30 January 2012

Planning for an orderly break-up of the European Monetary Union

Jens Nordvig (Lead Author)

Head of Fixed Income Research Americas & Global Head of G10 FX Strategy Nomura Securities

Dr Nick Firoozye
Head, European Rates Strategy Nomura Securities

Submission to Wolfson Economics Prize 2012: The opinions expressed in this paper reflect the personal viewpoints of the authors, not an official view of their employer.

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Table of Contents
Summary.............................................................................................................. 4 Section 1: Possible break-up scenarios ........................................................... 6 We see a real risk of break-up .......................................................................... 6 A very limited eurozone break-up: possible ...................................................... 7 A big-bang eurozone break-up: possible .......................................................... 7 A sequential onion peeling break-up process: unlikely ................................... 8 Section 2: Legal aspects of redenomination ................................................. 10 Redenomination risk: Which Euros will stay Euros? ....................................... 10 The importance of legal jurisdiction ................................................................ 10 The need for an ECU-2 and EU directives in a break-up ............................... 12 Risk premia and legal jurisdiction.................................................................... 14 More detail on legal jurisdiction ....................................................................... 14 The judicial process ........................................................................................ 16 Enforcement .................................................................................................... 17 Legal aspects of redenomination and contingency planning .......................... 17 Section 3: Size of Euro assets by legal jurisdiction ..................................... 18 Euro denominated bond markets by legal jurisdiction .................................... 18 Euro denominated derivatives by legal jurisdiction ......................................... 20 Euro denominated loans assets by legal jurisdiction ...................................... 21 Information gaps and redenomination complexity .......................................... 21 Section 4: Cost-benefit aspects of planning ahead ...................................... 23 Uncertainty about the eurozone is affecting investor behavior ....................... 23 The private sector is making contingency plans in any case .......................... 23 Uncertainty makes risk-management difficult ................................................. 25 Section 5: Key steps in planning for a break-up ........................................... 26 Aiming to avoid unnecessary disruption ......................................................... 26 Four steps in an plan for and orderly break-up ............................................... 27 Section 6: Guiding principles for redenomination ........................................ 28 Guiding principles for redenomination of local law assets .............................. 28 Guiding principles for redenomination of foreign law assets .......................... 28 Section 7: The new European Currency Unit (ECU-2) .................................. 30 The advantage of the basket currency redenomination .................................. 30 Potential weights of the new ECU ................................................................... 31 A brief history of the original ECU ................................................................... 33 A few technical considerations around the ECU-2.......................................... 34 Section 8: A hedging market for intra-EMU FX risk ...................................... 35 The need for a hedging market for intra-EMU exposure ................................ 35 Creating instruments for hedging intra-EMU currency risk ............................. 36 Creating instruments for hedging ECU-2 exposure ........................................ 36 Ensuring efficiency of intra-eurozone NDF markets ....................................... 36 Section 9: New regulatory frameworks .......................................................... 38 The need for quantification of intra-eurozone currency risk ............................ 38 Risk limits for systemically important institutions ............................................ 39

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Section 10: Concluding remarks ..................................................................... 40 Appendix I: Illustrative bank loss calculations in debt restructuring scenarios 41 Appendix II: BIS data on international bond issues by Eurozone issuers ...... 44 Appendix III: Valuing new national currencies ................................................ 45 Currency risk in a eurozone break-up ............................................................. 45 A framework for valuing new national eurozone currencies ........................... 46 Quantifying current real exchange rate misalignment .................................... 46 Quantifying future inflation differentials ........................................................... 48 Valuation of new national currencies: A two-factor approach ......................... 50 The countries not in our story ...................................................................... 51 How to interpret the results ............................................................................. 52 Appendix IV: Eurozone assets by legal jurisdiction further detail ................ 54 Appendix V: How to value the new ECU ......................................................... 55 References ...................................................................................................... 57

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Summary
Two types of break-up scenarios for the Eurozone are possible, from a practical perspective: A very limited break-up scenario, involving the exit of one or a few smaller countries, and big bang break-up scenario, which would see the Euro cease to exist. A sequential onion peeling type of break-up process, which would see only stronger core countries remain in the eurozone, is highly unlikely to be possible as the process would become uncontrollable around the exit of a larger Eurozone country. Policy makers should therefore plan primarily for the very limited break-up as well as the full-blown break-up scenario. The latter could be highly disruptive from a macroeconomic standpoint in the absence of any detailed and thoughtful advance planning. Eurozone break-up risk has clearly risen notably during the second half of 2011 as European policy makers have failed to put in place a convincing and credible backstop for the larger eurozone sovereign bond markets. Given this increased risk, investors and policy makers should think carefully about dynamics associated with redenomination of Euro denominated assets and obligations in a break-up scenario. There are important legal dimensions to this analysis, including the legal jurisdiction of the Euro denominated assets and obligation in question. In order to determine which contingency plans would be helpful to facilitate and orderly break-up process, it is important to understand certain legal aspects of a redenomination process, including the differences between domestic and foreign law instruments. In making contingency plans for a Eurozone break-up, it is important to think about the size of exposures involved, including new currency risks which would ensure from a redenomination process. Since Euro adoption was supposed to be irrevocable, very little attention has been paid to legal jurisdiction of assets and obligations up to this point, and the related differences in redenomination risk. But our preliminary analysis highlights the very large contingent open currency exposure. In particular, the importance of the size of Euro obligations under English and New York law, in the form of FX swap and forward contracts, as well as interest rate derivatives, should not be underestimated. The huge size of these markets illustrates that complications related to the redenomination process around such assets and obligations have potential to cause very significant disruptions, with dramatic macro economic implications. There is a general perception that any attempt to make contingency plans for a euro-zone break-up would lead to increased investor anxiety. But investor concerns about the risk of a eurozone break-up are already present. Moreover, the new uncertainties around breakup risk and related legal and political uncertainties around a possible redenomination process makes it hard for investors to manage risk related to their eurozone exposures. At this point in the crisis, communicating contingency plans for a break-up would reduce uncertainty, rather than add to it, and potentially even improve the current capital flow situation. In preparing for an orderly Eurozone break-up, we propose four key step in a contingency plan for orderly currency redenomination. European policy makers should: 1) Offer forward-looking guidance on the redenomination process for local and foreign law assets; 2) Specify the role of a new European Currency Unit (ECU-2) in the redenomination of foreign law assets and obligations in a full-blown break-up scenario; 3) Create a hedging market for intra-EMU currency risk, allowing risk reduction ahead of a break-up event; and 4) Adopt regulation which over time is aimed at reducing intra-EMU currency risk for systemically important institutions. Communicating guiding principles for redenomination of Euro denominated assets and obligations under local and foreign law ahead of a break-up would be a crucial first step in an orderly redenomination process. Communication ahead of the event would allow market participants to prepare efficiently, helping to avoid triggering bankruptcies and other disruptions as a function of losses on new currency exposures. Clear communication on guiding principles for the redenomination process ahead of time would help resolve uncertainty in the planning process, and reduce delays associated with legal disputes following an actual break-up.

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A new European Currency Unit (ECU-2) could play an important role in facilitating an orderly redenomination process for the myriad contracts and obligations under foreign law without a clear country specific nexus. Specifying the role of a new European Currency Unit in the redenomination process would be an important second step in planning an orderly redenomination process. The ECU-2 would be a basket currency, and would be mechanically linked to the performance of new national currencies of current eurozone member countries in accordance with a pre-determined weighting scheme. The ECU-2 would play a crucially important role in facilitating efficient redenomination of foreign law contracts, which would otherwise be hard to settle in a fair and efficient manner. The ECU-2 would thereby serve to minimize unnecessary insolvencies due to protracted legal battles about redenomination issues and due to losses on new currency exposure associated with a redenomination scenario. To facilitate an orderly break-up process, market participants would need instruments to reduce intra-EMU currency risk ahead of an actual break-up taking place. A third step in the planning process would involve the creation of non-deliverable currency forward markets for potential new national currencies of eurozone member countries. This step would be an important component in facilitating risk reduction in relation to contingent intra-EMU currency exposures. The availability of an efficient hedging market for intraEMU currency risk ahead of a bread-up would serve to minimize redenomination related disruptions in an actual break-up. The fourth and final step in preparation for an orderly eurozone break-up would be to implement new regulatory frameworks. The purpose of such a framework would be to monitor and over time reduce intra-Eurozone currency exposure for systemically important institutions, including by taking advantage of newly created hedging instrument for this purpose. Given the prevalence of Euro denominated assets and obligations under foreign jurisdiction, such a process should have a global component in order to shield the global banking system from shocks emanating from a eurozone break-up. The four-step plan outlined here offers a framework for orderly currency redenomination in a break-up scenario, including a full-blown break-up scenario where the Euro ceases to exist. To be clear, this would be just one aspect of an overall plan for an orderly break-up of the European Monetary Union. But this specific aspect is likely to be a crucial one given the very large contingent open intra-EMU currency exposures which have been accumulated since 1999. Any plan for a break-up, which does not include a framework to ensure an orderly currency redenomination process, is an incomplete one, and one which significantly underestimates the large disruptive force associated with an uncontrolled and unmanaged redenomination process.

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Section 1: Possible break-up scenarios

Two types of break-up scenarios for the Eurozone are possible, in our view: A very limited break-up scenario, involving the exit of one or a few smaller countries, and big bang break-up scenario, which would see the Euro cease to exist. A sequential onion peeling type of break-up process, which would see only stronger core countries remain in the eurozone, is highly unlikely in our view. Policy makers should therefore plan primarily for the very limited break-up as well as the full-blown break-up scenario, which could be highly disruptive in the absence of any advance planning.

We see a real risk of break-up

The treaties of the European Union, which also define the rules of the monetary union, do not contain any specific procedure for a eurozone breakup. When the euro was created, policymakers wanted euro adoption to be irrevocable, and they did not want to spell out a route to exit. But the eurozone debt crisis has changed matters. The turmoil around the suggested Greek referendum on the bailout package in November 2011 illustrated that a break-up is no longer inconceivable. Following then-Prime Minister Papandreous proposal for a referendum, key European policymakers, including French President Sarkozy and eurogroup head Juncker, talked openly about a potential Greek exit from the eurozone. European policymakers continue to argue that they will do what is needed to save the euro. But the genie is out of the bottle, and various break-up scenarios are now being discussed more openly. In December 2011, new ECB President Draghi even commented on the consequences of a break-up in a Financial Times interview.

Fig. 1: Opinion poll measuring support for the euro

85% 80% 75%

Fig. 2: Italian CDS and default probability

EUR will remain in 10 yrs EUR is preferred currency

600 500

bp

Over 30% probability of default

70% 65% 60%

400 300 200

55% 50%

100 0

Jan.08
Note: Grey bars represent respondents who answered Yes to the question, Do you think the euro will remain your nations currency in 10 years? Red bars represent respondents who answered Yes to the question, Do you prefer the euro to your past national currency? Source: Nomura, Wall Street Journal

Jan.09

Jan.10

Jan.11

Jan.12

Source: Nomura, Bloomberg

In this context, a key question is what form a potential break-up the eurozone could take. There are various theoretical possibilities: a one-off departure of a single country, such as Greece; a sequential process, where weaker peripheral countries gradually peel off, like

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layers of an onion; and a big bang break-up, where the eurozone collapses in one go and the euro ceases to exist. Distinguishing which of these break-up scenarios is possible (even if the probability is relatively low) and which is highly improbable (close to zero probability) is important. It will influence how various eurozone assets trade and the euros behavior during the transition process to the final outcome. This determination should also help guide policy makers, in their efforts to make contingency plans for possible scenarios, even those which are not the central case outcome. We think only two main types of break-up scenarios (the very limited break-up and the big bang break-up) are realistically possible. Meanwhile, a sequential and prolonged break-up process, which resembles peeling an onion, is highly unlikely in our view.

A very limited eurozone break-up: possible

A very limited break-up involving one or a few smaller peripheral countries is a possibility, in our view. This scenario could happen in the face of a political setback in Greece and/or Portugal, which would translate into unwillingness to satisfy EU demands and the breakdown of bailout programs (see Nomura Europe Special Report: Event risk in Greece December 1, 2011). A break-up is unlikely to happen by explicit choice, given the very large economic cost involved and the very significant political capital already invested. Moreover, opinion polls suggest that support for the euro remains relatively high in the periphery (see Figure 1). But that does not mean that a break-up is impossible. The turmoil around the suggested Greek referendum in November illustrates how a political accident can suddenly put a break-up on the agenda. More recently, the possibility of an Irish referendum has become a real risk. For example, Irish Finance Minister Noonan declared before Christmas 2011 that a referendum for an EU treaty change would be a referendum for euro membership, highlighting once again how political developments can serve as catalysts for a break-up.

A big-bang eurozone break-up: possible

A big bang break-up could result from a default in a major eurozone country, such as Italy. Such a scenario would render the bulk of eurozone banks insolvent and leave the ECB incapable of providing liquidity to banks in an orderly fashion. Hence, this scenario would likely involve a full-blown collapse of the eurozone. The consensus among institutional investors we speak to globally is that this is a very low probability scenario. But this view does not seem to be fully consistent with the default risk implied by Italian sovereign bonds and CDS contracts. The current spread of 400bp on the 5yr CDS contract (as of end-January 2012) can be translated into implied default probability of just below 30% (over a five-year period), using standard recovery rate assumptions (see Figure 2), and this implied default probability reached substantially higher levels during the most intense days of market turmoil in November 2011. The market is pricing an Italian default not as the central case, but as a very significant tail risk, and it is doubtful whether the eurozone monetary system can withstand an Italian default. Moreover, accidents can happen in terms of economic and market developments too. Recent deposit and capital flow dynamics in the eurozone suggest that destabilizing cross-border capital flows are starting to take place. A further deterioration in these dynamics could destabilize the banking system to a degree where concerns about a break-up could start to have a self-fulfilling element. This is especially the case if capital flows start to leak out of the eurozone, mirroring the type of capital flight dynamics typically seen in emerging market currency crises.

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A sequential onion peeling break-up process: unlikely

We think a sequential break-up where the eurozone over time is reduced to a core of strong eurozone countries is highly unlikely to be feasible in practice. This is at least the conclusion if the time frame is just a few years. Such an onion peeling process, during which weaker eurozone countries gradually exit, is likely to come to a halt when the process reaches one of the larger eurozone countries, such as Italy or Spain. At this point, we think the process would likely become uncontrollable and lead to a big bang collapse, including the core countries. There are three main reasons why we think an Italian exit and default scenario is unlikely to be manageable and would translate into a big bang collapse of the eurozone: First, Italy is a part of Europes core: Italy was one of only six founding members of the EU more than 50 years ago. In fact, the founding treaty of the EU was signed in Rome in 1957. It is no coincidence that the ECB president is an Italian and that the previous ECB presidents were also from original founding member countries (Duisenberg from the Netherlands, Trichet from France). There may have been some doubt about Italys position and role under Prime Minister Berlusconi. But after his resignation, Germany and France have strongly endorsed Mario Montis technocratic government and Italy is clearly back in the core. Second, an Italian default and exit would likely bring down large parts of the eurozone banking system: An exit by Greece or Portugal may be manageable given that those countries are small, and given that preparations for potential debt restructuring have already been under way for some time. But an Italian default and eurozone exit is a completely different matter. The size of Italys debt burden has precluded an explicit sufficient official sector backstop up to this point, and an Italian debt restructuring may indeed be too much for the French banking system to handle. Figure 3 shows the exposures of French banks to Italian assets based on BIS statistics, and Appendix 1 contains some illustrative calculations of potential losses for French banks. The losses for French banks in a situation of Italian exit/restructuring could generate losses in excess of 20% of French GDP. Given that the French debt to GDP ratio is already set to reach around 90% during 2012, this additional contingent liability and a related drop in the level of French GDP could see the debt to GDP ratio jump to levels in the region 120%, similar to the level in Italy currently. Hence, an Italian default and exit scenario would likely make core eurozone banking systems so unstable that capital controls would be a distinct possibility, at which point the euro project would be obsolete.
Fig. 3: French exposure to eurozone periphery countries

French exposure to eurozone periphery ($ bn)

Type of Exposure Greece Public sector Banks Non-bank private Total
Source: Nomura, BIS

Ireland Portugal 2.9 9.8 19.3 32.0 6.2 6.2 13.3 25.7

Spain 30.5 38.6 81.8 150.9

Italy 106.8 44.7 265.0 416.4

Total 157.0 100.9 422.8 680.7

10.7 1.6 43.5 55.7

Note: See Appendix I, Fig. 1 for further detail on exposure to eurozone periphery.

