Dropping Out of the Euro: The Practical Consequences
“The euro? It’s just another currency. I don’t understand the fuss,” commented an American treasury management system (TMS) salesperson to a prospective client in the late 1990s. Needless to say, he did not secure that piece of business. At that time, the approaching Millennium and the advent of the euro initiated a financial software boom, as these two inevitable events demanded essential technology modifications to manage the required changes.
The euro was launched at time of high idealism and optimism in the European community. It was seen as a valuable counterpoint to the US dollar, eliminating many of the costs and risks of cross-border operations, and as an important step towards closer European economic and financial integration. Furthermore, the arrival of the euro was regarded by some to be an important step towards achieving European unity, helping to make the possibility of a European war unthinkable. In more practical terms, it provided a standardised financial operating environment which would simplify treasury operations, and reduce financial and operational risk.
The creation of the euro was an extensive and complex exercise, with powerful geopolitical undertones, involving the planned convergence of the economies and monetary finances of the 12 founder states. The conversion rates for the legacy currencies were fixed and published. From that point, the legacy currencies continued to be used nominally for several years, but as their cross rates were unalterably fixed, the euro represented the underlying currency reality from 1999.
The conversion process proved to be relatively straightforward: the published conversion rates were supplemented by essential calculation rules, such as the decimal precision and the rounding convention to be used. With the introduction of euro-denominated notes and coin in 2002, the conversion process proceeded rapidly across the eurozone, and the legacy currencies soon faded into the mists of history.
Today, the 17 strong eurozone is at the centre of the sovereign debt crisis, with continued speculation about further debt restructuring and possible default – and about the possibility of some weaker countries dropping out of the euro altogether. There is presently no formal mechanism in place for a Member State to leave the euro, or to be expelled from it. Nonetheless the possibility that one or more countries exiting voluntarily or otherwise is raised as a real possibility as the debt crisis returns to the headlines with increasing intensity. The possibility of dropping out must look attractive to governments struggling with finding the necessary revenues to service their debt mountains for many years, and the need for sustained budget austerity, which of course makes a most unattractive political prospect. So if such an exit event were to occur, what might be the practical consequences?
At the formation of the euro, and at the moments when further countries subsequently signed up for it, the legacy currencies ceased to exist. They were subsumed at fixed rates into the euro and that was that. They cannot be revived (apart, perhaps, from in name) and so we need to envisage for each exit event the spontaneous creation of a new currency, at a defined conversion rate (and curve) versus the euro, and, presumably, with the publication of the arithmetic precision and rounding rules for the conversion calculations. One practical implication of this is that the banks, enterprise resource planning (ERPs), accounting systems and treasury management systems (TMS) would all need to be immediately ready to execute the sudden and irreversible change.
The situation is clearly not a mirror image of the process required for the assimilation of a new currency into the euro, which is accomplished – as if for all time – with the publication of the official conversion rate. For an exit, one can imagine that there might even be some measure of grey market trading in the new currency as soon as it had been announced; but the crucial fact is that there can be no transition period once the conversion rate is set.
The new currency will start trading immediately – and, given the unique nature of the event, in all probability with a significant level of volatility. The environment would certainly present a challenging playground for traders and speculators, as the market would seek levels against the country’s fiscal condition, revised (devalued) debt portfolio, credit rating, interest rates, economic outlook and perceived political strength, to name a few of the variables.
Against this backdrop, the corporate treasurers would need to measure and manage their organisation’s exposures denominated in the new currency. What would they do in practice? Would they be able to find sufficient liquidity and stability to hedge effectively? Or would they decide that it would be more prudent to close out all positions? We can only speculate how the situation might play out in practice; but it would in all likelihood take place in the course of an intense crisis, in which treasurers would of course be on the front line. We should not neglect the mechanics of the exit, with the conversions and base currency shifts having to be accommodated in all probability against very tight timelines, so that cash could continue to be measured and moved, risks hedged, funding and investment secured, and management reporting properly generated.
Today, the probability that one or more euro exits occurring is sufficiently significant that prudent treasurers will want to ensure that they understand the broad implications of such an event and they will want to have contingency plans in place to ensure operational continuity if matters were to develop in this way. They will want to be confident the systems supporting their operations, their banks and their accounting requirements are in a position to manage and report all the changes, including the establishment of new base currencies and the recalibration of their cash, treasury and risk management processes and analysis.
If such exit events do in fact come to pass, treasury practitioners may hope that governments, regulators and other key parties will act clearly and effectively to help all stakeholders to manage the transition. It certainly makes sense to evaluate and test each organisation’s capability to respond and act effectively to an exit – keeping in mind that such an event might in practice occur in a climate of crisis, chaos and recrimination. Let’s hope not.