Invited Contributors - Euro or Drachma, or Both? A Temporary Parallel Currency Concept
Euro or Drachma, or Both? A Temporary Parallel Currency Concept
By Carlos Abadi, Rafael de Arce Borda and Wolfgang Richter
May 6th, 2013
“Dramatic scenes in the streets of Athens; strikes are paralyzing all of Greece.” “Greek prime minister considers leaving the euro.” “German parliament will decide tomorrow whether to reject the refinancing of the public Greek debt due next month.” “Greek bank deposits are disappearing rapidly.”
The authors
Carlos Abadi
Carlos Abadi is President, CEO and member of the Board of Directors at ACGM and is responsible for the general and risk management of the firm, as well as the structuring of financial solutions to large, complex special situations. Carlos is a Member of the Boards of the Refco Litigation Trust and the Refco Private Actions Trust. He sits on the Advisory Board of Roubini Global Economics, LLC. and the Hillel International Board of Governors. Additionally, Carlos is President and Director of Abadi & Co., the ultimate parent of ACGM.
Carlos has been a guest lecturer at Columbia University, Harvard University, and New York University. Prior to founding the firm, he was Head Trader- Emerging Markets Debt Trading at The First National Bank of Chicago. Carlos has a Master's of Business Administration (Finance) from Cornell University's Johnson School of Business, and a Masters of Industrial Engineering from Universidad de Buenos Aires.
Rafael de Arce Borda
Rafael de Arce Borda is professor of Econometrics and Director of Master in Economics and International Relations: Geoeconomics and Geopolitics at University Autonoma de Madrid. Professeur MEAI Université Paris Dauphine. His research fields are focused in the development of Mediterranean economies, econometric models for policy simulation and multivariate analysis techniques for Social Sciences. Academically, he has been fellowship professor in several universities (Princeton, Dresden, Georgetown, Florence, Southbank, Nancy,…) and he is author of more than 50 academic and disseminative articles in prestigious journals. He acts as academic referee of Applied Economics, Economic Modeling, Political Sciences Review, Energy Policy. As a consultant, he has acted as advisor to several enterprises and institutional organizations (REPSOL, IBM, Iberdrola, United Nations – Link Project-, CEPREDE, Banesto, Sanitas).
Wolfgang Richter
Dr. Wolfgang Richter is Senior Advisor and European Representative for ACGM. Wolfgang has a long-standing career with the German Finance and Projects Group at DLA Piper, advising clients on all aspects of banking and finance. He is an expert in M&A deals in the financial sector, securitizations, real estate finance, non-performing loan deals, equity and debt structuring as well as advising investors and financial institutions on product development and strategy.
Wolfgang holds a J.D. from the University of Hamburg and a B.S. in economics from the University of Tuebingen. He is admitted to the Berlin bar.
Introduction
Numerous voices describe such headlines as a plausible future scenario. In spite of the recent relative calm in the markets, the euro break-up has been at the forefront of discussions since the start of the peripheral Europe crisis in 2007. In recent weeks this relatively quiet period has been disrupted by the Cypriot crisis and has led to renewed speculation about the future of the euro. All kinds of scenarios have been – and are being – considered including scenarios which foresee individual peripheral countries leaving the euro, or that core Euro Zone (EZ) countries do so [1] . Both the ECB and the political leaders of core Europe fiercely defy all break-up discussion and are fighting to keep the monetary union alive in its current form. But is this an optimal scenario? Or even a realistic one?
We believe the answer to the two above questions to be no and we offer an alternative approach: the temporary introduction of one or various parallel currencies to the euro in specific countries. Although there have been various proposals for parallel currencies in the wake of the current euro crisis, we believe that our approach offers some unique features which address problems that have not been yet been tackled.
In our opinion, clear goals and parameters are key for the success in this process:
Establishing a well-defined path of reversion (“return to euro”) will establish credibility and will boost the chances of turning the current macroeconomic vicious circle into a virtuous one;
The avoidance of improvisations with sudden announcements of short-term extraordinary measures; only a well-defined road map and calendar will produce the desired effects.
The latest events in Cyprus demonstrate how damaging improvisation and short-term measures can be. All parties involved have been under tremendous pressure, working within a very short time-frame, to come to an agreement on the refinancing of Cyprus’ public debt to avoid a disorderly insolvency and exit.
Economic and Political Factors
The crisis of the peripheral euro (Greece, Ireland, Spain, Portugal, and Italy) has led to a sharp widening of refinancing levels, sometimes dangerously closing in on or even surpassing the psychological 7% threshold. In several cases, the spectacular increase in spreads of peripheral debt as compared to German Bunds has led to public bailouts and/or private haircuts. As a result, peripheral countries are currently under severe public expenditure control (Ireland, Portugal, Spain and Greece).