Third, European policymakers have already articulated that an Italian default would spell the end of the European Monetary Union: When Chancellor Merkel and President Sarkozy meet with Mario Monti at the end of November 2011, Mr Montis office released a statement saying that Ms Merkel and Mr Sarkozy were aware that the collapse

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of Italy would inevitably be the end of the euro. As such, policymakers already recognize that failure to limit contagion to Italy would likely lead to a breakdown of the monetary union altogether. We therefore believe that even if a break-up begins to unfold in an onion peeling fashion, it will eventually spin out of control and turn into a big bang break-up of the eurozone. The conclusion is that policy makers should focus on contingency plans, which would minimize the disruptions associated with a very limited break-up and a full-blown breakup, in which the Euro ceases to exist. Those are the two main adverse scenarios to plan for.

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Section 2: Legal aspects of redenomination

Eurozone break-up risk has risen notably during the second half of 2011 as European policy makers have failed to put in place a convincing and credible backstop for the larger eurozone sovereign bond markets. Given this increased risk, investors and policy makers should think carefully about dynamics associated with redenomination of Euro denominated assets and obligations in a break-up scenario . There are important legal dimensions to this, including the legal jurisdiction of the assets and obligation in question. In order to determine which contingency plans would be helpful to facilitate and orderly break-up process, it is important to understand certain legal aspects of a redenomination process.

Redenomination risk: Which Euros will stay Euros?

Countries do change their currency from time to time. Argentina moved away from an effectively dollar-based economy in 2002, towards a flexible peso based currency system. Similarly, currency unions have seen break-downs in the past. The break-up of the Czechoslovakian currency union in 1993 and the break-up of the Rouble currency area between 1992 and 1995 are key examples from the relatively recent history. In the context of the eurozone, the issue of redenomination is complex because there is no well-defined legal path towards eurozone and EU exit. In addition, there is some debate about the specifics of Article 50 of the Treaty on the Functioning of the European 1 Union (TFEU) and the immediacy of its applicability . However, the recent political reality has demonstrated that the lack of legal framework for an exit/break-up is unlikely to preclude the possibility. Moreover, during its recent national congress the German CDU party approved a resolution that would allow euro states to quit the monetary union without having to also exit the EU. We note that this decision would need to be approved by the national parliament before having any legal power. Nevertheless, it shows the direction in which politics are moving. Since the risk of some form of break-up is now material, investors and policy makers 2 should be thinking about redenomination risk : Which Euro denominated assets (and liabilities) will stay in Euro, and which will potentially be redenominated into new local currencies in a break-up scenario?

The importance of legal jurisdiction

There are a number of important parameters, which from a legal perspective should determine the risk of redenomination of financial instruments (bonds, loans, etc). The first parameter to consider is the legal jurisdiction of an obligation. If the obligation is governed by the local law of the country which is exiting the eurozone, then that sovereign state is likely to be able to convert the currency of the obligation from EUR to the new local currency (through some form of currency law). If the obligation is governed by foreign law, then the country which is exiting the eurozone cannot by its domestic statute change a foreign law. If the currency is not explicit to the foreign contract, then it may be up to the courts to determine the implicit nexus of contract.

See P Athanasiou, Withdrawal and expulsion from the EU and EMU: Some reflections, ECB Legal Working paper series no 10, Dec 2009, (see link), although we note that the Commission has specifically said exit was not possible. 2 See, e.g., Eric Dor, Leaving the Euro zone: a user's guide, IESEG School of Management working paper series, 2011-ECO-06, Oct 2011, link. We note that France, Malta and Romania are not signatories to the Vienna Convention and this may complicate the international acceptance of Vienna-based methods of exit.

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Applying this principle to a scenario of Greek exit from the Eurozone, it implies that Greek government bonds issued under Greek law (which account for 94% of the outstanding debt), can be redenominated into a new Greek drachma. However, Greek Eurobonds, (which are issued under English law) or their USD-denominated bonds (under NY Law), would not easily be redenominated into a new local currency, and may indeed stay denominated in Euros. The second legal parameter to consider is the method for breakup. Is the method a legal or multilateral framework or is it done illegally and unilaterally? The method for breakup has vastly different consequences for the international recognition. Lawful and Consensual Withdrawal. There is debate about legal methods for exiting the Euro but there is some consensus around the use of Article 50 in the Lisbon Treaty. There may be other methods for opting out in the use of Vienna convention on the Law of Treaties3 if there is no agreement on the usage of Article 50, then this would accord more international jurisprudential acceptance. Unlawful and Unilateral Withdrawal. Treaties are merely contracts between sovereign nations and can be broken under some circumstances, and it may prove far more expedient to undergo a unilateral withdrawal rather than to wait for the vast array of agreements needed for consensual withdrawal. Similarly, expulsion could also be unlawful in theory. The third parameter to consider is the nature of the break-up, and what it means for the existence of the Euro as a functioning currency going forward. As discussed in section 1, there are many possible permutations, but they can be grouped into two main possible categories: Limited break-up: Exit of one or more smaller eurozone countries. In this scenario, the Euro will likely remain in existence. This scenario materializes if a few smaller countries, such as Greece and perhaps Portugal, end up exiting and adopt their own new national currencies. Full-blown break-up: In this scenario, perhaps precipitated by an Italian default, the Euro would cease to exist, the ECB would be dissolved, and all existing eurozone countries would convert to new national currencies or form new currency unions with new currencies, and new central banks.

This leaves four basic scenarios to consider, depending on whether obligations in question are issued under local or foreign jurisdiction and depending on the nature of the break-up. For obligations issued under local law, it is highly likely that redenomination into new local currency would happen through a mandatory statute/currency law. This is the case regardless of the nature of the break-up (unilateral, multilaterally agreed, and full blown break-up scenario). For example, Greek bonds, issued under local Greek law, are highly likely to be redenominated into a new Greek currency if Greece exits the eurozone. In fact, this is one of the underlying reasons why the current Greece restructuring is contemplating swapping old Greek bonds under local law into new Greek bonds issued under English law. For obligations issued under foreign law, the situation around redenomination is more complex. We will go into detail later. But before we do that, it is helpful to highlight the big picture:

Unilateral withdrawal and no multilaterally agreed framework for exit, foreign law contracts are highly likely to remain denominated in Euro. For example, Greek Eurobonds issued under UK law should remain denominated in Euros. Exit is multilaterally agreed, there may be certain foreign law contracts and obligations which could be redenominated into new local currency using the socalled Lex-Monetae principle, if the specific contracts in question have a very clear link to the exiting country, or if there is an EU directive specifying certain agreed criteria for redenomination. However, the large majority of contracts and obligations are likely to stay denominated in Euro.

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Full blown eurozone break-up: In a scenario where the eurozone breaks up in its entirety and the EUR ceases to exist, contracts cannot for practical purposes continue to be settled in Euros. In this case, there are three basic solutions. (1) obligations are redenominated into new national currencies by application of the Lex Monetae principle or there is significant rationale of the legal basis for the 3 argument of Impracticability or Commercial Impossibility . (2) where there is no specific nexus established to a country which previously used the EUR, (and thus the Lex Monetae principle cannot be used), an EU directive could be implemented ensuring that existing EUR obligations are converted into a new European Currency Unit (ECU-2), reversing the process observed for ECU denominated obligations when the Euro came into existence in January 1999. (3) Euro denominated obligations could in theory be settled in an international foreign currency, such as GBP or USD, as per terms implicit in English and NY Law contracts, with exchange rates as determined by directive, legislation, or by Courts

Fig. 4: Redenomination risk on eurozone assets

Small Break-Up scenario: EUR remains the currency of core Eurozone countries Unilateral withdrawal Multilaterally agreed exit

Full-blown Break-up Scenario: Euro ceases to exist

Securities/Loans etc governed by international law

No general redenomination: EUR remains currency of payment, although certain EUR Redenomination happens either No redenomination: EUR remains contracts/obligations could be to new local currencies by the currency of payment (except redenominated using lex applying lex monetae principle or in cases of insolvency where local monetae principle (if there are by converting coart may decide awards) special attributes of contracts) contacts/obligations to ECU-2 and/or an EU directive setting criteria for redenomination

Securities/Loans etc governed by local law

Redenomination to new local currency (through change in local currency law, unless not in the interest of the specific sovereign)

Source: Nomura

The need for an ECU-2 and EU directives in a break-up

There are a number of practical difficulties associated with creating a new European Currency Unit (ECU-2) to provide a means of payment on EUR denominated contracts and obligations. We will address those issues in detail in Section 7 (Do you remember the ECU?). For now, we simply want to highlight the introduction of the ECU-2 as a attractive option for settling payment on EUR obligations and contracts in the full-blown break-up scenario. Without some overriding statutory prescription, the Courts are left having to decide the currency of each contract. While this has certain advantages given the overall flexibility of the Lex Monetae principle (see Box 3: Lex Monetae) for attempting inference as to the originally intended (and likely more equitable) currency of the contract, in the event of complete split-up, it is likely that a great many ambiguous cases result in arbitrary awards. For example, if English courts decided on redenomination into British pounds, as case

The more common Frustration of Contract is unlikely to apply, see Procter, Euro-Fragmentation.

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law gives precedence to (as highlighted by Charles Proctor), clearly the redenomination process would involve currency risk that would seem rather arbitrary, and would depend crucially on conversion rates decided upon by courts, (i.e., most likely some last official EUR-GBP exchange rate before trading halted). As we will discuss in more detail later, the lack of an economically fair unit for settling purposes would likely lead to a large number of redenomination related bankruptcies. This is the key attraction of a new European Currency Unit. While courts themselves will be unable to apply a conversion to a new ECU-2 without some overriding legislation, it would be necessary for the EU Council to adopt a directive, essentially to the effect of:

Where the EUR was previously the currency of denomination of any contract that is not so determined to have a nexus to any one particular country which had previously used the EUR, it will henceforth be redenominated into the ECU. As Governing Law is one of several determinants of the nexus of a given contract, it is altogether likely that national courts would only apply this directive in the case where the governing law is that of an EU country, not in the Eurozone, i.e., England, Scotland, Northern Ireland, Wales, Sweden, Denmark and the CEE. Furthermore this directive could only apply where there was no means for the courts to infer a nexus of the contract under the other typically usual terms of Lex Monetae as highlighted in the grey box below.

Box 1: Lex Monetae

Lex Monetae or the law of money is a well determined principle with a great deal of case law. It is generally established that sovereign nations have the internationally recognised right to determine their legal currency. Reliance on this principal was actually key to the establishment of the EUR itself (see W Duisenberg, The Past and Future of European Integration: A Central Banker s Perspective, IMF 1999 Per Jacobsson Lecture, see link). For a brief overview of the principle, see C Proctor, The Euro-fragmentation and the financial markets, Cap Markets Law J (2011) 6(1) (see link) or The Greek Crisis and the Euro A Tipping Point, June 2011 (see link) and for a more in-depth exposition as well as the history of case law, C Proctor, Mann on the Legal Aspect of Money, 6th Ed, Oxford UP, 2005 (see link). When thinking about the likely redenomination process, the following parameters are likely to be crucial in order to establish the legal territorial nexus of contract/obligation: 1. Explicit Nexus of contract can be established via a (re)denomination clause: The EUR or in any event the legal currency of <Exiting Country> from time to time. Implicit Nexus of contract if a. b. c. Contract is governed by the Laws of <Exiting Country> Location of Obligor (debtor) is <Exiting Country> Location which action must be undertaken (e.g., place of payment) is <Exiting Country> Place of payment is <Exiting Country>

2.

d.

If no denomination clause exists, it is up to the courts to determine the Implicit Nexus of the contract. Was EUR meant to be EUR or the currency of the <Exiting Country>? If all of the factors mentioned tie the contract to the <Exiting country>, there is a rebuttable presumption that the parties to the contract had intended to contract on the currency of the <Exiting Country>. If one or more of the implicit tests fails, it is highly likely that there is insufficient evidence to determine the link to the <Exiting Country> and the contract or obligation is likely to kept in EUR. We expect that under this principle, the vast majority of English Law contracts originally denominated in EUR will remain in EUR (if it exists).

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Risk premia and legal jurisdiction

The overall conclusion from our perspective is that the risk of redenomination of EUR obligations into new local currency is higher for local law obligations than for obligations issued under foreign law, and this type of differentiation based on redenomination risk is already starting to impact investor behavior. This distinction is especially relevant in scenarios where the break-up is limited, and where the EUR remains a functioning currency. In the alternative scenario of a full-blown break-up, redenomination into new local currency or ECU-2 is possible even for foreign law bonds, and there is a less clear-cut case for differing risk premia based on different jurisdictions. In any case, the immediate conclusion from an investor perspective should be that assets issued under local law should trade at a discount to foreign law obligations, given the greater redenomination risk for local law instruments. This conclusion is based on the implicit assumption that a new national currency would trade at a discount to the Euro. Obviously the validity of this assumption will depend on the specific country in question, but most would agree that this assumption is likely to be correct for countries such as Greece, Portugal, Ireland, Spain and Italy, and our analysis in Appendix III substantiates this. The caveat to this argument is that insolvency may alter the conclusion. In the case of insolvency, foreign law obligations may remain denominated in Euro (in a limited breakup scenario). But there could still be a material hair-cut on foreign law obligations. Hence, in an insolvency, whether local law obligations should trade at a discount to similar foreign law obligations will then depend on an evaluation of the higher redenomination risk relative to the size of likely haircuts on local law vs foreign bonds. If hair-cuts on foreign law bonds are higher than local law bonds, that could negate the redenomination effect, and foreign law bonds should no longer trade at a premium in this scenario.

More detail on legal jurisdiction

In making contingency plans for various break-up scenarios, policy makers would need to understand issues around the redenomination process in detail. This is an extremely complex issue to think about in totality, and it would require significant leg work by key European institutions to aggregate issued at the micro level to a full macro perspective. The table below highlights the legal jurisdiction of a number of key eurozone assets. While we cannot claim completeness, we have attempted to highlight the appropriate governing principals, whether Local, English or NY and the body of law (e.g. Banking Law for deposits, Covered Bond law for Pfandbriefe, Company Law for Equities) which governs each security, contract or interest. In the case of English or NY law, the only relevant body of law likely will be contract law, as foreign law is only used as a means of contracting outside of a local jurisdiction, and no specific foreign statute could have an impact. We give examples of the various financial instruments which trade. For instance, while BTPs and GGBs are governed by local statute and local contract law and for the most part international bonds (Rep of Greece Eurobonds, and Rep of Italy Eurobonds) are governed by English law or NY law, there are some countries which have issued international bonds (i.e., for international investors) under local law, making the outcome of a redenomination far less certain given the ambiguity of the nexus of the governing law. What is obvious as well about this table is the vast number of master agreements which underpin most financial transactions. These include the various swap agreements from ISDA (under NY or English law) to those under French, German or Spanish law, as well as the various Repo and Securities Lending master agreements and MTN platforms for issuing bonds. Each master agreement involves far more paperwork than a single standalone swap contract or bond. But the setup costs ensure that once the master agreement is finished, individual swap and bond transactions can be documented quickly and efficiently. Moreover some master agreements such as MTNs may be flexible enough as to allow the issuance of bonds to be under various different governing laws.

