How to leave a currency union

How can a country exit from the euro? EuroThinkTank, a group of economists and financial market experts, published a report that explains how an exit from a modern currency union should be handled. In this technical entry, I will go through our main arguments for a successful exit.

How to leave: the principles A sovereign state can always choose to adopt its own currency, as suggested for Greece by other euro members during the Summer of 2015. Formally this happens, when its government makes a domestic currency the only legal tender within a country, and the national central bank announces that it will not any more exchange any monetary union (MU) currency and national currency (NC) accounts at a rate of 1:1. This instantaneous and potentially large change in the price of assets of the exiting country creates a possibility of rapid and large capital movements due to unanticipated markets reactions. It also runs the risk of the failure of the payment and domestic financial systems. These create a need for careful and confidential advance planning of exit.

The planning process can be summarized to three questions, which also determine the overall costs:

  1. Can the exiting country guarantee the functioning of the payment system during the transition?
  2. Is there a possibility of economic and political retaliation in the part of the MU?
  3. Can domestic liabilities be converted to the new currency using lex monetae?

Payments system

The payments system is used to control and clear internal and external payments. Its failure would send the costs of an exit through the roof. Exit also requires that banks are legally forced to redenominate at least parts of their balance sheet from the MU currency into the new national currency. The structure of the IBAN (International Bank Account Number) is unrelated to the currency used, so the account numbers of the exiting MU member need not to be changed. However, a redenomination of domestic deposits and assets held in electronic form to a newly introduced currency can be time consuming. In the worst case, even manual processing of accounts is not possible and a whole new system needs to be introduced, which will take several months or even longer. In any case, banks and their customers will a very strong motives to establish a way to handle and clear payments.

In principle, a country can revert to cash if the payment system is not working properly. Obtaining new cash notes before exit may become a problem, if they cannot be designed and ordered without the formal approval from the parliament. In this case, the country needs to either stamp the existing currency or use an alternative currency for a transition period. Stamping of the existing currency of a MU may be problematic for three reason:

  1. notes are likely to be the property of the central bank of the MU,
  2. stamps need to be easily recognizable and difficult to forge, especially if new (stamped) scrip is issued, and
  3. stamped MU notes could still hold nominal value in the MU and elsewhere.

The seriousness of the problem of obtaining the cash notes during an exit will vary between countries depending on the extent to which retail payments are made using cash and on the ability of the banks and financial authorities to operate a payments system under the new currency.

The new currency also needs to be backed by a central bank that is independent from the system of central banks of the MU. If the national central bank is an integral part of the system of MU central banks, separating it from the system of MU central banks may be impossible. In this case a new central bank is needed. The new central bank needs to commit to a credible monetary policy.

The possibility of retaliatory measures If exit creates a dangerous prejudice for other countries to leave a MU and/or if it is considered to lead to a disintegration of a wider politically agreed union, the exiting country may face political and/or economic retaliation. Limits on MU sanctions will be determined both by the economic situation and size of the exiting country and by the consequent reputational effects on MU authorities. This has three implications:

  1. Sanctions will not in be arbitrarily large and long since MU reputation and the perceived advantages of MU membership may be negatively affected by overly strong sanctions.
  2. The exiting country can reduce the likelihood of sanctions by active communication among remaining MU members of the reasons for the decision.
  3. A large exiting country presents the MU with larger economic consequences than a small one. It may therefore hope to negotiate relatively benign exit conditions with the remaining MU members.

Solvency of the banking, private and public sectors

Exit will inflict major economic costs if it leads to insolvency of the banking sector, major domestic corporations and/or government entities. The ability to denominate debts to NC currency is crucial determinant for this.

The law of money, or lex monetae, establishes that, because a sovereign state has the right to regulate her currency under international law, the creation and substitution of the national unit of payment are entitled to recognition by other countries including their courts and official bodies. When a country exits from a currency union, there are two lex monetaes: the one of the departing country and the one of the MU. Therefore, both the law and the jurisdiction of a financial contract will determine the likelihood of redenomination. When the obligation is under both foreign law and jurisdiction it can still be redenominated depending on the decision of a foreign court or through multiparty settlement.

To stay or leave?

Despite the relatively large uncertainty related to costs of an exit form a MU, there is no point staying in a dysfunctional currency union. When considering the long-run well-being of citizens of a country, a dysfunctional currency arrangement should be abandoned, virtually whatever the cost.