Unlike the case of the US, the failure of labor mobility within the EZ has led to radically different employment situations in countries like Spain or Greece (with unemployment rates of over 25%), as compared to others like the Netherlands, France or Germany (with unemployment figures in the 7-10% range).
Austerity policies as a fiscal deficit reduction tool have proven ineffective and even detrimental across euro member states as they often resulted in an activity slowdown across almost all the European countries. Although internal devaluation strategies have worked out for approximately 10 years within the EZ, their negative effects on output have overshadowed the positive impact on public accounts, which leads us to question their validity.
Fiscal austerity faces several problems when it is used as a tool to improve competitiveness. While public sector pay cuts may have a positive effect, a real challenge appears in the private arena: when drastic cuts in income are not simultaneously offset by lower prices of goods and services, austerity quickly faces social refusal. Additionally, private agents are often reluctant to reduce their prices in line with the public sector price cuts. In theory, this disconnect could be overcome by legislation mandating across-the-board cuts in salaries and prices; however, this policy, even if legally feasible, would certainly face stiff political resistance and, even if ultimately implemented, would lead to supply-demand imbalances.
It is obvious that the peripheral euro states need massive growth in order to be in a position to service their current debt levels [2]. Three main factors have to be taken into account: (i) the country’s productivity relative to other member states, (ii) its unemployment rate, and (iii) its fiscal primary balance (which is heavily influenced by the first two factors, but also dependent on spending behaviour of the member state and its citizens).
Therefore, boosting the real economy is the only efficient tool to adjust the differences in productivity and employment between peripheral and core euro countries, hence the call for devaluation, being it external or internal, to solve the current status quo.
Yet, excessive public expenditure in a context of income reduction (resulting from GDP contraction) has hampered the growth opportunities for several economies in Europe which have already committed to austerity measures to meet the stability conditions of the Euro Club. Trapped in a vicious circle, public expenditure cuts reduce the scope for counter-cyclical policies, leading to further GDP contraction and, ultimately, reduced fiscal revenues. As a result, the public deficit worsens and the increased public debt must be financed at wider spreads over the reference rate: this further restrains public policies that could potentially be implemented and often results in even more difficult structural reforms in terms of productive investment (external finance flows decrease due to a higher default risk). So, the international competitive position deteriorates in both real and financial terms.
In order to invert this vicious circle, exchange rate devaluation [3] could be the key to:
Reduce the current account deficit by improving competitiveness;
Increase domestic consumption and investment through new monetary flows (coming from the private banks and the Central Bank) and new employment opportunities;
Reduce the pressure on public accounts through debt denominated in the newly-introduced national currency (sterilized, as needed by the Central Bank) and, especially, from the additional fiscal revenue resulting from the positive economic growth and unemployment reduction; and
Facilitate structural reform policies, and boost the long-term competitive position.
External devaluation can obviously be achieved by a definitive withdrawal of a euro state. Yet it would obviously endanger the benefits of a single currency between the states within the single European market. The suppression of exchange rate costs in a single market heavily concentrated between EU members would disappear, and the national monetary stability produced by the system within the EZ would be compromised. Most importantly, the balance-sheet costs of exit would be substantial.
A temporary withdrawal cannot be managed successfully ex-ante, as an open negotiation prior to introducing the new currency would most probably foster tremendous capital flight.
So external devaluation is coveted as it fulfils the requirement of completeness (all prices) and immediacy, as the process is instantaneous. However, immediacy poses a tremendous problem in practical terms: the switch to the new currency has to happen overnight to avoid massive capital outflows from the local state into other member states or even foreign states. A standard approach consists of announcing the introduction of the new currency on a Friday after close of business, imposing immediate capital controls and preparing the opening on Monday morning (or later) so as to guarantee non-disruptive trading in the new currency. Secrecy in the introduction of the new currency is required to avoid damaging speculation and ensure a totally managed process. While it may be possible to engineer a unilateral exit/devaluation with the required secrecy, the relationship to the other EZ states and a potential return path could not be pre-negotiated under this template. This process, aside from being suboptimal, would entail huge risks.
The Solution: Parallel Currency for Value Creation Going Forward
Our parallel currency approach aims to capture the advantages of a devaluation, while avoiding the cost of an unmanaged breakup.
There have been long-standing experiences of parallel currency systems (see Dirk Meyer, 2011 or Borssone and Sarr, 2011 [4]). The recent case of IOUs in Argentina (“patacones” et al) at the beginning of the century offers a great illustration. Provincial governments issued one year IOUs and used them to meet their current obligations. These IOUs were then used as a parallel currency and actually traded relatively close to par (see The Economist, November 10th 2011 [5]). However, none of those attempts have been carried out on large enough of a scale to successfully address the competitiveness problem, and certainly not in the framework of a monetary union managing a parallel currency in an agreed process with the other member states.
