MONETARY POLICies
EUR remains the currency of core Eurozone countries Small Break-Up Scenario:
Unilateral withdrawal Multilaterally agreed exit
Securities/Loans etc governed by international law
No redenomination: EUR remains the currency of payment (except
in cases of insolvency where local court may decide awards)
No general redenomination: EUR remains currency of payment, although certain EUR
contracts/obligations could be redenominated using Lex
Monetae principle (if there are special attributes of contracts) and/or an EU directive setting criteria for redenomination
Securities/Loans etc governed by local law
Full-blown Break-up Scenario: Euro ceases to exist
FX
Redenomination happens either to new local currencies by
applying Lex Monetae principle or by converting
contacts/obligations to ECU-2
normal FX adjustments, which would happen under a flexible exchange rate regime. Real exchange rates are now potentially significantly misaligned from their „equilibrium” levels in some countries. The first
component
in the valuation is an estimate of the current real exchange rate misalignment.
Redenomination to new local currency (through change in local currency law, unless not in the interest of the specific sovereign)
of
Redenomination risk on eurozone assets re-denomination
of denominated contracts and Source: Nomura
Euro a
framework to value the potential new national currencies. The first aspect is less interesting for this article but I feel it is worth to show a summary table of the potential implication for existing Euro denominated contracts.
The second aspect is by far more relevant for the currency trader:
How much could new national
currency move up
or down from in case of Euro breaking-up?
Currency valuation is a complex exercise and the uncertainties associated with a eurozone break- up further complicate the analysis. To simplify the analysis, Nomura focuses
on currency valuation
at the national level, country by country, rather than for possible new groups of countries. Still, this exercise, if extreme, could be considered instructive, as - even if some eurozone countries manage
to maintain a currency union - the value of a new composite currency is likely to be linked to the value of the individual component currencies.
The framework used for valuing potential new national currencies concentrates on two main medium-term effects:
• Current real exchange rate misalignments: the eurozone currency union has, by definition, disabled the
1.30 1.50
1.10 0.90 1.25
0.50 0.70
0.30 1.02 0.57 1.25 1.21 1.36 1.3% -6.8% -23.9% -57.6% 1.25 0.96 0.97 0.71 0.86 -6.7% -9.4% -28.6% -27.3% -35.5% -47.2% -7.1%
• Future inflation risk: a break-up of the eurozone would mean that countries
return
individual eurozone would
to
independent monetary policies. The national central banks would have differing inflation fighting credibility and face varying degrees of pressure to provide liquidity for banks and public institutions. Those differences would leave potential for significant divergence in inflation trends. The second component in the valuation framework is the projected future inflation risk.
Here is the interesting result. 1.34
Note: These fair value estimates are calculated for the national currencies of each of the 11 original eurozone members and are based on a 5 year horizon following a potential eurozone breakup. The percentages included in the chart represent the degree of appreciation/depreciation from the current EUR/USD value, which stands at roughly 1.34. as of December 2.
Fair value estimates for new national in a eurozone break-up scenario Source: Nomura
FX TRADER MAGAZINE January - March 2012 41
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