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Fig. 5: Governing law and standard financial securities and contracts

Governing Law Governing Law Local Law Local Law Law Governing
Local Law

Security Type Security Type Sovereign Bonds, Bills Sovereign Bonds, Bills Security Type International Bonds International Bonds Sovereign Bonds, Bills
International Bonds Corporate Bonds Corporate Bonds Covered Bonds (Pfandbriefe, OF, Covered Bonds (Pfandbriefe, OF, Corporate Bonds Cedulas, etc) Cedulas,Bonds (Pfandbriefe, OF, Covered etc) Schuldscheine Schuldscheine (marketable loans) Cedulas, etc) (marketable loans) Loans Loans Schuldscheine (marketable loans) Equities Equities Loans Equities Commercial Contracts Commercial Contracts Deposits Commercial Contracts Deposits Sovereign Deposits Bonds Sovereign Bonds Sovereign Bonds

Body of Law Body of Law Local Statute/Contract Local of Law Body Statute/Contract Local Contract Local Contract Local Statute/Contract
Local Contract Contract Contract Covered Bond Law Covered Bond Law Contract (Pfandbriefe) (Pfandbriefe) Law Covered Bond Contract Contract (Pfandbriefe) Contract Contract Company Company Contract Company Contract Contract Banking Contract Law Banking Law Contract Banking Law Contract Contract

Examples Examples GGBs, Bunds, OATs GGBs, Bunds, OATs Examples Rep of Italy, Kingdom Rep of Bunds, OATs of Spain, etc GGBs, Italy, Kingdom of Spain, etc
Rep of Italy, Kingdom of Spain, etc

Pfandbriefe, Obligacions Foncieres, Pfandbriefe, Obligacions Foncieres, Cedulas, Irish CBs Cedulas, Irish CBs Pfandbriefe, Obligacions Foncieres, Banking Irish CBs Banking schuldscheine Cedulas,schuldscheine Banking schuldscheine Any EU Equity Any EU Equity Any EU Equity CDs CDs Greek CDs Euro-bonds, Rep Italy Greek Euro-bonds, Rep Italy Eurobonds, Kingdom of Belgium USDGreek Euro-bonds, Rep Italy Eurobonds, Kingdom of Belgium USDdenominated bonds Eurobonds, Kingdom of Belgium USDdenominated bonds denominated bonds Euro-Loans Euro-Loans Euro-Loans Yankees, Samurai, Kangaroos, Maple, Yankees, Samurai, Kangaroos, Maple, Bulldogs, Dim Sum, Kauri, Sukuk, etc Yankees, Samurai, Kangaroos, Maple, Bulldogs, Dim Sum, Kauri, Sukuk, etc Bulldogs, Dim Sum, Kauri, Sukuk, etc

English Law English Law English Law

NY / Other Law NY / Other Law NY / Other Law

Master Agreements Master Agreements Master Agreements

Corporate Bonds (Euro-bonds) Corporate Bonds (Euro-bonds) Loans (Euro-Loans) Corporate Bonds (Euro-bonds) Loans (Euro-Loans) Commercial Contracts Loans (Euro-Loans) Commercial Contracts Sovereign Bonds Commercial Contracts Sovereign Bonds Sovereign Bonds Corporate Bonds Corporate Bonds Loans Corporate Bonds Loans Commercial Contracts Loans Commercial Contracts International Swap Dealers Commercial Contracts International Swap Dealers Association Swap International(ISDA) Dealers Association (ISDA) Commodity (ISDA) Association Master Agreements Commodity Master Agreements Commodity Master Agreements Rahmenvertrag fr Rahmenvertrag fr Rahmenvertrag fr Finanztermingeschfte (DRV) Finanztermingeschfte (DRV) Finanztermingeschfte (DRV) Fdration Bancaire Franaise Fdration Bancaire Franaise Fdration Bancaire Franaise (AFB/FBF) (AFB/FBF) (AFB/FBF) Contrato Marco de Operaciones Contrato Marco de Operaciones Contrato Marco de Operaciones Financieras (CMOF) Financieras (CMOF) Financieras (CMOF)Repurchase ICMA Global Master ICMA Global Master Repurchase ICMA Global Master Repurchase Agrement (GMRA) Agrement (GMRA) Agrement (GMRA) Agreement Master Repurchase Master Repurchase Agreement Master Repurchase Agreement (MRA) (MRA) (MRA) European Master Agreement (EMA) European Master Agreement (EMA) European Master Agreement (EMA) General Master Securities Loan General Master Securities Loan General Master Securities Loan Agreement (GMSLA) Agreement (GMSLA) Agreement (GMSLA) Agreement Master Securities Loan Master Securities Loan Agreement Master Securities Loan Agreement (MSLA) (MSLA) (MSLA)Medium Term Note (Euro) Medium Term Note (Euro) Medium Term Note (Euro) Programme (MTN/EMTN) Programme (MTN/EMTN) Programme (MTN/EMTN)

Contract Contract Contract Contract Contract Contract Contract Contract Contract

Contract Contract Contract Contract Contract Contract Contract English Contractor NY Contract English or NY Contract English or NY Contract Various for each commodity Various for each commodity Various for each commodity German Contract German Contract German Contract French Contract French Contract French Contract Spanish Contract Spanish Contract Spanish Contract

IR Swap/Fwd, FX Swap/Fwd, CDS, IR Swap/Fwd, FX Swap/Fwd, CDS, Bond options IR Swap/Fwd, FX Swap/Fwd, CDS, Bond options Gold options BondSwaps/Forwards, Electricity Gold Swaps/Forwards, Electricity Gold Swaps/Forwards, Electricity Swaps/Fwds, etc Swaps/Fwds, etc Swaps/Fwds, etc with German Swaps and Repos Swaps and Repos with German Swaps and Repos with German counterparties counterparties counterparties Swaps with French counterparties and Swaps with French counterparties and Swaps with French counterparties and all local authorities all local authorities all localwith Spanish counterparties Swaps authorities Swaps with Spanish counterparties Swaps with Spanish counterparties Repo Agreements Repo Agreements Repo Agreements Standard NY Law Repo Agreements Standard NY Law Repo Agreements Standard NY Law Repo Agreements Repo with Euro-systems NCB/ECB Repo with Euro-systems NCB/ECB Repo with Euro-systems NCB/ECB Sec lending Sec lending Sec lending Sec lending Sec lending Sec lending WB, Rep Italy, EIB MTN Programmes WB, Rep Italy, EIB MTN Programmes WB, Rep Italy, EIB MTN Programmes

English Contract English Contract English Contract NY Contract NY Contract NY Contract English Contract English Contract English Contract English Contract English Contract English Contract NY Contract NY Contract NY Contract English or NY Contract English or NY Contract English or NY Contract

Other Other Other

Bond Futures (Eurex) Bond Futures (Eurex) Bond Futures (Eurex) IR Futures (Liffe) IR Futures (Liffe) IR Futures (Liffe) Equity Futures Equity Futures Equity Futures OTC Futures OTC Futures OTC Futures Clearing Houses (LCH, ICE, etc) Clearing Houses (LCH, ICE, etc) Clearing Houses (LCH, ICE, etc) Cash Sales Cash Sales Cash Sales

German Contract German Contract German Contract English Contract English Contract English Contract Local Law/English Law Local Law/English Law Local Law/English Law English or NY Contract English or NY Contract English or NY Contract English Contract, etc English Contract, etc English Contract, etc Sales or Transaction Sales or Transaction Sales or Transaction

Bund, Bobl, Schatz, BTP Futures on Bund, Bobl, Schatz, BTP Futures on Bund, Bobl, Schatz, BTP Futures on Exchange Exchange Exchange Euribor Contracts on Exchange Euribor Contracts on Exchange Euribor Contracts on Exchange SX5E, DAX, CAC40, MIB, IDX, IBEX, SX5E, DAX, CAC40, MIB, IDX, IBEX, SX5E, DAX, CAC40, MIB, IDX, IBEX, BEL20, PSI-20,WBA ATX BEL20, PSI-20,WBA ATX BEL20, PSI-20,WBA ATX Client back-to-back futures with Client back-to-back futures with Client back-to-back futures with member firm member firm member firm Repo, CDS etc via clearing houses Repo, CDS etc via clearing houses Repo, CDS etc via clearing houses All cash sales prior to settlement (i.e., All cash sales prior to settlement (i.e., All cash sales prior to settlement (i.e., before T+3) before T+3)

Source: Nomura

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The judicial process

In terms of the judgment, there will likely be some variance as to courts decisions based on both the method for introduction of the new currency and any legislation directly binding on the courts. The general criteria for decision is as follows: Local Courts

Specific Legislation (a currency law) for Redenomination of Local Contracts into new currency can bind courts and overrule any contractual terms. It is particularly likely that contractual terms will be changed to re-denominate all local law contracts.

English Courts:

Lawful and Consensual Process implies application of Lex Monetae principle: if legal nexus is to the exiting country then redenomination can happen in some cases. Otherwise, the Euro will remain the currency of payments. Unlawful and Unilateral Withdrawal - No redenomination -- As UK is signatory to the Treaties, unlawful withdrawal is manifestly contrary to UK public policy and no redenomination will likely allowed. EU Directive/UK Statute to redenominate and ensure continuity of contract: English Court must uphold UK statute and/or interpret UK Statute so as to be in agreement with EU directive and re-denominate.

NY/Other Courts:

Lex Monetae principle: If legal nexus is to the exiting country then redenominate. Otherwise, leave in euro. NY (or other) Statute to redenominate and ensure continuity of contract. NY Courts must uphold NY State Legislation and redenominate contracts if so directed.

We note that the difference between lawful and unlawful exit/breakup is crucial for UK courts. This is, in particular, because the UK was signatory to the treaties, and unless otherwise directed, a Legal tender law from an exiting country in flagrant violation of the treaties will be considered to be manifestly contrary to UK public policy and the Lex Monetae of the Exiting Country will likely not be upheld in UK Courts. The legality of exit is of little consequence to NY and other non-EU courts and probably will not prejudice their judgments. We thus expect that foreign law will insulate contracts from redenomination in the vast majority of cases, and in the UK in particular, will do so in all cases when the method of exit is unilateral and illegal. The one overriding concern would be the introduction of legislation (NY or EU/English) which circumvents any court decision, although due to the politics of exit, it is unlikely that any such legislation would occur unless there were complete breakup. In a scenario where the eurozone breaks up in its entirety and the EUR ceases to exist, contracts cannot for practical purposes continue be settled in Euro s. In this case, there are two basic solutions. Either obligations are redenominated into new national currencies by application of the Lex Monetae principle or there is significant rationale of the legal 4 basis for the argument of Impracticability or Commercial Impossibility . Alternatively, existing EUR obligations are converted into a new European Currency Unit (ECU-2), reversing the process observed for ECU denominated obligations when the Euro came into existence in January 1999. With specific mention of sovereign bonds, it is likely that local law sovereign bonds will immediately be redenominated, while the foreign-law bonds, with obvious international distribution, would likely remain in EUR.

The more common Frustration of Contract is unlikely to apply, see Protter, Euro-Fragmentation.

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Enforcement
The court of judgment is of some matter, but the court of enforcement is of paramount importance in determining payoffs. In particular, if the court is: Local Court:

Courts will enforce only in the local currency (as per the new Currency law) and conversion will take place at the time of award or at some official rate (which may differ from the market rate (see Nomuras Global Guide to Corporate Bankruptcy, 21 July 2010, link.) Insolvency: If the entity is undergoing an insolvency governed by local law, conversion is generally made at time of insolvency filing (irrespective of eventual award). There probably will be uncertainty over the timing of payment and the conversion rate may not be at market rates, but exchange controls may further complicate repatriation of awards.

English NY/Other Court:

Redenomination is unlikely to change the award and enforcement will likely be made in appropriate foreign currency. Insolvency: If English or other court is determined to be the appropriate jurisdiction for insolvency, then delivery in appropriate foreign currency (see Global Guide to Corporate Bankruptcy, link)

The combination of the award and the enforcement risk highlight a number of interesting credit concerns. If there is an exit, local law instruments will typically be redenominated and there will be little protection in them, but foreign law affords far greater protection. If on the other hand the exit also involves an insolvency, foreign law instruments may similarly afford little protection. This would be true, for instance, for Greek bonds. Generally, investors look to Greek Eurobonds for the extra protection afforded by English Law in an attempt to avoid some of the restructuring risk in GGBs. If, on the other hand, we take exit into account, it would make more sense for the Greek government to continue to service their GGBs using seignorage revenue (or perhaps with support of the CB) and default on the overly expensive Eurobonds. The current PSI discussions underway, however, appear to give little comfort to holders of either Greek or foreign law debt.

Legal aspects of redenomination and contingency planning

The purpose of this section has been to outline a number of important legal aspects of a currency redenomination process in a Eurozone break-up. A detailed understanding of these conceptual issues is a prerequisite for adequate contingency planning in an orderly redenomination process for European policy makers. In the next section, we will offer some preliminary estimates of the size of various Euro exposures, broken down by legal jurisdiction. Proper planning for orderly redenomination should be guided both by the underlying conceptual legal aspects of redenomination as well as the economic importance of certain types of exposures currently in place across the broadest possible spectrum of relevant markets.

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Section 3: Size of Euro assets by legal jurisdiction

In making contingency plans for a Eurozone break-up, it is instructive to think about the size of exposures involved, and the aggregate currency risks potentially associated with a redenomination process. Since Euro adoption was supposed to be irrevocable, very little attention has been paid to legal jurisdiction of assets and obligations up to this point. But there are ways to estimate the importance of foreign law assets and obligations. These estimates highlights the very large size of Euro obligations under English and New York law in the form of FX swap and forward contracts, as well as interest rate derivatives. The huge size of these markets illustrates that complications related to a redenomination process have potential to have dramatic macro economic implications.

We argued in section 2 that the legal jurisdiction of a given asset or obligations would play a crucial role in a redenomination scenario. Against this background, it is instructive to break eurozone assets and obligations into their legal jurisdiction. In practice, however, this is much easier said than done, since there is no official data available. The universe of Euro denominated instruments is rather large, involving bonds, loans, deposits, fx forwards, interest rate swaps, as well as a myriad of derivative contacts. Information about the legal jurisdiction of such instruments has generally been ignored by market participants, except in situations involving insolvencies. But information about legal jurisdiction is now becoming relevant, including from a macro perspective, as a parameter to evaluate in order to assess systemic risks.

Euro denominated bond markets by legal jurisdiction

Generally, bond markets offers more transparency than loan, forward, and swap markets, which are dominated by over-the-counter (OTC) transactions and therefore harder to monitor from an outsiders perspective. But even for the bonds, good and detailed information about the legal jurisdiction of assets is generally not available. There are ways, however, to try to extract this information, bond by bond. One source which can be used to get a sense of the break-down of eurozone assets by legal jurisdiction is Bloomberg. We scanned all debt instruments by eurozone issuers which are listed on the Bloomberg system. In total, the sample covers in excess of four hundred thousand individual bonds, and we believe Bloomberg is likely to cover the majority of bond issues, at least the larger ones relating to eurozone issuers (Appendix II compares the figures derived from Bloomberg with BIS data, and the overall magnitudes are generally similar). The overall sample covers around EUR16.0 trillion of bonds issued by Eurozone issuers, of which EUR14.2 trillion were Euro denomination. To be specific, the sample of Euro denominated bonds includes 436998 bonds, from the 11 larger Eurozone countries (excluding Malta, Cyprus, Slovenia, Slovakia, Estonia and Luxemburg), which we analyzed in detail. We note that the database, which is derived from this source does not cover bonds in Euro issued by non-eurozone issuers. But such an exercise would be relatively straightforward to run. The tables below show a general break-down of bonds issues by eurozone issuers broken down by legal jurisdiction. Key figures to note, for allocated issues, include: EUR224b of foreign law bonds in the sovereign category.

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EUR684bn of foreign law bonds in the financial issuer category. EUR432bn of foreign law bonds in the non-financial (corporate) category.

