The Future of the Euro

“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”  ECB President Mario Draghi, 26 July 2012.

In 2012, the ECB faced down a mortal threat to the euro: fears of redenomination (the re-introduction of domestic currencies) were feeding a run away from banks in the geographic periphery of the euro area and into German banks. Since Mario Draghi spoke in London that July, the ECB has done things that once seemed unimaginable, helping to support the euro and secure price stability. For example, since March 2015, the ECB has acquired more than €1.3 trillion in bonds issued by euro-area governments, bringing its total assets to just over €3¾ trillion.

So far, it has been enough. But can the ECB really do “whatever it takes”? Ultimately, monetary stability requires political support. Without fiscal cooperation, no central bank can maintain the value of its currency. In a monetary union, stability also requires a modicum of cooperation among governments.

Recent developments in France have revived concerns about redenomination risk and the future of the euro. According to reported statements by senior representatives of the Front National (FN), if their leader (Marine Le Pen) wins the upcoming presidential election, the plan is to exit the euro and reintroduce the French Franc. France would then convert the bulk of its €2.1 trillion in government debt into the new currency, and engineer a depreciation to both make repayment easier and boost the country’s competitiveness.

Representatives of S&P and Moody’s have said that this would be a default—by far the largest sovereign default in history. Given candidate Le Pen is leading in recent polls, and that odds makers give her roughly a one in three chance of becoming President, an FN victory is clearly within the realm of possibility. (Recall that the odds of a Trump victory were no higher a few months before the U.S. elections.)

To understand the consequences—just of the heightened risk, not the realization—consider how other euro-area countries would react if France, indeed, exited the euro. First and foremost, small peripheral economies—Cyprus? Greece? Portugal?—might be inclined to leave quickly. If, as we suspect, Italy and Spain also follow, the euro as we know it would be finished.

Why focus on France and not Italy? In recent months, concerns about Italian banks have been in the news. The Italian banking system is surely weak and in need of recapitalization, as are banks in other parts of Europe. But, in the end, addressing this capital shortfall is a question of how, within the context of the rules of the EU Recovery and Resolution Directive, to come up with the tens of billions of euros needed to keep Italy’s banks afloat. Unless policymakers seriously miscalculate, this is not an existential challenge for the euro.

French redenomination is different. At the core of the euro (and the European Union) is the stable political relationship between France and Germany. A French government that abandons the euro would be a far greater political shock in Europe than Britain exiting the European Union.

As in 2011 and 2012, rising redenomination risk (this time arising from the possibility of a French exit) would boost risk premia and encourage money to flow out of the weaker 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 Target2, the euro-area’s real-time gross settlements system.

The following chart shows the yield spreads between French, Italian and Spanish long-term government bonds and equivalent-maturity German bonds. These yield spreads converged in anticipation of the monetary union that began on January 1, 1999. Between 1999 and 2008, they never rose above 50 basis points. (While not in the figure, the same is true for Greece from the time it joined the euro in 2001 until the crisis intensified seven years later.) Importantly, in recent months, the spreads have begun to widen again. For France, that widening has been 40 basis points. For Spain and Italy, spreads have increased by 30 and 50 basis points, respectively. To be sure, these yield spreads remain far narrower than during the 2011-2012 crisis, but the warning signs are plainly visible.

Long-term yield spreads over German government bonds, month-end, 1990 to February 2017

Source: Harmonized long-term interest rates for convergence assessment purposes, European Central Bank. The final observation, for 10 February 2017, is based on bond yields reported in the Financial Times.

Source: Harmonized long-term interest rates for convergence assessment purposes, European Central Bank. The final observation, for 10 February 2017, is based on bond yields reported in the Financial Times.

If concerns about a possible Le Pen victory grow, 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. That is, we would expect to see shifts from banks in France, Italy, and Spain into those in Finland, Germany, Luxembourg, and the Netherlands. European Union regulations are clear that such shifts cannot be stopped, except in exceptional 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 Target2 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 following chart shows the evolution of balances in the Target2 system since 2006. The positive numbers are for the countries that are creditors, where we highlight Germany in blue. The negative numbers are for debtors, where we distinguish several countries, including the largest debtors Italy (green) and Spain (purple). The varying intensity of the euro-area crisis is clearly reflected in the fluctuating size of these imbalances. The mid-2012 peak is coincident with President Draghi’s London speech. The significant decline that followed is a measure of the success of the ECB’s aggressive policy response—the long-term refinancing operations (LTROs), outright monetary transactions (OMT), changes in collateral eligibility requirements, and various asset-purchase programs—implemented during the 2012-2014 period.

Target2 balances by country (monthly, billions of euros), 2006-2016

The most troubling thing about this picture is that the level of Target2 balances already has returned to its mid-2012 peak. Germany’s credit balance alone is currently just under €800 billion (roughly 25 percent of German GDP). On the other side, as of the end of 2016, Italy owes €363 billion and Spain €333 billion (22% and 30% of GDP, respectively).

France’s balance is still only €35 billion, but that number 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 (see here for details on the mechanics).

While we have written recently about risks in China, events in Europe suggest that the biggest near-term threat to global financial stability does not emanate from there. If a bank run begins prior to the French election, Target2 will facilitate the flow, while yield spreads could widen sharply further. Were the FN unexpectedly to win the May runoff, implementation of the party’s reported plans would spell the end of monetary union, triggering what Barry Eichengreen once called the “mother of all financial crises” as creditors and debtors battle for years over property rights associated with re-denominated contracts. Spillovers to the rest of the world would threaten a sequel to the 2007-2009 Global Financial Crisis a mere decade later.

European economic and monetary union (EMU) is not now, nor has it ever been, primarily an economic endeavor. Instead, its founders viewed EMU as a step toward political union in Europe. Helmut Kohl famously elevated the importance of European integration to a question of war and peace in the 21st century. Some (and perhaps many) EMU advocates understood that a common currency would lead to stresses—financial, economic and political. Yet, their experience with the disaster of 20th century European nationalism (and with the policy developments that preceded the euro) led them to expect that these stresses would push future European leaders to make greater sacrifices of sovereignty to save and advance political union.

As we wrote two-and-one-half years ago, that outcome was never pre-ordained. Now, it seems, the public’s will to continue is more uncertain than it has ever been. When asked, the British have voted to leave the European Union. Will the French, when they are given the opportunity in a few months, opt to leave the euro? Will the nationalism that led to repeated 20th century catastrophes resurface? We surely hope not. But markets price risk, not hope.