December 20, 2011

What to do when leaving the Eurozone!

What if a country had to leave the euro zone?

It would need to do the following:
  • Announce and immediately impose capital controls
  • Impose immediate trade controls (because companies would otherwise falsify imports in order to get their money out)
  • Impose immediate border controls (to prevent a flight of cash)
  • Implement a bank holiday (to stop citizens from withdrawing their money and running before the devaluation) and - although this is somewhat hard to imagine - stamp every euro note in the country, converting it back to the national currency.
  • Announce a new exchange rate (presumably not floating at the beginning, given capital and exchange controls) so that trade could  continue.
  • Decide how to deal with existing outstanding euro-denominated debt, which would probably entail a major government and private-sector debt restructuring (that is, default). This might be easier in the case of government debt, which tends to be governed by domestic law, in contrast to the debt of major corporations, which normally governed by UK law (but we would assume enactment of laws declaring a haircut here, as well).
  • Recapitalize the (insolvent) banks to make up for losses from defaults
  • Determine what to do with the non-bank financial sector, the stock and bond markets, and every company account and commercial contract in the country.

Any break up would lead to significant turbulence in financial markets - just think about the number of CDS outstanding - and a worldwide recession. The OECD has warned that a breakup of the euro zone would lead to 'massive wealth destruction, bankruptcies, and a collapse in confidence in European integration and cooperation,' leading to 'a deep depression in both the existing and remaining euro area countries as well as in the world economy.' The chart above describes a breakup scenario and its potential implications.
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