We note that the available data does not have information about jurisdiction for every single issue. For sovereign issues, this seems a smaller problem, as most issues have this information. But for non-financial issuers (corporations) the information about legal jurisdiction is unknown for the majority of issues. However, among the issued with known jurisdiction we find that EUR432bn or 60% is under foreign law. If we apply this percentage to the entire population of Euro denominated corporate debt, it suggests that EUR1.3 trillion could be issued under foreign law. This highlights that the redenomination process could be extremely complex for corporate debt in general. Figure 6 below has the detailed figures broken down by the eleven Eurozone countries which we have scanned (Noting that amounts listed under the sovereign header include subsovereigns, i.e., regions and municipalities, and agencies):

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Fig. 6: Euro-denominated bond amounts outstanding in the eurozone (EUR bn)

Sovereign
Local Law Austria Belgium Finland France Germany Greece Italy Ireland Netherlands Portugal Spain Total 176 309 69 1421 1530 256 1517 114 282 107 638 6420

Financial

Nonfinancial Total
459 446 115 2466 3916 360 2673 579 1363 244 1608 14230

Foreign Foreign Foreign Unknown Local Law Unknown Local Law Unknown Law Law Law 2 1 151 58 30 11 19 9 16 5 2 7 1 10 9 86 1 0 9 14 10 3 8 1 19 12 422 139 125 139 89 100 1 23 2053 66 130 54 16 43 9 5 19 18 47 2 3 1 74 14 567 141 90 17 43 210 0 0 51 111 49 0 15 239 15 0 188 81 131 23 196 448 13 2 39 16 22 16 2 26 74 16 490 32 33 14 32 279 224 80 3990 684 670 288 432 1443

Source: Nomura, Bloomberg

The table below, Figure 7, offers additional detail on the specific foreign jurisdiction which applies. As it turns out, the most relevant foreign jurisdictions are English, German, and New York. For simplicity, the data is reported as aggregate figures, rather than broken down by individual Eurozone countries. The main message here is that English law accounts for the majority of all foreign law issues, especially for sovereign and financial issuers. For the non-financial (corporate) issuers, we note that a number of Eurozone issuers seem to use German law rather than their own domestic jurisdiction. Meanwhile, New York law applies to just below 10% of financial and non-financial issuance under foreign law, and less than that for sovereign issues.

Fig. 7: International EUR-denominated bond amounts outstanding (EUR bn)

Sovereign
Amount Outstanding (EUR bn) Total 258.7 Unallocated 79.6 Allocated 179.0 Local 121.0 Foreign 58.1 English 51.7 New York 2.1 German 1.9 Other 2.3
Source: Nomura, Bloomberg

Financial
% 100% 31% 69% 68% 32% 89% 4% 3% 4% Amount Outstanding (EUR bn) 2304.4 669.8 1634.7 1060.2 574.5 454.4 50.2 42.9 26.9 % 100% 29% 71% 65% 35% 79% 9% 7% 5%

Nonfinancial
Amount Outstanding (EUR bn) 1931.6 1442.5 489.0 138.2 350.8 200.7 31.1 115.1 3.9 % 100% 75% 25% 28% 72% 57% 9% 33% 1%

Total
4494.7 2191.9 2302.7 1319.4 983.3 706.8 83.4 159.9 33.2

Euro denominated derivatives by legal jurisdiction

Turning to derivatives markets, the importance of foreign law jurisdiction grows further, including for basic markets such as FX forwards, FX swaps, and interest rate swaps. These contracts are generally written with reference to English and New York law, which would add significant complexity to any redenomination process. Moreover, these markets are very large in size. The outstanding notional of FX forwards and FX swaps is potentially very large, potentially in the EUR15-25trillion range. We are not aware of any official estimates of the notional size outstanding of FX forwards, but one way to proxy it would be to look at daily turnover statics, estimate average maturity of contracts, and supplement with information about the Euros share in these transactions

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The latest Tri-annual BIS surveys states daily FX market turn-over of $2.5trillion, when excluding spot transactions), The average tenor of contracts traded is estimated to be roughly around 1 month, based on input from Nomuras Foreign Exchange Franchise. The Euro share of FX market turn-over is 40%, again according to BIS.

Working with the assumption of 22 trading days in a month, this would give a proxy estimate of outstanding notional of Euro denominated FX forward, swap and other derivates of around USD22 trillion, or EUR17 trillion at the current EURUSD exchange rate. Without going into details, we simply note that the outstanding notional amounts of Euro based interest rate swaps is also very large. Since it is generally the case that these instruments are traded predominantly under English or New York law agreements, it would be very complicated to redenominate such contracts in an economically fair fashion in a break-up scenario, as they would have no clear nexus to a given country.

Euro denominated loans assets by legal jurisdiction

As with derivatives contracts, there is a general lack of information about the legal jurisdiction under which loans are extended. BIS data for the third quarter of 2011, which were released in January 2012, shows that total cross-border loan exposure in Euro reported by global banks add up to USD11 trillion. It is our understanding that a large portion of these loans are governed by foreign laws, particularly English law , although we are not aware of any publicly available database to quantify the split by legal jurisdiction more specifically.

Information gaps and redenomination complexity

The bottom line from the examples presented here is that Euro denominated exposure in foreign law contracts is very large. In addition to the relatively well-defined exposure in bond markets (in the region EUR2.5 trillion), there may be around EUR10 trillion such exposure in the form of cross-border EUR denominated loans. In addition, FX related derivates, may involve outstanding notional amounts in the region EUR15-25 trillion. Even excluding the exposure through Euro denominated interest rate swaps, aggregate exposure to foreign law Euro denominated instruments could easily add up to a figure well in excess of EUR30 trillion. And since the majority of these instruments are governed by foreign law, it would create major redenomination issues in a break-up scenario. One added complexity is the fact that many such transactions involve laws of several countries. For instance, it would be possible to have issued an ABS securitization of Spanish assets under English law. There are similar complexities involving so-called back-to-backs, where banks generally intermediate trades which are meant to be economically hedged, but the underlying contracts have several jurisdictions. A common example is members facing Eurex under German law, but facing non-member investors in a back-to-back contract under English law. Regulators would need to investigate the break-down of assets by legal jurisdiction more carefully to close the current information gap. The analysis above of bond market information is based on a sample of more than four hundred thousand bonds. But this sample is not covering the entire spectrum of bonds outstanding. More importantly, there is almost no aggregate data available on the legal jurisdiction of derivatives and loan contracts. Regulators, in preparation for a possible break-up, should seek to quantify the exposures at the institutional level to instruments of different jurisdiction, in order to determine implicit open currency exposures, and determine the need for planning across various

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jurisdictions, including English, New York and other jurisdictions. In particular, these derivative transactions and back-to-backs where several legs could potentially be differently redenominated, which will be the cause for far greater scrutiny by regulators and Courts seeking resolutions which are the least disruptive to the majority of counterparties involved.

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Section 4: Cost-benefit aspects of planning ahead

There is a general perception that any mention of contingency plans for a euro-zone break-up would lead to increased investor anxiety. But investor concerns about the risk of a eurozone break-up are already present. Moreover, the elevated uncertainty about key legal and political aspects of a possible redenomination process makes it hard for investors to manage risk related to their eurozone exposures. At this point in the crisis, communicating contingency plans for a break-up would reduce uncertainty, rather than add to it, and potentially even improve the current capital flow situation.

Uncertainty about the eurozone is affecting investor behavior

There was no plan for a eurozone break-up when the European Monetary Union was created. In fact, policymakers made an effort not to spell out any procedures for an exit from the eurozone as euro adoption was supposed to be irrevocable. But the genie is now out of the bottle. As mentioned in Section 1, various forms of eurozone disintegration are possible, ranging from a very limited break-up (involving one or a few small countries), to a full-blown break-up (which would see the euro cease to exist). The increasing risk of a break-up is already having an impact on investor behaviour. Since the Italian bond market came under pressure in mid-2011, foreign investors have been looking to reduce their eurozone exposure across the board, both in the periphery and in the core. In December 2011 and January 2012, we have also seen a shift in euro trading dynamics. Euro weakness is now seen in the strength of currencies from both emerging markets and other European countries relative to the Euro. This is a departure from patterns observed up to November, when euro weakness was concentrated versus the US dollar and the Japanese yen. The recent broadening of the euro weakness points to nascent capital flight out of the eurozone. This would be a disturbing development, if it continues. Since fears about a break-up are already present and affecting investors flows, the costbenefit analysis of announcing contingency plans for a break-up is very different to what it would have been in 1999. At this juncture, contingency plans would help to reduce uncertainty, rather than add to it.

The private sector is making contingency plans in any case

Foreign investors around the world, as well as institutions within the EU are already trying to make contingency plans for a eurozone break-up. The types of market participants making such plans includes global central banks and major banking institutions. There is even evidence that some regulators outside the eurozone are asking banks to submit contingency plans for various eurozone break-up scenarios. Against this background, the cost-benefit analysis of planning ahead versus pretending that a break-up is not possible has shifted: Back in 1999, it would have created unnecessary uncertainty to spell out procedures for and exit (although perhaps it could be argued that awareness of the exit possibility it would have avoided the seemingly irrational spread compression in Eurozone bond markets generally observed during 1999-2007). Today, the cost-benefit analysis is clearly different. The worlds biggest investors are already drawing up contingency plans. They have to, since objective market based metrics are showing high default risk in the biggest eurozone bond markets, and since policy makers are increasingly open about the possibility of various break-up scenarios, ranging from the very limited break-up, to the full-blown collapse of the monetary union.

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There is no simple way to prove that these specific considerations are affecting investor investor behavior and flows. But recent trends in Eurozone cross-border capital flows point to a new form of structural weakness, suggesting that concerns of a new type is driving investors away. In the July to November period, foreign investors purchased eurozone fixed income instruments to the tune of only EUR66bn, or EUR160bn annualized. This compares to an inflow of EUR270bn in H1, or EUR540bn annualized, and is a very large swing (see Figure 8). Only a small part of the eurozone bond market has consistently traded as a risk-free asset. Downgrades have hit Italian and Spanish bonds, and all major rating agencies have recently warned that France could see its AAA rating put in question. More generally, there is now a certain type of stigma associated with European exposures, making it more difficult for US banks to hold such exposures, for example. These factors point to a more structural form of weakness, which is less likely to be impacted by short-term changes in risk sentiment. The fact that weakness in inflows into Eurozone debt instruments has persisted over the July-November period, through ups and down moves in risk assets, supports this notion. Importantly, investors are no longer substituting from the periphery to the core. This was the case in 2010, when weakness in the periphery tended to generate additional demand for German and French bonds. But in the second half of 2011, there has been no evidence of a substitution effect. In fact, foreign sales appear to be broad-based, including sales of core eurozone bond holdings.

Fig. 8: Fixed income investment into eurozone (monthly by region of investors)

(EUR bn) 80 US Japan Other area Total

60

40

20

-20 Net selling -40 2007 2008 2009 2010 2011

Note: 3 month moving average. Source: Nomura, Bloomberg, MOF, US Treasury.

For example, private investors in Japan, were large net-sellers of eurozone fixed income assets during August November (see Figure 9), and they were selling not only the three small peripheral countries, and Spain/Italy. They were also selling out of core exposures. In addition, global central banks demand for Eurozone bond appear to have dropped too. This is partly a function of slower global reserve accumulation than normal. But it could hint at a shift in preference for eurozone bonds within the official sector too.

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Fig. 9: Japanese investment in eurozone fixed income (periphery, Spain/Italy, and core)
(EUR bn) 8

Other countries Spain & Italy 3 peripheral countries Euro area total

6 4
2

0 -2
-4

-6
Net selling

-8 2007 2008 2009 2010 2011

Note: Monthly figures calculated as 3-month moving average. November figure is Nomura estimate. Source: Nomura, MOF, Bloomberg.

Uncertainty makes risk-management difficult

Making contingency plans is currently very difficult given the huge legal uncertainty around the break-up process. It is very difficult for investors to assess with confidence what would happen to certain assets and obligations in a break-up scenario: What is the redenomination risk for local law assets? How would the redenomination process work for the myriad of English and New York law assets?

Against this background, there is now an opportunity to reduce ex ante uncertainty by offering a plan. This advantage comes in addition to the benefits such well thought out plans would have on market functioning in an actual break-up. As we will detail below, a suitable contingency plan will offer guidance on orderly redenomination of euro-denominated assets and obligations in a break-up scenario. Such guidance is crucial in connection with a full-blown break-up scenario, in which the euro would no longer exist as a currency. This specific scenario involves a host of very complex redenomination issues associated with the very large number of assets and obligations which are subject to English law (not the laws of the eurozone countries). The basic problem is that it is extremely difficult to predict with confidence how the redenomination process would work for such instruments. At the current time, foreign investors are leaving eurozone fixed-income markets, in part due to the uncertainty about break-up and redenomination risk. A contingency plan for orderly asset redenomination in a break-up scenario could help alleviate investor worries about the tail-risk for eurozone assets, and may improve the current capital flow situation and funding costs for sovereigns. Ironically, spelling out guidelines for a eurozone breakup may at this stage in the crisis even help to reduce the risk of the break-up itself.

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Section 5: Key steps in planning for a break-up

Having outlined the very complex legal aspects of redenomination of foreign law assets and illustrated the huge size of assets and obligations issued under foreign law, we are ready to outline key steps needed to facilitate an orderly currency redenomination process. We propose four key elements in a contingency plan: 1) Offer guidance on the redenomination process for local and foreign law assets; 2) Specify the role of a new European Currency Unit (ECU-2) in the redenomination of foreign law assets and obligations; 3) Create a hedging market for intra-EMU currency risk; and 4) adopt regulation which over time is aimed at reducing intra-EMU currency risk for systemically important institutions.

We have outlined that various forms of eurozone break-up are distinct possibilities, and that investors are already making contingency plans for various scenarios, and that this is already having an adverse impact on capital flows. A break-up of the eurozone is hardly going to be a smooth process. In the best of circumstances it is likely to be very disruptive indeed. Nevertheless, the quality of the preparation will be crucial in determining the degree of disruption. In a disorderly break-up scenario, with little forward looking guidance on the redenomination process, court decisions on redenomination are likely to be inconsistent, potentially arbitrary from an economic stand-point, and they are likely to be very slow. This would be a worst case outcome.

Aiming to avoid unnecessary disruption

The fall-out from a disorderly redenomination process, for which market participants would have had little chance to prepare, would likely be to trigger a large number of bankruptcies among banks, corporations, and other financial market participants. Importantly, a significant portion of bankruptcies would be arbitrary, linked to specific court decisions, and would affect viable companies and financial institutions. Overall, this would raise the risk of more severe than necessary banking crisis, with create a negative impact on actual and potential growth for a prolonged period of time. We will not try to directly quantify the negative effects associated with a disorderly and unmanaged redenomination process, although it would be an important an interesting exercise. But our prior is that these negative effects would be very large. The huge size of Euro denominated assets and obligations (as illustrated in Section 3) would create new open currency exposures in a break-up scenario. Combined with the current inability to hedge those exposures (as discussed in Section 8) suggests that a large wave of bankruptcies would be triggered in Europe and globally as a function of losses on new currency exposures associated with the redenomination for specific institutions. A key goal for an orderly break-up process would be to reduce the amount of bankruptcies triggered by redenomination itself. There would likely be insolvencies associated with sovereign defaults, but that is a separate matter. An orderly break-up process should facilitate redenomination in a way where the break-up is not in itself a catalyst for unnecessary disruptions, including those triggered by losses on new currency exposures associated with the redenomination process.

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Four steps in an plan for and orderly break-up

Four specific steps would be important in a contingence plan for a break-up. These steps are aimed at avoiding unnecessary disruptions and bankruptcies associated with currency losses on new currency exposures resulting from a redenomination. Clearly this is only one aspect of managing an orderly break-up process. But given the size of exposures involved, and the current inability to manage risks around those exposures, it is probably one of the most important aspects. And it is certainly one aspect to which sufficient attention has not yet been given. We propose the following four steps as part of the contingency planning: STEP 1: Communicate guiding principles for the redenomination of Euro denominated assets and obligations under local and foreign law in various break-up scenarios. STEP 2: Define the role of a new European Currency Unit (ECU-2) in the settlement of EUR denominated assets and obligations under foreign law in a full-blown break-up scenario. STEP 3: Create a hedging market for intra-Eurozone currency exposure, including creating a non-deliverable FX forward market for potential new national currencies of current eurozone member countries and creating a hedging market for potential ECU-2 exposures following a break-up. STEP 4: Introduce a new regulatory framework to reduce intra-Eurozone currency exposure for systemically important institutions in preparation for a eurozone break-up, by encouraging hedging of potential new FX exposures.. This four-step plan would not address the disruptions associated with sovereign defaults, disruptive capital flows; nor does it outline plans for how to dissolve the ECB. Those, and other important aspects of a holistic contingency plan, would have to be analyzed in detail separately. But the plan does present a framework for facilitating an orderly currency redenomination process. In the absence of such a framework, any break-up of the Eurozone is likely to be devastatingly disruptive, highlighting the importance of such specific contingency plans, as a part of an overall package of contingency plans.

