From Wolf Street, by Wolf Richter
It’s the closest the Eurozone has come to falling apart.
Marine Le Pen, the leader of the National Front, will get enough votes in April during the first round of the French presidential election but will be defeated in the second-round runoff in May, according to the polls. So at least hopes the French political class, and by extension the European establishment.
They’re hoping Le Pen would be defeated because she is campaigning on taking France out of the euro (after holding a referendum) and re-denominating the entire €2.4 trillion pile of French government debt into new franc. Then the government can just print the money it wants to spend.
There are some complications with her plan, including that the diverse and bickering French political class will unite into a slick monolithic bloc against her during the second round. And if she still wins, her government will face that bloc in parliament. But hey. And now people are seriously thinking about it.
Greece was on the verge of leaving the euro, but then within a millimeter of actually taking the step, it blinked and inched back from the precipice in the hot summer of 2015. And so for now still no one knows what the cost would be to leave… they can only grapple with the costs of staying.
In Italy, the Five Star Movement, which has been gaining momentum, is making noises about a referendum on euro membership. Italy has a special set of problems: It wants to bail out its banks but doesn’t have the money to do it; and it needs to devalue its currency as it had done so many times before it joined the euro, but has no currency it can devalue.
So the question of what it would cost to leave the euro is uncomfortably on everyone’s mind and lips – that’s how far this has gone.
One thing is clear: If a country leaves the euro and devalues its new currency, it practically must re-denominate all its existing government debt into the new currency because it would be impossible to service the euro debt with a devalued new currency.
The ratings agencies, with their eyes on those euro bonds, have already spoken up. Moritz Kraemer, S&P’s head of sovereign ratings, wrote in a letter published in the Economist on February 4 that Le Pen’s plan of re-denominating French debt into new francs would constitute a sovereign default:
There is no ambiguity here: it would. If an issuer does not adhere to the contractual obligations to its creditors, including payment in the currency stipulated, S&P Global Ratings would declare a default. Our current AA rating on France suggests, however, that such a turn of events is highly unlikely.
In other words, S&P doesn’t believe that Le Pen will get that far, and so they have not yet slapped a “D” for default on French government debt.
Moody’s too declared a few weeks ago that a re-denomination of French government bonds into new francs “might technically count as a default.”
Bondholders don’t like the idea of not getting “their” money – the euro – back when the bond matures, and they despise watching the purchasing power of their principal get watered down, as such a plan would do. They bought these bonds with ultra-low yields that had assumed that there wouldn’t be any of these risks.
Hence the “Le Pen premium,” a new term in the financial vernacular to describe the spiking yield spreads between German and French government bonds.
Now ECB President Mario Draghi is stumbling into the fray.
“The euro is irrevocable,” he told the European Parliament on Monday, to counter the populist rejection of the euro. “This is the treaty,” he said.
Which evoked memories of the good ol’ days of the sovereign debt crisis, when, to put an end to it in July 2012, Draghi said that the euro was “irreversible” and that the ECB was “ready to do whatever it takes to preserve the euro.” At the time, the Spanish 10-year yield was above 7% and the Italian 10-year yield was above 6%.
So now, same tune, different scenario. It’s not a debt crisis. It’s just a question of whether or not it’s possible to leave the euro, and if yes, how much it would cost.
And that question has already been raised officially. On January 18, Draghi had sent a letter to European Union lawmakers Marco Valli and Marco Zanni, telling them: “If a country were to leave the Eurosystem, its national central bank’s claims on or liabilities to the ECB would need to be settled in full.”
That was the opening – the IF. “If a country were to leave…” It meant that a country could leave! It was the first official admission that this was actually possible. It was just a matter of cost. That’s how Zani saw Draghi’s response. Bloomberg:
“I wanted to bring up the issue of exit from the euro and how it can happen,” he said in an interview before the testimony. “Draghi has now clearly admitted that such an exit is possible and now there is need to have more clarity about the cost. I’m sure that in case of Italy’s exit from the euro, benefits exceed costs.”
Alas, in his testimony before the European Parliament, Draghi refused to put a price tag on leaving the euro.
Valli asked him whether the “liabilities” Draghi had referred to that would “need to be settled in full” were the so-called Target2 imbalances. These are a result of payment settlements within the European System of Central Banks. They’d soared during the debt crisis to hundreds of billions of euros, a sign of the underlying financial tensions between debtor and creditor countries.
But Draghi dodged the question: “I cannot answer a question that is based on hypotheses, on assumptions which are not foreseen” by the European treaties, he said. “What I could do is send you a written answer which compares our Target2 system with the Federal Reserve-based system.”
Which was very helpful.
But even though he refused to put a price tag on leaving the euro, the whole exchange confirmed that it’s possible to leave the euro, though there is nothing in the treaties that mentions leaving the euro.
Other Eurozone central bankers are also trying to stem the tide, evoking soaring borrowing costs for France, if it chose to leave, and outright “impoverishment,” as ECB Executive Board member Benoit Coeure put it.
Whatever the ultimate costs of leaving the euro – they may be greatest for the holders of affected euro debt – for the Eurozone’s second- and third-largest economies, it has come down to just doing the math and making a decision. That’s the closest the Eurozone has ever come to falling apart.