti in Boston and Kim Schoenholtz in New York

Thu 23 Feb 2017

As in 2011 and 2012, rising redenomination risk today – the reintroduction of domestic currencies – from the possibility of a French exit from the euro area would boost risk premiums and encourage money to flow out of weaker European economies and into Germany. The impact of the first would appear in sovereign bond yield spreads, and the effects of the second in the balances in Target-2, the euro area’s real-time gross settlements system.

The yield spreads between French, Italian and Spanish long-term government bonds and equivalent-maturity German bonds converged in anticipation of the monetary union that began on 1 January 1999. Between 1999-2008, they never rose above 50 basis points. The same was true for Greece from the time it joined the euro in 2001 until the financial crisis intensified seven years later.

In recent months, the spreads have begun to widen: for France, Spain and Italy, by 40, 30 and 50 basis points, respectively. These spreads are far narrower than in 2011-12, but the warning signs are visible.

If concerns grow about a victory of Marine Le Pen, leader of the National Front (FN), in the forthcoming French presidential elections, the response is likely to spill over outside the bond market. Savers will find it desirable to move funds into banks in jurisdictions where they believe they will retain their value. One would expect to see shifts from banks in France, Italy, and Spain to those in Finland, Germany, Luxembourg, and the Netherlands. Under European Union regulations, such shifts cannot be stopped, except in extraordinary circumstances like those of the 2013 banking crisis in Cyprus.

When the flow of deposits from one country to another is not balanced by a flow in the opposite direction, the asymmetry is mirrored in the Target-2 system. In normal times (say, prior to 2007), the system’s cumulative balances are close to zero, reflecting the usual two-sided ebb and flow of deposits across borders. However, that flow can become one-directional, as it did in the run-up to the euro area crisis. Starting in mid-2011, the flows intensified, as depositors in some peripheral countries lost faith in their banks, in the ability of governments to backstop them, or both.

The varying intensity of the euro area crisis is reflected in the fluctuating size of the Target-2 imbalances. The mid-2012 peak coincided with a speech given by Mario Draghi, president of the European Central Bank, in London. He said then that the ECB was prepared to do ‘whatever it takes’ to preserve the euro. The significant decline that followed is a measure of the success of the ECB’s aggressive policy response in 2012-14. This included long-term refinancing operations, outright monetary transactions, changes in collateral eligibility requirements, and various asset purchase programmes.

The most troubling aspect is that the Target-2 balances have returned to the mid-2012 peak (even if recent levels partly reflect the ECB’s expanded asset purchases). Germany’s credit balance is at a record €796bn as of end-January, roughly 25% of its GDP. On the other side, as of end-2016, Italy owes €363bn and Spain €333bn, or 22% and 30% of GDP, respectively.

France’s balance is only €35bn, but that figure can grow quickly. Importantly, the cost of shifting funds is negligible, while the failure to do so could lead to large losses in the unexpected event of an FN victory. Put differently, insurance – obtained by running from a French, Italian or Spanish bank into a German, Dutch or Finnish bank – is virtually costless. Whenever savers believe that there will be a difference between a euro deposited in Madrid, Rome or Paris and one in Frankfurt, Amsterdam or Helsinki, they have an incentive to move their funds from the former and into the latter.

If a bank run begins prior to the French election, Target-2 would facilitate the flow, while yield spreads could widen further. Were the FN unexpectedly to win in May, implementation of the party’s plans to leave the euro and reinstate the French franc would spell the end of monetary union, triggering what Barry Eichengreen, the Berkeley economic historian, once called the ‘mother of all financial crises’. Creditors and debtors would battle for years over property rights associated with redenominated contracts.

Spillovers to the rest of the world would threaten a sequel to the 2007-09 financial crisis, this time fuelled by the breakdown of post-war relationships in Europe in a world already brimming with risks.

This is the second in a two-part article by Stephen Cecchetti and Kim Schoenholtz. The first part can be read here. The original version appears in the authors’ website, Money & Banking. Cecchetti is Professor of International Economics at the Brandeis International Business School. In 2008-13 he was Economic Adviser and Head of the Monetary and Economic Department at the Bank for International Settlements. Kim Schoenholtz is Professor of Management Practice in the Department of Economics at New York University’s Leonard N. Stern School of Business and Director of NYU Stern’s Center for Global Economy and Business. He was Global Chief Economist of Citigroup in 1997-2005.

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