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Section 6: Guiding principles for redenomination

Communicating guiding principles for redenomination of Euro denominated assets and obligations under local and foreign law ahead of a break-up would be crucial. Communication ahead of the event would allow market participants to prepare efficiently, helping to avoid triggering bankruptcies and other disruptions as a function of losses on new currency exposures. Clear communication on guiding principles for the redenomination process ahead of time would help resolve uncertainty in the planning process, and reduce delays associated with legal disputes following an actual break-up.
Step 1 of an orderly currency redenomination process would be to communicate, ahead of time, the key guiding principles for the redenomination of both local law assets and foreign law assets. The so-called Lex Monetae principle could help establish an initial framework for redenomination of some assets and obligations, and the guiding principles of the redenomination process should specify the application of those principles in some detail, as appropriate. If it can be argued that the currency of a given obligation refers to the currency of a certain country, rather than the euro (the currency of the European Union), then redenomination from euro to the new national currency is feasible, and in some cases probably desirable from the perspective of limiting disruptive redenomination.

Guiding principles for redenomination of local law assets

As mentioned in section 2, it would generally be relatively straight-forward to devise a fairly efficient redenomination process for local law assets and obligations. Each Eurozone country, following a limited for full-blown break-up, should be able to redenominated assets and obligations in accordance with a new currency law. Nevertheless, in planning for an orderly EMU break-up, it would be beneficial to communicate guiding principles for this process, to clarify areas of legal uncertainty, and make planning more efficient. The guidance principles should correspond to established legal principles in the area, such as those outlined in Section 2. And the guidance will be particularly important in grey areas where exposures are large from a macroeconomic perspective.

Guiding principles for redenomination of foreign law assets

Importantly, there is an essential need to reduce the very high level of legal uncertainty about the process around redenomination of Euro denominated assets and obligations under foreign (non-Eurozone) law in a full-blown break-up scenario. In this scenario, some form of redenomination would be necessary, by definition. But no single existing currency globally would provide a good and fair redenomination option, nor would any of the potential new national currencies of Eurozone countries. As we will detail in the following section, there is a need to specify a role for a new European Currency Basket (ECU-2) in this scenario as a means to settle payments on Euro denominated assets and obligations. Fortunately, the majority of foreign law contracts (as indicated in section 3) are under the jurisdiction of English law. Since the United Kingdom is a member of the European Union, there is an opportunity to use EU directives to guide the redenomination process for contracts under English law. This was the process used for ECU denominated assets were redenominated into Euro in 1999, and it would be logical to use the same process in reverse in a eurozone break-up scenario.

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This does not directly address the redenomination of Euro denominated assets under the jurisdiction of countries and states outside the European Union. But these assets and obligations are smaller in size (although derivates exposure under New York law is very significant). Importantly, if an EU directive can offer guidance for redenomination of English Law and other non-eurozone EU area assets and obligations, there is hope that New York courts and other courts will follow that precedent. That was the case in connection with the redenomination of ECU denominated assets in 1999, and it could be the case again in the future.

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Section 7: The new European Currency Unit (ECU-2)

A new European Currency Unit (ECU-2) could play an important role in facilitating an orderly redenomination process for the myriad contracts and obligations under foreign law without a clear country specific nexus. The ECU-2 would be mechanically linked to the performance of new national currencies of eurozone countries in accordance with a pre-determined weighting scheme. The ECU-2 would play a crucially important role in facilitating efficient redenomination of foreign law contracts, and thereby serve to minimize unnecessary insolvencies due to protracted legal battles about redenomination issues and due to losses on new currency exposure, some of which could be purely a function of unpredictable court decisions
Step 2 of an orderly currency redenomination process would be to specify the role of a new European Currency Unit (ECU-2) as a means of settling Euro denominated contracts under foreign law in a full-blown break-up scenario.

The advantage of the basket currency redenomination

The advantage of applying an ECU-2 based redenomination is that it removes legal uncertainty around obligations that would otherwise be difficult to re-denominate into national currencies. There are many examples of obligations and contracts where there is no clear nexus to a specific eurozone country. Examples where it would be very hard to link EURdenominated obligations to a specific country include:

A EUR-denominated loan from a UK bank to a Polish corporation. A EUR/USD FX forward transaction between a Japanese bank and a US asset manager. A fixed/floating interest rate swap between a French bank and a German insurance company.

We have argued (in Section 3) that the notional value of contracts and obligations where a re-denomination into new national currencies would be problematic and potentially arbitrary is very large. Without claiming any great degree of precession, we suggested that foreign law Euro denominated instruments could easily amount to something in excess of EUR30 trillion in terms of notional value, including foreign law bonds, crossborder loan contracts, and FX derivatives such as currency forward contracts (but excluding interest rate swaps). How the redenomination process would work for assets and obligations of this nature is crucially important since case law suggests that contracts and obligations are unlikely to be frustrated simply due to their redenomination. Contracts and obligations would continue to live on after the euro ceased to exist. Hence, making the redenomination process as smooth, fair and efficient as possible is an important goal in its own right, including in relation to macroeconomic performance, such as growth. From this perspective, a new European Currency Unit (ECU-2) which would be a basket currency linked to new national currencies according to a pre-determined weighting scheme - could play an important role in facilitating an orderly redenomination process for the myriad contracts and obligations that do not have a clear country specific nexus. By issuing an EU directive, English courts would be instructed to interpret EUR in any contract to mean ECU-2 thereafter. In this context, we note that the Euro itself was created by the process of EU directives as well as passage of legislation in NY, Tokyo 5 and other localities (while some were determined to need no further statutes) . These statutes were passed to ensure continuity of the contract and in order to do so, they
5

Hal S Scott, When the Euro Falls Apart, Intl Fin 1:2 1998, 207-228 (see link) lists particulars of UK and NY adoption of legislation to ensure continuity of contract.

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specifically stated that frustrations that force major clauses, redenomination clauses or the possibility of claiming material adverse change would all be overruled. In order to ensure a timelier and more certain outcome, an EU directive could compel UK courts to re-denominate contracts into some official new currency such as the ECU-2, at a specified rate.
Fig. 10: ECU basket currency weights over time

Original ECU weights Belgium Denmark Germany Greece Spain France Ireland Italy Luxembourg Netherlands Portugal UK Austria Finland Estonia Cyprus Malta Slovenia Slovak Republic Total Apr 1990 - Nov 1992 Nov 1992 - Mar 1995 Mar 1995 - Dec 1998 7.8% 8.1% 8.4% 2.5% 2.6% 2.7% 30.5% 31.7% 32.7% 0.8% 0.6% 0.5% 5.2% 4.8% 4.2% 19.4% 20.2% 20.8% 1.1% 1.2% 1.1% 9.9% 9.0% 7.2% 0.3% 0.3% 0.3% 9.5% 9.9% 10.2% 0.8% 0.8% 0.7% 12.1% 10.9% 11.2% 100.0% 100.0% 100.0%

Note. Source: Nomura, ECB

As mentioned, the new European Currency Unit (ECU-2) would be a basket currency linked to the new national currencies created after a break-up akin to the original ECU basket (although there would be technical differences, as detailed below). The value of the new ECU would be mechanically linked to the performance of the new currencies of previous eurozone countries, and the redenomination process would mirror how ECU-denominated instruments were redenominated into euro in 1999.

Potential weights of the new ECU

The specific nature of any break-up process would play a role in determining the weights of individual national currencies in a new European Currency Unit (ECU-2). If the break-up process happens in sequential fashion where weaker eurozone countries exit before the later full-blown break-up, then there would be zero weight attached to certain of the current eurozone countries in the new European Currency Unit. However, if a break-up happens more like a big-bang, presumably all eurozone countries (including weaker eurozone countries) would have a weight in the ECU-2, provided that the break-up is multilaterally agreed. Based on our analysis in Section 1, we would focus on scenarios where all major eurozone countries will have a weight (as would be the case in a big-bang break-up). For illustrative purposes, we also show weighting schemes where Greece, Ireland and Portugal are excluded, based on the idea that they could exit the eurozone before a bigbang collapse. But given their small size and small equity weights in the ECB, it does not make a large economic difference whether they are excluded or not. The original ECU weights, shown in Figure 10 were determined based on the size of the economy and the magnitude of intra-EU trade, although no strict mathematical formula was applied. A similar approach may be applied in the future, but it is more likely that the

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ECB equity weights (derived from the size of the national population and GDP) will be used. The current ECB equity weights are shown in Column A in Figure 11 below (in a raw and not normalized fashion). Baseline ECU-2 weights, based on normalized ECB weights, are shown in column B of the table. Note that we have excluded the six smallest eurozone countries from this calculation (Luxemburg, Cyprus, Malta, Slovenia, Slovakia and Estonia). This is because their weights are likely to be very small (their combined ECB weight is 1.9%) and because having very small and illiquid basket components in the new ECU may make it harder to manage from an operational perspective. Specifically, considerations around liquidity may make it preferable not to have very small currencies in the basket, and this type of consideration could be used to exclude additional currencies, as appropriate. Linked to this, an additional caveat in relation to the weights is that the ECU would only work if new national currencies remain convertible and actively traded. This is similar to the considerations behind the IMFs SDR basket, which only consists of highly liquid convertible currencies (USD, EUR, JPY and GBP). Such considerations could become particularly relevant in a situation where the break-up process creates a need for capital controls in certain countries (as discussed below).

Fig. 11: Fair value estimates of a potential ECU-2

ECU-2 fair value estimation

ECB Weights (A) Belgium Germany Greece Spain France Ireland Italy Netherlands Portugal Austria Finland ECU-2 calculations ECU-2 valuation 2.4% 18.9% 2.0% 8.3% 14.2% 1.1% 12.5% 4.0% 1.8% 1.9% 1.3% Baseline ECU-2 weights (B) 3.5% 27.7% 2.9% 12.1% 20.8% 1.6% 18.3% 5.8% 2.6% 2.8% 1.8% Sum (B * E) 1.13 ECU-2 weights (ex. Greece) (C) 3.7% 28.5% 0.0% 12.5% 21.4% 1.7% 18.8% 6.0% 2.6% 2.9% 1.9% Sum (C * E) 1.14 ECU-2 weights (ex. Greece, Ireland, Portugal) (D) 3.8% 29.8% 0.0% 13.1% 22.4% 0.0% 19.7% 6.3% 0.0% 3.1% 2.0% Sum (D * E) 1.16 Fairvalue in breakup (E) 1.02 1.36 0.57 0.86 1.21 0.96 0.97 1.25 0.71 1.25 1.25 -

Note: ECU fair values are expressed in ECU/USD terms. Source: Nomura, ECB

Figure 11 above shows an illustration of an ECU-2 valuation exercise, based on the fair value estimates of individual eurozone currencies shown in Appendix III. In our baseline case where all current eurozone countries, except the smallest ones, have a weight in the ECU basket, the estimate comes out at 1.13 versus the USD (bottom row of table). This calculation is only shown for illustrative purposes, as one should expect potentially significant under-shooting of individual new national currencies and the ECU-2 basket relative to standard fair value considerations in the immediate aftermath of a break-up, given the need for sizeable risk premia.

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Fig. 12: Spread between private ECU and official basket

bp 200 100
0 -100 -200

Fig. 13: ECU/USD and EUR/USD

1.60 1.50
1.40 1.30 1.20 1.10

ECU

EUR

1.00
-300 -400 90 91 92 93 94 95 96 97 98

0.90
0.80 90 92 94 96 98 00 02 04 06 08 10

Source: Nomura, FRB, ECB

Source: Nomura, ECB

A brief history of the original ECU

The European Currency Unit (ECU) was created by the European Monetary System (EMS) in March 1979. The ECU originated as a basket of nine national currencies, each with its own particular weight based on such economic factors as the countrys GNP and intra-community trade. The ECU basket was adjusted in 1984 to include the Greek drachma and amended again in 1989 to include the Spanish peseta and the Portuguese escudo. The ECU was intended to stabilize the national currencies and eventually create a single composite currency. Moreover, all EU area budgets were denominated in ECU and increasing portions of national debt over time. There was never an official mechanism to convert private ECUs one for one into the basket of the ECU currencies corresponding to the definition of the official ECU. From 1979 to 1988, a group of private European clearing banks stood ready to convert private ECUs into the basket at par. This convertibility at par ended in 1988, and from then on the private ECU was in principle a free floating currency. Linked to this, a gap between the composite interest rate on underlying ECU currencies at the actual ECU interest rate (a fixing of which was administered by the BIS) also opened up. Initially, however, the private ECU continued to trade close to par versus the official basket and this period of stability (1990-91) saw significant issuance of ECU-denominated debt instruments by European sovereigns and supranational institutions. A large derivatives market developed, including LIFFE futures, which were ECU denominated futures, settling at the BBA EUR LIBOR fixing, (after the launch of the EUR, new contracts were later based on the EURIBOR fixing). Things changed during 1992 as tensions in European currency markets surfaced. This was the case especially during the ERM crisis, when the private ECU traded at a discount of 250bp to the basket. The exchange bands of the ERM had to be expanded to 15% in 1993, and only France, Denmark, Belgium and the Netherlands managed to avoid devaluations of central ERM parities, while the UK, Italy, Spain, Portugal, Finland and Sweden all had to exit the ERM in some form. The value of the private ECU eventually converged to that of the underlying basket on increasing expectations (in 1997-98) that the ECB would eventually enforce par convertibility between the private ECU and the official ECU basket. Finally, on 1 January, 1999, the ECU was replaced by the euro at parity. The process of re-denominating ECU obligations into EUR is also interesting as it involved an EU regulation that held that the introduction of the euro should not terminate (or alter the terms of) any legal instruments. Moreover, several foreign jurisdictions, including the State of New York, passed legislation to ensure that the euro was recognized as the successor to the ECU. These steps ensured that ECU obligations,

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whether under local (EU) jurisdiction or foreign (e.g., New York) law, could be smoothly redenominated into euro, with effect from 1 January, 1999.

A few technical considerations around the ECU-2

Settlement issues: Following the implementation of the EU directive and re-denomination into ECU-2 of certain contracts, payment on contracts and obligations which were originally in euro would then be affected by delivering ECU-2, or more specifically, an acceptable equivalent in a given new national currency, based on official fixing rates between the ECU-2 basket and national currencies. Transparent pricing: In order to use the ECU basket effectively for settlement and delivery purposes, its component parts would need to be transparently priced (likely with the BIS as pricing agent) and actively traded. Capital controls and convertibility: If capital controls are imposed by a given country, it may make sense to exclude the currency of that country from the ECU-2 basket for operational reasons, similarly to how certain currencies were excluded from the original ECU basket, and reweight the basket in a fashion which would minimize the fall-out, including jumps in the ECU-2 exchange rate versus the Dollar and other global currencies. Specifically, having non-convertible currencies in the new European Currency Unit would be potentially problematic in relation to maintaining efficient settlement and pricing mechanism. Such issues could be partially addressed by allowing settlement of payments on ECU-2 assets and obligations in one convertible currency (rather than delivering the components of the basket) in accordance with the market exchange rate between that currency and the ECU-2. But allowing delivery in one convertible currency would not address issues around lack of pricing transparency, and this could become a real issue in a situation of severe capital controls and potential dual currency regimes. Differences relative to the original ECU regime: As mentioned above, from 1990 to 1998, the private ECU traded freely in the market and there was no private or official mechanism in place to ensure it traded in line with its theoretical value, as defined by the weights of the individual ECU component parts and their market-based exchange rates. The private ECU was to some degree anchored by expectation of eventual conversion of ECU assets into EUR assets, but the strength of this anchor varied based on the conviction of the market that eventual conversion would happen. However, during a reverse process of re-denominating euro obligations into ECU-2, there would be no such anchor because there would be no expectations of future conversion at a given rate. To avoid problems associated with this lack of determinacy, some provision would likely be needed to allow settlement of ECU-2 denominated obligations in national currencies, in accordance with the market-based value of the ECU-2, as calculated from ECU-2 weights and the exchange rates of its component parts. ECU-2 interest rates: Linked to the currency redenomination, there would also be a need to shift from Euro interest rates to ECU-2 interest rates, this would be a blended interest rate, derived arithmetically from the underlying interest rates in individual eurozone countries, and the weights stipulated in ECU-2 basket, possibly with the BIS as a fixing agent for daily ECU interest rates.

