With Greece’s position in the euro continuing to look uncertain, Cass Business School, part of City University London, has issued a white paper that proposes a plan for a euro member to exit without the catastrophic consequences feared by many.
A soft consensus has developed that if a country were to leave the euro it would have to exit unilaterally to a floating exchange rate and that bank deposits would have to be devalued alongside domestic contracts. However, the paper by Rob Thomas, advisory board member of Cass’s centre for asset management research, questions these assumptions.
The author argues that the risk to the eurozone economy of a unilateral exit would be such that all parties would realise the need to agree an exit plan, that only a fixed exchange rate would provide the exiting country with the stability it required and, crucially, that the value of bank deposits in the exiting country can and should be preserved by applying a more favourable conversion rate to them.
Maintaining the value of deposits on redenomination would remove the need for a surprise announcement in the exiting country, implemented over a weekend, as well as the need for capital controls. It would also remove the risk of capital (deposit) flight from other weak eurozone members.
The key elements of the proposal are:
- The euro zone needs an agreed blueprint for member exit. Exit would need to be agreed between, for example, Greece, the other euro zone members, the European Central Bank (ECB) and the EU. Unilateral exit must be avoided because the consequences for the euro zone and the global economy would be catastrophic.
- All euro denominated contracts governed by Greek law would be converted at a rate of one new drachma for one euro.
- All euro contracts governed by foreign law would remain in euros.
- The value of the new drachma would be fixed at two drachma to the euro supported by the ECB and Bank of Greece. This would be the cornerstone of Greece’s post exit monetary policy, ensuring that any price rises do not become embedded in permanently high inflation.
- Greek banks would convert their assets and liabilities governed by Greek law at a rate of one for one with the exception of deposits which would be converted at two new drachma for each euro based on the lower of the balance outstanding on ‘announcement day’ and ‘conversion day’.
- As a result, the value of deposits in Greek banks would be protected. Therefore, exit would not have to be rushed (redenomination over a weekend as some have suggested), no capital controls would need to be imposed and the risk of contagion of panic cash withdrawals from other weak euro members would be removed. Indeed, this blueprint would encourage depositors in other peripheral countries to repatriate funds already moved abroad.
- Conversion day would be set six months after announcement day, giving banks and others time to prepare for the redenomination. This would also be sufficient time to have drachma bank notes ready.
- Greek banks would receive a ‘balancing credit’ from the Greek government on conversion day, both to allow for the likely excess of foreign liabilities over foreign assets that would remain in euros and to allow for the higher rate of exchange applied to deposits.
- The report’s author estimates that the cost of the balancing credit would be approximately 260 billion new drachma (€130bn); of which 190bn drachma would cover the cost of converting deposits at the higher two for one rate and the remaining 70bn drachma would cover the mismatch in assets and liabilities that would remain in euros.
- The Bank of Greece would fund this one-off balancing credit on behalf of the government by creating new money. The cost of the balancing credit would thus be met by Greece. It should not be inflationary as banks would be required to repay ECB debts with the proceeds (i.e. Greece’s TARGET2 liabilities should be repaid in full) and because in a fixed exchange rate regime the quantity of money in circulation will be determined by demand not supply (i.e. central bank currency reserves will adjust to meet money demand).
Report author Rob Thomas comments: “In fact, if Greece decided it needed to exit, it would have to work with the ECB and its eurozone partners to successfully manage the transition. Greece would need a fixed exchange rate to give its post exit monetary policy credibility.
“Finally, and most importantly, it would be vital to maintain the value of euro bank deposits in Greece to avoid ‘confiscation by redenomination’. This would not only be more just, it would also make euro exit practical by negating the need for a surprise announcement or the introduction of capital controls and it would remove the risk of capital (deposit) flight from other weak eurozone countries.”