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Section 8: A hedging market for intra-EMU FX risk

To facilitate an orderly break-up process, market participants would need instruments to reduce intra-EMU currency risk ahead of an actual break-up taking place. The creation of non-deliverable currency forward markets for potential new national currencies of eurozone member countries would be an important step in facilitating such risk reduction. The availability of an efficient hedging market for intra-EMU currency risk ahead of a bread-up would serve to minimize redenomination related disruptions in an actual break-up.

Step 3 of an orderly currency redenomination process would involve creating a hedging market for intra-Eurozone currency exposure. This should include creating a nondeliverable FX forward market (NDF) for potential new national currencies of current eurozone member countries as well as creating a hedging market for ECU-2 exposures resulting from a break-up. Adoption of the Euro was supposed to be irrevocable, and risk management of eurozone exposures has generally not been taking into account the redenomination risk associated with different Euro denominated assets and obligations: The risk of intra-Eurozone currency fluctuations following a break-up has generally not been incorporated into real-life risk management exercises. Developments during 2011, however, have shown that break-up risk is non-negligible. Commensurate with this new reality, risk management practices are in the process of being amended to account for break-up and redenomination risk of within the Eurozone. Some bank regulators are already asking major banks to present analysis of break-up scenarios, including sensitivity to redenomination of certain assets and obligations. But this process is in its infant stage, and political considerations could hold back the process within the eurozone itself, where it is likely to be the most important. Since the risk of a break-up is no longer negligible, this is a potentially dangerous strategy. A more prudent strategy would allow market participants to reduce intra-eurozone currency exposure ahead of a possible break-up, and as we will argue in the next section, this process is particularly important for systemically important institutions. As a general point, such risk reduction in relation to intra EMU currency risk - requires identification and quantification of intra-Eurozone currency risk, as well as efficient instruments to hedge those risks.

The need for a hedging market for intra-EMU exposure

A key element in risk management of intra-Eurozone currency exposure, would be the creation of efficient hedging instruments. Such hedging requires an instrument, which shields market participants against depreciation of potentially weak new eurozone currencies and against appreciation of potentially strong new eurozone currencies, depending on the type of exposures present at the micro level. These instruments would help to ensure the survival of a greater number of banks who should be able to exchange and mitigate some of the ongoing redenomination risk of which they are increasingly aware. It is generally perceived that a new Greek drachma would be substantially weaker than the Euros current value. Similarly, it is generally perceived that a new German mark would be stronger than the Euros current value. In the appendix, we show some specific illustrative estimates of potential fair values for new Eurozone currencies, based on a simple two-factor approach, incorporating metrics of current misalignment, as well as future inflation risk. These estimates show a slight appreciation potential of the new German mark, and a significant depreciation risk for the new Greek drachma (all estimates are expressed relative to the dollar. The important point here is not the specific point estimates, but rather the general finding that a eurozone break-up would be likely to

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see large currency moves between the new currencies of the individual eurozone countries.

Creating instruments for hedging intra-EMU currency risk

A so-called non-deliverable forward contract (NDF) could be used to allow market participants to hedge currency risks associated with current exposures (asset and liabilities) to certain eurozone countries. Since current eurozone member countries dont have their own currencies at this stage, this would be a contract linked to their potential future national currencies. Specifically, we imagine a new market with the following characteristics: Non-deliverable forward (NDF) contract, very similar to NDF contracts in many offshore emerging markets e.g. Brazil, China, India Settlement based on FX rate of official currency of the current Eurozone member country, versus US dollar Official currency and FX rates determined by the countrys central bank, with new currencies entering the picture in a break-up scenario. Cash settled in US dollars Maturity on specific quarterly dates, likely corresponding to IMM futures, for standardization purposes.

There would be NDF contracts associated with each Eurozone currency. For example, there would be a German NDF, which would settle at expiry based on value of the German currency at that time. If Germany has the Euro at the time of expiry, the contract would settle in accordance with the EURUSD exchange rate at the time. If Germany has adopted a new German mark as its currency ahead of the expiry of the contract, the contract would settle in accordance with the DEMUSD exchange rate at the time. As is generally the case with non-deliverable forward contracts, an official fixing rate, generally from the central bank, would be used to determine the specific pricing at expiry, and similar to the majority of NDF contracts (which are common in emerging market countries), contracts would settle in USD at expiry.

Creating instruments for hedging ECU-2 exposure

Following on to the development of hedging markets for new national currencies; it would be relatively easy to develop hedging markets for future ECU-2 exposure, provided that guidance on the role of the ECU-2 and its possible weights is sufficiently explicit (in line with the issues discussed in section 6). Market makers would be able to market markets in ECU-2 instruments (without taking excessive risk in the process) by hedging exposure in the basket components (the country specific NDF countracts). Hence, once a liquid NDF market for new national currencies has been developed, it would be a relatively little additional step to expand the menu of hedging instruments to include those needed to hedge ECU-2 related exposures. Obviously, the liquidity of the ECU-2 hedging market would be linked to the liquidity of the underlying NDF markets, and this again highlights that consideration should be given to liquidity issues, when determining the basket weights in the ECU basket (as discussed in section 7).

Ensuring efficiency of intra-eurozone NDF markets

Setting up and NDF market for new eurozone currencies may be relatively straightforward in theory. In fact, it seems likely that such a market will develop to some degree in coming

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quarters given that end-users are increasingly concerned about and looking to reduce Eurozone currency exposures, including intra-EMU currency mis-matches. However, creating a hedging product is only one step towards creating and efficient hedging market. In order to build a liquid and efficient market, the market would need to have active participation from a diverse set of banks, as well as a diverse set of end-users globally. Given that eurozone banks are likely to be under severe pressure from various sources in a break-up scenario, it would be important that other global banks, including US, UK, Japanese and other banks would participate actively in the market. Global banks should be able to re-distribute the risk more efficiently (at an appropriate price) to financial market participants around the world, including asset managers, hedge funds, etc. In addition, having participation of global banks would be crucial in terms of limiting counter-party risks in an actual break-up. Having NDF contracts trade on an exchange could also help reduce counter-party concerns, and make the hedging product more liquid, and such an option should be investigated as a part of the planning process for creating efficient hedging markets for intra-EMU currency exposures. In the ideal world, the NDF market would allow banks, and other systemically important institutions to manage and limit their intra-Eurozone currency risk. By reducing excessive exposures, it would make them more resilient in an actual eurozone break-up, as well as in the run-up to the actual break-up event. Relative to the current situation, where risk is likely to be concentrated in certain eurozone financial institutions, the availability of hedging instruments would offer an avenue for risk reduction at the eurozone institutional level. Moreover, this would also serve as an avenue to reduce systemic risk in the Eurozone banking system, which would already be under severe pressure in a break-up scenario.

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Section 9: New regulatory frameworks

The final step in preparation for an orderly eurozone break-up would be to implement new regulatory frameworks. The purpose of such a framework would be to monitor and over time reduce intra-Eurozone currency exposure for systemically important institutions, including by taking advantage of newly created hedging instrument for this purpose. Given the prevalence of Euro denominated assets and obligations under foreign jurisdiction, such a process should have a global component in order to shield the global banking system from shocks emanating from a eurozone break-up.

Step 4 of an orderly currency redenomination process would involve introducing a new regulatory framework to monitor intra-Eurozone currency exposure for systemically important institutions in preparation for a eurozone break-up. Over time, following the implementation of steps 1-3 of the contingency plan for orderly redenomination, this would involve encouraging and ensuring reduction of potential new FX exposures in a break-up scenario. A new regulatory framework aimed at limiting disruptions associated with currency redenominations in a eurozone break-up would need to include several elements. First, there would be a need to quantify intra-eurozone currency risk at the institutional level and at certain aggregated levels to evaluate systemic risks. Second, following a suitable transition period, there would be a need to encourage risk reduction in relation to intraEMU currency risk for systemically important institutions, within the Eurozone, and globally.

The need for quantification of intra-eurozone currency risk

Regulators across the Eurozone, possibly under the guidance of the EBA, should initially ask Eurozone banks, and other systemically important institutions, to quantify and disclose to regulators, their intra-eurozone currency risk. This step of the preparation process can only happen after the initial step clarification and communication of process and rules for redenomination has already taken place. The quantification of intra-EMU currency exposures is likely to show very large contingent open currency exposures for a number of institutions, particularly those within the Eurozone itself. For example, German banks, which rely on local deposits would be likely to see those deposits redenominated into new DEM in a full-blown break-up scenario. At the same time, German banks with significant exposures to other Eurozone countries on the asset side of their balance sheets, would face devaluation risk on those assets in a break-up scenario. Hence, German banks would have a significant need to hedge contingent intra-EMU currency exposures. Specifically, they would need to sell peripheral currency risk through the newly created NDF markets, or reduce exposure by other means. A Similar arguments can be made for French banks, and banks in other countries, which are likely to see relative appreciation relative to the rest of the Eurozone. The currency valuation estimates for new national currencies shown in Appendix III could be used for such an initial risk assessment. We will not go into detail with other sectors. But clearly very large intra-EMU currency exposures have been accumulated since 1999, and quantifying them across sectors and individual institutions would be a first step in a new risk management exercise, incorporating break-up related risks.

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Risk limits for systemically important institutions

The final step in a new regulatory framework would be to impose risk limits on open intraEMU currency exposures in preparation for a break-up. This would obviously be a final step, and one which could only be implemented after rules for the redenomination process had been spelled out and communicated, and after hedging markets for intraEMU currency risk had developed. Sufficient time would also be needed to allow institutions a transitions period, potentially spanning a number of years, to manage down intra-eurozone currency risk. Hence, if a break-up happened sooner, there would not be sufficient time to notably reduce systemically important intra-EMU exposures ahead of the event. This in itself would be an argument to implement policies to delay a break-up, even if a break-up is deemed as ultimately inevitable by policy makers.

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Section 10: Concluding remarks

This paper has focused on four steps to plan for an orderly break-up of the EMU, focusing on issues related to currency redenomination. The plan offers a framework for orderly currency redenomination in a break-up scenario, including a full-blown break-up scenario where the Euro ceases to exist. This is just one aspect of an overall plan for an orderly break-up of the Eurozone. But it is likely to be a crucial one given the very large contingent open currency exposures which have been accumulated since 1999. Any plan for a break-up, which does include a framework to ensure an orderly currency redenomination process, is an incomplete one, and one which underestimates the large disruptive force associated with an uncontrolled and unmanaged redenomination process.

STEP 1: Communicate guiding principles for the redenomination of Euro denominated assets and obligations under local and foreign law in various break-up scenarios. STEP 2: Define the role of a new European Currency Unit (ECU-2) in the settlement of EUR denominated assets and obligations in a full-blown break-up scenario. STEP 3: Create a hedging market for intra-Eurozone currency exposure, including creating a non-deliverable FX forward market for potential new national currencies of current eurozone member countries and creating a hedging market for potential ECU-2 exposures following a break-up. STEP 4: Introduce a new regulatory framework to reduce intra-Eurozone currency exposure for systemically important institutions in preparation for a eurozone break-up, by encouraging hedging of potential new FX exposures over time.
These four proposed steps will not make a eurozone break-up an easy process. The process is likely to be a disruptive one to some degree regardless of how well it is managed. But the point about degree is an important one. In the absence of any guidance and contingency planning in relation to redenomination of EUR assets and obligations ahead of a break-up, we would likely be facing a chaotic situation. It would be a disorderly process characterized by protracted legal battles, occasionally arbitrary court decision, and widespread insolvencies across various market sectors, solely as a function of currency losses linked to new currency exposures resulting from redenomination. Such an ad hoc and uncontrolled redenomination process would inevitably lead to large losses for certain institutions, and unnecessary failures in the bank sector and elsewhere, with major implications for economic output over a multi-year period. More clarity on the redenomination process would allow institutions to plan and manage risk ahead of time. In conjunction with the development of effective hedging markets for new national currencies (and the new ECU) this would allow banks and other institutions to reduce open (contingent) exposures to certain new national currencies of eurozone member countries. Finally, new regulation could, over time, help reduce contingent intraEMU currency risk within systemically important institutions. Allowing planning and hedging would help avert unnecessary bank failures and corporate insolvencies due to currency redenomination, and this could have a significant positive impact on aggregate lending dynamics relative to the alternative scenario of an unmanaged and ad hoc redenomination process. Moreover, averting protracted legal battles would in itself free up resources for productive investment. Our four-step plan is focused on achieving orderly currency redenomination. It is just one aspect of a full plan for an orderly break-up process, but a crucially important aspect.

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Appendix I: Illustrative bank loss calculations in debt restructuring scenarios

Fig. 1: Bank losses in sovereign default scenarios

Germany

Spain

France

Italy

Other EMU

UK

Japan

US

ROW

Total

Total EMU

Type of Exposure Sovereign Banks Other Total Sovereign Banks Other Total Sovereign Banks Other Total Sovereign Banks Other Total Sovereign Banks Other Total Sovereign Banks Other Total Sovereign Banks Other Total Sovereign Banks Other Total Sovereign Banks Other Total Sovereign Banks Other Total Sovereign Banks Other Total

Spain

Losses ($bn) resulting from default in: Italy GR, IE, PT 17.7 28.6 14.9 27.7 19.3 14.4 15.8 13.2 21.4 61.1 61.1 50.7 0.0 6.7 4.7 0.0 1.7 2.5 0.0 4.9 17.0 0.0 13.3 24.1 18.3 64.1 11.8 15.4 17.9 7.0 16.4 53.0 15.2 50.1 134.9 34.1 3.8 0.0 1.8 2.7 0.0 2.6 3.4 0.0 2.6 9.9 0.0 7.0 9.8 30.3 39.3 21.3 15.4 9.0 21.6 7.5 16.3 52.7 53.2 64.6 4.6 10.5 5.3 7.2 3.6 8.8 15.1 9.5 29.6 26.8 23.5 43.7 6.5 18.5 1.3 2.0 1.7 1.0 2.2 1.8 3.9 10.7 22.1 6.3 4.6 7.7 3.2 11.4 7.6 6.6 6.2 3.0 9.1 22.1 18.4 18.9 0.3 0.3 0.7 0.5 0.5 1.0 0.4 0.4 1.0 1.3 1.3 2.6 65.6 166.7 83.0 88.0 67.7 52.9 81.0 93.2 116.1 234.6 327.6 251.9 49.6 129.6 72.5 67.1 54.3 35.5 57.1 78.5 72.5 173.8 262.4 180.5

Total 61.2 61.4 50.3 172.8 11.4 4.2 21.8 37.4 94.2 40.3 84.6 219.1 5.6 5.3 6.0 16.9 79.4 45.7 45.4 170.5 20.3 19.5 54.2 94.0 26.4 4.7 7.9 39.0 15.5 25.6 18.2 59.3 1.4 1.9 1.8 5.1 315.3 208.6 290.2 814.2 251.7 156.9 208.1 616.7

Note: Periphery countries total losses are the sum of bank losses in Greece, Ireland, Portugal, Italy, and Spain. Source: Nomura, BIS

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Our calculations of the losses are based on the cross-border exposure calculated by the BIS as of the second quarter of 2011. We conduct scenario analysis of direct and indirect bank losses in a realistic restructuring scenario, incorporating additional defaults in banking and non-financial sectors as a function of sovereign debt restructuring. Our main assumptions are: 1. 2. The sovereign will restructure its debt with a recovery rate of 60%. As a result of the losses on their holdings of sovereign debt, the local peripheral banks will also be forced to also restructure their debt, but with a lower recovery rate of only 40%. The restructuring of the banking sector also leads to restructuring/defaults of some non-bank debt. Here, we assume that about 50% of non-bank debt needs to be restructured with a recovery rate of 40%.

3.

These figures are for illustrative purposes only, and the actual haircuts could end up being substantially larger, as negations around the current Greek PSI process indicate.

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Fig. 2: Eurozone sovereign exposures to periphery countries

Q2 2011 Type of Exposure Public sector Banks Non-bank private Total Public sector Banks Non-bank private Total Public sector Banks Non-bank private Total Public sector Banks Non-bank private Total Public sector Banks Non-bank private Total Public sector Banks Non-bank private Total Public sector Banks Non-bank private Total Public sector Banks Non-bank private Total Public sector Banks Non-bank private Total Greece 12.4 1.8 7.1 21.4 0.5 0.0 0.7 1.2 10.7 1.6 43.5 55.7 1.9 0.2 1.7 3.7 7.9 2.0 16.1 26.1 3.3 1.1 8.3 12.6 0.1 0.4 0.8 1.4 2.3 2.5 3.5 8.4 0.0 0.1 0.5 0.6

Germany

Spain

France

Italy

Other Eurozone

Great Britain

Japan

US

ROW

Exposures ($bn) to: Ireland Portugal 3.5 9.0 21.5 12.6 85.5 14.3 110.5 35.9 0.2 7.1 1.2 5.1 7.9 76.3 9.2 88.5 2.9 6.2 9.8 6.2 19.3 13.3 32.0 25.7 0.6 0.5 4.4 1.9 9.9 1.6 14.8 3.9 52.4 5.3 9.4 11.2 59.4 5.8 121.2 22.2 3.7 1.9 16.9 4.0 120.3 19.6 140.8 25.4 1.0 1.1 1.9 0.3 17.9 0.9 20.8 2.2 1.9 1.1 11.7 2.3 40.0 1.9 53.6 5.3 0.6 0.6 1.2 1.2 2.1 2.1 3.9 3.9

Spain 29.5 69.1 78.9 177.5 0.0 0.0 0.0 0.0 30.5 38.6 81.8 150.9 6.4 6.7 16.9 30.0 16.3 53.2 108.2 177.6 7.6 18.0 75.3 100.9 10.9 4.9 11.1 26.9 7.6 28.4 30.8 66.8 0.6 1.2 2.1 3.9

Italy 47.6 48.3 65.8 161.8 11.2 4.2 24.4 39.8 106.8 44.7 265.0 416.4 0.0 0.0 0.0 50.5 38.5 37.5 126.5 17.4 8.9 47.4 73.7 30.9 4.3 9.0 44.2 12.9 19.1 14.9 46.9 0.6 1.2 2.1 3.9

Total 101.9 153.4 251.6 507.0 18.9 10.5 109.2 138.6 157.0 100.9 422.8 680.7 9.4 13.2 29.9 52.5 132.4 114.2 227.0 473.6 33.9 48.8 270.9 353.5 43.9 11.8 39.7 95.5 25.9 64.0 91.0 180.9 2.3 4.9 9.0 16.2

Source: Nomura, BIS

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Appendix II: BIS data on international bond issues by Eurozone issuers

Fig. 1: Assets outstanding in the eurozone by location of issue - BIS data

Assets outstanding in the eurozone by location of issuance (bn EUR)

Sovereign Domestic International 112.7 88.3 229.9 128.3 21.6 61.1 1448.2 54.0 1432.0 256.6 128.0 171.5 1622.2 204.5 47.9 49.6 331.0 21.4 102.2 51.5 549.9 148.2 6025.4 1234.9 Financial Domestic International 123.1 158.0 195.9 309.3 34.9 45.7 981.9 1284.3 388.6 1876.5 85.7 155.4 585.6 821.6 218.1 321.3 383.2 1022.5 94.9 148.5 621.5 1316.9 3713.4 7459.8 Nonfinancial Domestic International 35.9 35.7 17.2 24.9 10.9 18.2 228.2 350.3 309.4 108.7 0.1 9.0 286.9 79.7 1.3 10.1 94.4 74.3 40.0 8.8 18.7 18.7 1043.1 738.2

Total
553.7 905.4 192.3 4346.9 4371.7 549.6 3600.4 648.3 1926.7 445.9 2673.9 20214.8

Austria Belgium Finland France Germany Greece Italy Ireland Netherlands Portugal Spain Total
Source: Nomura, BIS

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Appendix III: Valuing new national currencies

Investors holding EUR assets and obligations are facing risk of redenomination of contracts into new national currencies. To quantify the economic magnitude of the redenomination risk, we develop a transparent framework for valuing new national currencies. The framework is based on: i) current misalignment of the real exchange rate, ii) future inflation risk. The framework quantifies the medium-term depreciation risk associated with a redenomination into new national currencies. For a number of current eurozone member countries, the potential depreciation risk is very material.

Currency risk in a eurozone break-up

We have discussed the importance of legal jurisdiction as a major determinant of redenomination risk in eurozone countries. Here, we discuss potential valuation of new national currencies following a eurozone break-up. The estimates could be relevant both in a limited break-up scenario (for the departing countries) and in a full-blown break-up scenario (for all eurozone countries). We view these estimates as an initial benchmark for where currencies may trade in a new equilibrium following a potentially lengthy and extremely volatile transition period. Such estimates will be moving targets, influenced by country specific policies, the global environment, and regional political developments in the European Union For full disclosure, we are not regarding the break-up scenario as our central case. But it has become a real risk over the last few months, and a possibility which investors and policy makers should now plan for.
Fig. 1: Fair value estimates for new national currencies in a eurozone break-up scenario
1.50

1.3%
1.30

1.34
-7.1% -28.6% -57.6% -27.3% -35.5%

-6.8% -23.9%

-6.7%

-9.4%

1.10

-47.2% 1.25
0.96 0.97 0.71 0.86

0.90

1.25
0.70

1.25 1.02

1.36 1.21

0.50

0.57
0.30

Austria

Belgium

Finland

France

Germany

Greece

Ireland

Italy

Netherlands Portugal

Spain

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 EUR/USD value, which stood at roughly 1.34 as of early December. Source: Nomura

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A framework for valuing new national eurozone currencies

Currency valuation is a complex exercise, and the uncertainties associated with a eurozone break-up further complicate the analysis. There are many possible permutations for a break-up. To simplify the analysis, we will focus on currency valuation at the national level country by country rather than for possible new groups of countries. We think this exercise is 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. Similarly, currency projections at the national level can be used in a bottom-up valuation exercise for a new European Currency Unit (ECU-2). Since the uncertainties in the valuation exercise are large, we want to focus on a relatively simple and transparent framework. And we want to stress up-front that these estimates are unlikely to be particularly precise. They are intended to give a sense of potential magnitudes involved over a 5-year forward time frame, after which we believe temporary transition effects should be smaller. Our framework for valuing potential new national eurozone countries concentrates on two main medium-term effects: 1. Current real exchange rate misalignments: The eurozone currency union has, by definition, disabled the normal FX adjustments, which would happen under a flexible exchange rate regime. Moreover, given rigidities in nominal prices, especially in terms of downward adjustments of wages, real exchange rates are now potentially significantly misaligned from their equilibrium levels in some countries. The first component in our valuation framework is an estimate of the current real exchange rate misalignment. 2. Future inflation risk: A break-up of the eurozone would mean that individual eurozone countries would return 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 our valuation framework is the projected future inflation risk. A eurozone break-up will create additional short-term risks and require new risk premia for investors. These extraordinary risk premia will vary by country depending on factors such as market volatility and liquidity conditions, as well as issues relating to capital controls, including possible taxes on capital flows. Since our analysis is focused on equilibrium considerations over a 5-year period, we will not focus directly on these more temporary effects, although we recognize that they could be crucial in the short-term.

Quantifying current real exchange rate misalignment

It is fairly uncontroversial that some eurozone countries are facing significant competitiveness issues associated with overvalued real exchange rates. One simple indication of this is the extremely high peak and average trade and current account deficits observed in Greece, Portugal and Spain in the post-EMU period (see Figure 2 below).

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Fig. 2: Current account deficits of eurozone countries: recent vs. historical (% of GDP)

Peak Greece Portugal Spain Ireland Italy Belgium France Germany Austria Finland Netherlands

Post-EMU (%) Average -14.6 -11.6 -10.0 -5.3 -3.4 -2.9 -1.9 -1.7 -1.6 1.3 1.9

Peak -9.1 -9.0 -5.8 -2.1 -1.6 2.6 0.1 3.5 1.7 4.9 5.4

Pre-EMU (%) Average -3.8 -6.8 -3.6 -1.5 -2.7 1.8 -0.8 -1.4 -2.9 -5.4 2.1

-2.4 -2.0 -1.8 1.6 0.3 4.1 0.7 0.0 -1.2 -0.1 4.1

Note: Post-EMU period is defined as 1999-current day for all countries, including Greece. Pre-EMU period is defined as 1989-1999. Source: Nomura, Eurostat

In order to quantify current exchange rate misalignments, we use two alternative frameworks: First, we use a standard framework based on equilibrium current account and sustainable net foreign assets positions to estimate currency adjustments in real effective terms which would be consistent with achieving external balance. Specifically, we draw on the work of the European Commission in terms of assessing competitiveness and we use the average estimates of the real effective exchange rate misalignment from the current account and net foreign asset based approaches (for simplicity, we assume that bilateral misalignments versus the dollar would be similar in size to the trade-weighted misalignment reported by the European Commission, to allow the averaging mentioned below). Second, we use a time-series based approach to gauge real exchange rate misalignment. Specifically, we look at the position of current bilateral real exchange rates vs. the Dollar relative to the rates which prevailed in the period prior to EMU entry. This is not a perfect benchmark, since structural changes may have happened in the meantime, but it does provide a sense of currencies natural equilibriums over a period where market forces generally played a dominant role. The two approaches give generally similar conclusions, although the specific magnitudes of implied misalignment differ to some degree. Averaging the two approaches shown in the chart by country, current currency misalignment is estimated to be the largest in Greece (18.9%), followed by Portugal (16.1%) and Spain (11.2%). At the other end of the spectrum, Germany and Finland stand out as the two countries with potentially undervalued real exchange rates (-1.1% and -0.5%, respectively). All other eurozone countries appear to have real exchange rates which are closer to fair value currently, although the general bias is towards moderate overvaluation.

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Fig. 3: Estimates of current misalignment of country-specific real exchange rates

30% 25% 20% Time-Series Misalignment Structural External Balance Misalignment

27%

18%
16% 15% 8% 6% 2% 6% 2% 6% 1% 3% 9% 13%

15% 10% 5% 0%

9% 7%

10%

9%

1%

-1%
-5% -10%

-2%

-4%
Ireland France
Spain

Finland

Netherlands

Portugal

Germany

Belgium

Greece

Note: Positive figures indicate overvaluation. Source: Nomura

Quantifying future inflation differentials

In a break-up scenario where individual eurozone countries return to independent monetary policy, there is potential for significant divergence in inflation rates. Projecting future inflation is challenging under normal circumstances, but it is doubly difficult in an environment of severe instability and structural changes associated with establishing new frameworks for monetary policy at the national level. Nevertheless, there are a number of parameters which help gauge the country specific inflation risk in a eurozone break-up scenario. Here, we will focus on four main parameters that we think are important. We do not view this as a complete analysis, but rather as an initial attempt to quantify some of the key parameters involved. We focus on four parameters which measure future inflation risk: 1. Sovereign default risk: Financial stability and conduct of sound monetary policy is closely linked to fiscal stability. From this perspective, sovereign default risk will be a key parameter influencing future inflation risk. This is especially the case since sovereign default is likely to trigger a domestic banking crisis, in which case central bank action may be partially dictated by the liquidity needs of banks. We look at the implied default probability in 5yr CDS to quantify sovereign default risk per country. Inflation pass through: The degree to which the inflation process is vulnerable to shocks depends on openness, indexation, unionization, terms-of-trade volatility and other factors. The exchange rate pass-through is a summary measure, which captures a number of these effects. Past inflation volatility is another proxy for susceptibility to shocks, such as energy price shocks. We use estimates from academic studies of the exchange rate pass-through coefficient per country and we combine this with the observed volatility of CPI inflation in the past at the country level.

Austria

Italy

2.

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3.

Capital flow vulnerability: Combination of Large current account deficits combined and a weak structure of capital flows can leave a vulnerable capital flow picture. A vulnerable balance of payment situation may imply a higher risk of capital flight, with implications for money demand and inflation dynamics. We look at the basic balance, defined as the current account balance plus net foreign direct investment flows, as a simple metric of capital flow vulnerability by country Past inflation track record: Inflation expectations can have long memory, and past experiences may matter when new monetary policy frameworks are put in operation. The inflation track-record before Euro entry may therefore be important. We look at inflation performance in the pre-Euro period (1980s and 1990s) by country.

4.

In order to translate these different metrics of future inflation risk into a common indicator, we use a simple scoring method. The first step is to define the range of possible outcomes for future inflation. There is no obvious upper limit to how much inflation could result in a worst-case scenario. But we think a look at countries affected by currency crises in the past may provide some clues. The table below looks at inflation dynamics around a number of prominent currency crises in the past (Argentina 2001, Thailand 1997, Indonesia 1997, Russia 1998 and Mexico 1994). We define the inflation shock as the increase in average annual inflation in the five years following the beginning of the currency crisis, as compared to the inflation level in the two years prior to the crisis. The table shows that Russia is an outlier, with a very large inflation shock of 22%. A number of the other examples (Indonesia, Mexico and Argentina) show a cluster around 15%, while Turkey was an outlier in the other direction, with a negative inflation shock, due to successful macroeconomic stabilization.

Fig. 4: Inflation dynamics in times of currency crisis (y-o-y CPI inflation)

5 years following currency crisis Average post2 years prior to Inflation (from date of de-peg) currency crisis currency crisis shock inflation (A) (B)-(A) 1st year 2nd year 3rd year 4th year 5th year (B) Russia Mexico Indonesia Argentina Brazil Thailand Turkey 14 8 7 -1 8 6 59 97 35 34 26 15 9 57 32 35 50 15 7 2 43 22 21 2 4 7 1 25 17 16 10 10 4 2 10 14 17 13 11 4 1 8 36 25 22 13 7 3 29 22.0 16.3 14.6 14.1 -0.4 -2.8 -30.8

Source: Nomura, Bloomberg, Eurostat, OECD

We use this analysis to define an extreme upper limit of 15% on the potential inflation shock eurozone countries could experience on an annual basis over a 5-year period, following a eurozone breakup. To define a lower limit, we look at the lowest CPI readings observed in the eurozone over the last 20 years. There have been many episodes of moderate deflation, but peak deflation has generally not seen CPI inflation drop below minus 2%. We use this as the lower limit of the inflation shock.

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The second step is to map the four inflation risk parameters into this scale (from -2% to +15%). We do this by mapping sovereign default risk, inflation pass-through, past inflation measures into a -2%-15% scale using the cross-sectional distribution of the parameter values. Similarly, we map the external balance measures into a 0% to 15% scale, assigning a value of 0 to all countries with a positive external balance. These calculations are summarized in Figure 5. (For a more detailed view of future inflation risk calculations, see Box 1: Complete calculation of future inflation risk below)

Fig. 5: Inflation risk parameters and potential future inflation shock in a break-up scenario

Sovereign Default Risk (%) Austria Belgium Finland France Germany Greece Ireland Italy Netherlands Portugal Spain 14.2 22.7 5.8 15.2 7.9 99.6 45.2 32.8 8.9 59.7 28.4

Inflation Pass-Through FX PassCPI Through Volatility 0.77 0.9% 0.83 1.2% 0.77 1.3% 0.79 0.7% 0.75 0.7% 0.78 1.0% 0.56 2.8% 0.94 0.7% 0.79 0.9% 0.82 1.3% 1.04 1.2%

Capital Flow Total Future Past Vulnerability Inflation Inflation (%) (%) Shock (%) 3.0 -7.6 3.1 0.4 7.0 -11.2 -4.8 -2.7 9.0 -12.6 -5.5 3.1 3.5 4.7 4.6 2.7 15.3 5.8 7.7 2.7 11.9 7.2 1.1 4.1 1.5 1.6 0.5 11.1 5.3 4.9 0.9 9.3 6.1

Source: Nomura, Bloomberg, Eurostat, FRB

In order to keep the real exchange rate constant, and maintain competitiveness, equivalent annual depreciations of nominal exchange rates would be needed. For example, assuming no inflation shock in trading partner countries, this analysis suggests that the new Greek currency would need to depreciate by 47.7% in nominal terms over a 5-year period in order to compensate for the cumulative inflation differential associated with an annual inflation shock of 11.1% over the period. At the other end of the spectrum, Germany and the Netherlands stand out, and our estimates suggest that Germany may experience only very moderate inflationary pressure in a eurozone breakup scenario (less than 1%). In addition, both countries also have a better inflation track-record than the US, which is our benchmark country.

Valuation of new national currencies: A two-factor approach

Having quantified the two components of our valuation framework, we can derive fair value estimates of new national currencies as the product of the two effects: i) the current real exchange rate misalignment, and ii) the future inflation risk. Our model has an explicit medium-term focus, and in order to make the investment implications clear, the results are expressed in nominal terms, relative to the dollar. We note again that the framework is not incorporating extraordinary risk premia, which could be very significant in the transition period toward a new equilibrium.

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The key results are summarized in the table below, and they are based on the nominal exchange rate value versus the dollar from early December (1.34).
Fig. 6: National currency fair value projections in a eurozone break-up scenario

Fair Value Estimate

Estimate Austria Belgium Finland France Germany Greece Ireland Italy Netherlands Portugal Spain 1.25 1.02 1.25 1.21 1.36 0.57 0.96 0.97 1.25 0.71 0.86 Total Change (%) -6.8 -23.9 -6.7 -9.4 1.3 -57.6 -28.6 -27.3 -7.1 -47.2 -35.5

Estimated change due to:

Current FX Future Misalignment (%) Inflation Risk (%) -3.4 -3.5 -5.6 -19.3 0.5 -7.2 -4.3 -5.4 1.1 0.2 -18.9 -47.7 -10.8 -19.9 -7.0 -21.8 -5.2 -2.0 -16.1 -37.1 -11.2 -27.3

Note: Estimates should be viewed as 5-year ahead fair value projections. Source: Nomura

The fair value calculations show potential for significant (58%) depreciation of the new Greek drachma relative to the US dollar, followed by a 47% depreciation of the new Portuguese escudo. Perhaps not surprisingly, our estimates also suggest that Ireland, Spain and Italy are likely to see significant depreciation of new national currencies in a break-up scenario. We estimate depreciation of about 25-35% for this group, driven by a combination of the two factors in our framework. At the other end of the spectrum, Germany stands out as facing no material depreciation risk within the equilibrium framework considered. In fact, our estimates suggest a marginal appreciation potential, although the effect is too small to be economically meaningful.

The countries not in our story

Our study has focused on the first 11 eurozone member countries, although the analysis excludes Luxembourg, which is likely to re-peg its currency to another stable European country, given its very small size. We have also excluded the five newcomers to the eurozone: Slovenia, Slovakia, Cyprus, Malta, and Estonia from this initial study. The reason is two-fold. First, these countries are all relatively small in terms of the size of their economies and their financial markets. Second, the methodology we have been using is not directly suitable for the countries which joined the eurozone later on. We may do a customized analysis for those countries at a later date.

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How to interpret the results

Our estimates provide an initial attempt to quantify potential medium-term depreciation risk of individual national eurozone currencies in a break-up scenario. Our estimates are based on the notion that the real exchange rate in most developed markets tends to have a mean-reverting component, meaning that it settles at a new equilibrium level after the effect of temporary shocks have abated. This again implies that the nominal exchange rate in the medium-term (which we define as a 5-year period) can be viewed as a function of i) the current real exchange rate misalignment, and ii) cumulative inflation differentials. The framework does not explicitly incorporate effects, which could permanently affect the level of the real exchange rate. Such effects include permanent terms of trade shocks and diverging productivity trends. Since, we are dealing with eurozone countries, which generally have limited commodity resources, we do not think the exclusion of terms-oftrade dimension is likely to be crucial, and we do incorporate an effect from varying inflation pass-through when accounting for inflation risk in our framework. We recognize that structural reform initiatives could have a significant impact on productivity growth, and may need more consideration over time. At this stage, however, it seems almost impossible to quantify such effects, and we have not yet made the attempt.

Fig. 7: Depreciations of currencies in the 2 years surrounding breaks from pegs

140 ARS IDR

120
100 80 60 40 20 0 -2 1

THB
MXN

RUB

-1

Years before/after break in peg

Source: Nomura, Bloomberg

The framework also does not incorporate cyclical effects, which could be material. A break-up scenario would likely involve important growth underperformance in Europe overall, relative to the Americas and Asia, for example, with implications for real interest rate dynamics. But this effect would come in addition to the effects analyzed here. Our estimates are explicitly dealing with a medium-term concept of currency fair value. In the shorter-term, however, other influences on the exchange rate could be significant. This is the experience from previous currency crises. In the Argentine crisis, for example, the Argentine Peso staged a dramatic drop of 72% in nominal terms in the five months

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following its break off the peak, and this move arguably exceeded what turned out to be justified from a real exchange rate analysis perspective. In general, the short-run path is likely to be influenced by the interaction between a number of forces. Certain extraordinary risk premia are likely to be required by investors and other market participants to compensate for risk associated with excess volatility and illiquidity. In addition, there may be additional risks associated with capital controls, including taxes on capital flows. High local interest rates may provide partial compensation for such risk, limiting the need for a depressed currency value, although this may again depend on the condition of the banking system, which could well be in a very fragile state.

Box 1: Complete calculation of future inflation risk

Sovereign Default Risk
Implied Inflation risk Default #1 Probability

Inflation Pass-Through

Capital Flow Vulnerability

Basic Balance Inflation risk #3

Past Inflation (%)

FX Passthrough

CPI Volatility

Inflation risk #2

Past Inflation

Inflation risk #4

Future Inflation Risk (%)

Austria Belgium Finland France Germany Greece Ireland Italy Netherlands Portugal Spain

14.2 22.7 5.8 15.2 7.9 99.6 45.2 32.8 8.9 59.7 28.4

0.4 1.9 -1.0 0.6 -0.7 14.9 5.7 3.6 -0.5 8.1 2.8

0.77 0.83 0.77 0.79 0.75 0.78 0.56 0.94 0.79 0.82 1.04

0.9% 1.2% 1.3% 0.7% 0.7% 1.0% 2.8% 0.7% 0.9% 1.3% 1.2%

2.6 5.1 3.7 2.7 1.5 3.1 6.1 6.8 3.1 5.1 10.0

3.0 -7.6 3.1 0.4 7.0 -11.2 -4.8 -2.7 9.0 -12.6 -5.5

0.0 7.6 0.0 0.0 0.0 11.2 4.8 2.7 0.0 12.6 5.5

3.1 3.5 4.7 4.6 2.7 15.3 5.8 7.7 2.7 11.9 7.2

1.5 1.9 3.2 3.1 1.0 15.0 4.5 6.5 1.0 11.2 6.0

1.1 4.1 1.5 1.6 0.5 11.1 5.3 4.9 0.9 9.3 6.1

Source: Nomura, Bloomberg, Eurostat, FRB

This table is an extension of Figure 16, showing the raw inputs contributing to each of the four intermediate measures (labeled Inflation risk #1-4) u sed to calculate the final future inflation risk percentage. Each subcomponent is indexed from -2 to 15, with values less than zero representing future deflation and values greater than zero representing future inflation. The exception to this indexation method is the basic balance, which was indexed from 0 to 15 because a surplus in a countrys balance would not imply negative inflation risk. In the case of inflation pass-through, indexed FX pass-through and indexed CPI volatility were averaged together to find a final indexed value of inflation pass-through (inflation risk #2). Following this process, inflation risks #1-4 were averaged together to find an overall future inflation risk value for each eurozone country.

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Appendix IV: Eurozone assets by legal jurisdiction further detail

Fig. 1: Euro-denominated bond amounts outstanding in the eurozone (EUR bn)

Sovereign
Domestic International Domestic

Financial
International Domestic

Nonfinancial
International

Total

Foreign Foreign Foreign Foreign Foreign Foreign Local Law Local Law Unknown Local Law Local Law Unknown Local Law Local Law Unknown Law Law Law Law Law Law Austria 176 2 0 0 1 124 9 27 49 30 9 4 2 16 9 Belgium 306 15 4 0 5 2 0 0 7 1 7 4 2 6 86 Finland 69 0 0 1 0 8 1 1 13 10 3 1 0 8 1 France 1376 15 46 4 12 167 6 254 132 125 56 8 83 81 100 Germany 1491 1 39 0 23 1544 7 509 58 130 25 8 28 8 43 Greece 255 8 0 1 5 6 2 13 16 47 2 2 0 0 1 Italy 1498 56 19 19 14 531 29 36 112 90 15 12 1 31 210 Ireland 114 0 0 0 0 14 19 36 92 49 0 7 0 8 239 Netherlands 282 15 0 0 0 44 20 144 61 131 9 31 14 164 448 Portugal 105 12 2 1 2 21 2 18 14 22 14 2 3 0 26 Spain 627 42 11 32 16 469 13 21 19 33 10 3 4 29 279 Total 6299 166 121 58 80 2930 109 1060 574 670 150 81 138 351 1443

459 446 115 2466 3916 360 2673 579 1363 244 1608 14230

Source: Nomura, Bloomberg

Fig. 2: All EUR-denominated bonds

Sovereign
Amount Outstanding (EUR bn) Total 6723.4 Unallocated 3724.1 Allocated 2999.3 Local 2775.4 Foreign 223.9 English 133.1 New York 17.9 German 16.9 Other 56.0 % 100% 55% 45% 93% 7% 59% 8% 8% 25%

Financial
Amount Outstanding (EUR bn) 5343.9 1763.1 3580.8 2897.1 683.7 502.5 53.4 70.1 57.7 % 100% 33% 67% 81% 19% 74% 8% 10% 8%

Nonfinancial
Amount Outstanding (EUR bn) 2162.6 1477.9 684.8 253.1 431.7 236.5 56.8 132.4 6.0 % 100% 68% 32% 37% 63% 55% 13% 31% 1%

Total
14229.9 6965.1 7264.9 5925.5 1339.3 872.1 128.1 219.4 119.7

Source: Nomura, Bloomberg

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Appendix V: How to value the new ECU

We have argued that defining a new ECU would be important in facilitating an orderly redenomination process for certain eurozone assets and obligations. We also argued that introducing an ECU would be logical from a historical perspective. A transition process from EUR to ECU-2 for certain EUR denominated obligations could potentially reduce a number of difficult legal problems associated with redenomination, although the process is highly unlikely to be as smooth as was the case in 1999. In this appendix, we focus on the potential future value of the new ECU (ECU-2). Conceptually, there are two key fundamental inputs in the ECU-2 valuation exercise: The weights of individual national currencies in an ECU-2 basket; and The (expected) FX rates of the individual new national currencies.

Turning to the potential value of the ECU-2, we will rely on the initial estimates of new national currencies we have published separately (see Currency risk in a eurozone breakup: Valuing potential new national currencies - December 5, 2011) and presented in Appendix III of this document. We note that these estimates are based on a simple, twofactor framework, and should be viewed as longer-term equilibrium estimates, rather than an attempt to predict where currencies would trade immediately following a break-up. All estimates are expressed versus the USD.

Fig. 1: Fair value estimates of a potential ECU-2

ECU-2 fair value estimation

ECB Weights (A) Belgium Germany Greece Spain France Ireland Italy Netherlands Portugal Austria Finland ECU-2 calculations ECU-2 valuation 2.4% 18.9% 2.0% 8.3% 14.2% 1.1% 12.5% 4.0% 1.8% 1.9% 1.3% Baseline ECU-2 weights (B) 3.5% 27.7% 2.9% 12.1% 20.8% 1.6% 18.3% 5.8% 2.6% 2.8% 1.8% Sum (B * E) 1.13 ECU-2 weights (ex. Greece) (C) 3.7% 28.5% 0.0% 12.5% 21.4% 1.7% 18.8% 6.0% 2.6% 2.9% 1.9% Sum (C * E) 1.14 ECU-2 weights (ex. Greece, Ireland, Portugal) (D) 3.8% 29.8% 0.0% 13.1% 22.4% 0.0% 19.7% 6.3% 0.0% 3.1% 2.0% Sum (D * E) 1.16 Fairvalue in breakup (E) 1.02 1.36 0.57 0.86 1.21 0.96 0.97 1.25 0.71 1.25 1.25 -

Note: ECU fair values are expressed in ECU/USD terms. Source: Nomura, ECB

Figure 1 shows potential ECU-2 valuation of 1.13 (USD per ECU-2) in our baseline case where all current eurozone countries, except the smallest ones, have a weight in the ECU basket. The estimate rises to 1.16 (USD per ECU-2) if Greece, Ireland, and Portugal are

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excluded. The estimate is higher since these countries currencies are expected to be particularly weak in a break-up scenario. But the size of the difference is small given their small weight in the basket in the baseline case. The range of estimates 1.13-1.16 is well within the range where the euro has been trading versus the dollar since inception, and from a longer-term perspective, these estimates may be reasonable. However, one should expect potentially significant under-shooting of individual new national currencies and the ECU-2 basket in the immediate aftermath of a break-up. There is a large academic literature on currency undershooting in connection with 6 currency crises . Without going into detail, we think the same type of mechanics would apply in a eurozone currency crisis, certainly for a number of the currencies in the ECU 7 basket. Figure 2 below, derived from an IMF study by Baig and Goldfajn , illustrates the magnitude of the undershooting effect in certain historical currency crisis. The historical examples highlighted here indicate an average undershooting effect of 21% in past currency crises. Whether this magnitude of an undershooting effect would be appropriate for eurozone countries as well would depend on an evaluation of countryspecific parameters, such as external reserves, default risk, political stability, and net foreign asset positions, among others. How these effects interact with long-term inflation risk is likely to depend on country-specific dynamics, but that analysis will require another paper.

Fig. 2: Depreciation and under-shooting in past currency crises

80 70 60 50 40 30 % Estimated overvaluation (pre-crisis) Real depreciation (post-crisis) Estimated "under-shooting"

20
10

0
-10
Philippines
Mexico

Malaysia

Indonesia

Source: Nomura, IMF

Chile

Sweden

Thailand

Korea

UK

For example, see Cavallo, Michele, Kate Kisselev, Fabrizio Perri, and Nouriel Roubini. Exchange rate overshooting and the costs of floating. Federal Reserve Bank of San Francisco Working Paper. May 2005. 7 Baig, Taimur and Goldfajn, Ilan. Monetary Policy in the Aftermath of Currency Crises: The Case of Asia. International Monetary Fund. December 1998.

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References

Athanasiou, P. Withdrawal and expulsion from the EU and EMU: Some reflections", ECB Legal Working paper series No. 10, 2009. BaFin (2006): KfW risk weighting eq. Baig, Taimur; and Ilan Goldfajn, Monetary Policy in the Aftermath of Currency Crises: The Case of Asia. International Monetary Fund, 1998. BIS (2010): Triennial Central Bank Survey: Foreign exchange and derivatives market activity in April 2010, Monetary and Economic Department of the Bank for International Settlements (BIS), 2010. Cavallo, Michele; Kate Kisselev, Fabrizio Perri, and Nouriel Roubini, Exchange rate overshooting and the costs of floating, Federal Reserve Bank of San Francisco Working Paper, 2005. Dor, Eric, Leaving the Euro zone: a users guide, IESEG School of Management working paper series, 2011. Duisenberg, W.:The Past and Future of European Integration: A Central Banker s Perspective, International Monetary Fund per Jacobsson Lecture, 1999. European Commission, 2010: Surveillance of intra-euro-area competitiveness and imbalances, Economic and Financial Affairs,. Ferguson, Niall: 2021: The New Europe, The Wall Street Journal, 19 November 2011. KfW Bankengruppe (2006): Law concerning KfW. Nomura Europe Special Report: Event risk in Greece, 1 December 2011. Nomura Global Guide to Corporate Bankruptcy, 21 July 2010. Nomura Special Topic: Currency risk in a eurozone break-up: Valuing potential new national currencies, 5 December 2011. Nomura European Rates Flash: The CDO at the heart of the eurozone, 29 June 2011. Nomura Rates Insights: European Financial Stability Fund, 17 June 2010. Nomura Rates Flash: EFSF revisited, 4 October 2010. Nomura G10 FX Insights: FX after ECB: Taking Stock, 8 December 2011. Proctor, Charles, The Euro-fragmentation and the financial markets, Cap Markets Law J 6(1), 2011. Proctor, Charles, The Greek Crisis and the Euro A Tipping Point, 2011. Proctor, Charles, Mann on the Legal Aspect of Money, 6th Ed, Oxford UP, 2005. Scott, Hal S.: When the Euro Falls Apart, Intl Fin 1:2, p. 207-228,1998.

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