Our suggestion of a parallel currency has several unique features:
(i) The external devaluation will only apply to value creation going forward, i.e. current values will be maintained in euros or euro equivalents [6];
(ii) Those market participants having on the one hand obligations to be paid in euros, and on the other claims to be collected in the parallel currency (mainly banks) will get compensated by the local Central Bank for those contracts effective at the cut-off date;
(iii) There would be a devaluation target set by the local Central Bank and executed via capital market instruments; the inflationary effect of the parallel currency would be monitored and managed by the local Central Bank in coordination with the ECB;
(iv) At any point in time, the parallel currency can be converted into euros and any parallel currency holder can always decide to hedge in euros.
As previously mentioned, the key problem of introducing a new currency is that it has to happen virtually overnight to avoid massive capital outflows from the local member state into other member states or other currencies. Since we maintain in our approach the values of the assets at the cut-off date in euro, there is no incentive for capital flight resulting from the introduction of this new currency [7].
We suggest redenomination at par, i.e. one unit of the parallel currency represents one euro. The principle is that all the claims before cut-off date stay in euro so as to not be expropriatory [8]. If the basis for the performance is initiated after the cutoff date, then the claim/liability is redenominated. However, the creditor should be entitled to compensation by the local Central Bank if the creditor is faced with long-term contracts which cannot be terminated early and the creditor receives consideration in parallel currency. The two main types of long-term contracts that this would affect are bank financing/refinancing and long-term renting/leasing. Bank deposits and other bank refinancing instruments would not be redenominated; however, banks’ lending often is long-term and clearly, such banks’ loans have to be redenominated to achieve the benefits of devaluation – parallel devaluation of income and the cost base for the citizenry (with the exception of imports), i.e. we cannot impose on a borrower to repay a loan in euro with a wage paid in local currency. Technically, such compensation to the banks could be in the form of bonds issued by the local Central Bank which allow banks to be compensated at a future date based on a devaluated local currency amount. Until such moment, those bonds would not introduce inflationary pressure as they would simply sit on the banks’ balance sheets, allowing them to maintain their pre-cutoff date capital levels. Yet situations where the banks refinancing obligations mature prior to the maturity of these “compensation bonds” need to be addressed. One solution would be to allow refinancing through the local Central Bank with a predefined haircut.
Long-term renting and leasing in principle suffer the same problem for the lessor. In these cases, the difficulty lies in quantifying the compensation the lessor is entitled to. If the lessor’s refinancing is also redenominated into the new local currency, there should not be compensation claim. The situation becomes different if the performance of the lessor is financed by equity or by non-redenominated funds. Then compensation would be appropriate.
Clearly, one has to look at how this affects inflation of the parallel currency. The inflationary consequences resulting from these newly issued bonds can be controlled, for instance by limiting the banks’ ability to use the proceeds to refinance themselves through the local Central Bank or actively trading them. However, the main purpose of our approach is to instigate a controlled inflationary process in order to achieve an external deflation effect. So it may even be appropriate to allow refinancing, as this could expand the monetary supply in a controlled manner.
Obviously, which of the respective contractual obligations should be redenominated and/or should be subject to a compensation claim has to be carefully thought out. For instance, all contracts related to future events like forward swaps are priced according to sophisticated forward looking models. The party entitled to receive future payments could rightfully expect that those payments should be made in euros rather than in parallel currency to avoid any loss. But this should only be the case when the receiving party has to meet obligations in euros.
Managing the Money Supply of the Parallel Currency
The local Central Bank can use all available money market instruments to control the supply of the new currency. This includes the setting of refinancing interest rates charged to banks, active open market operations, and capital control measures. The initial devaluation target should be a political decision pegging the parallel currency to the euro rather than the result of free market forces. We suggest that the member state should initially fix a specific devaluation target for a specific period of time, for instance two years.
We further suggest that the Central Bank of the member state introducing a parallel currency should manage the devaluation target by offering forward contracts to the market that secure parallel currency exchange into euros with a specific premium and a minimum settlement date (for instance 2 years). That would allow the Central Bank to manage the inflationary expectations of the parallel currency by varying the swap premium and using money market policies to manage the exchange rate. For instance by affecting the supply of parallel currency (M1), publishing inflation targets, etc.
The swaps would be brokered on an exchange platform run by a clearing institution which guarantees that the exchange contracts will be fulfilled. Each swap holder could then trade these contracts at any time. At settlement date, the exchange platform settles all the contracts. The necessary euro amounts are provided by the local Central Bank from its reserves.
The entire process would be pre-agreed with the ECB. A procedure would need to be agreed upon between the local Central Bank and the ECB as to how the parallel currency is managed in terms of inflation, interest rates etc. This process would require the ECB, other member states, the local Central Bank and the local government(s) to agree on how long and under which criteria the parallel currency system is to be implemented and an exit strategy for the reconversion of the parallel currency into euros at a future date. We do not view these agreements as specific automatic processes of reintegration, but rather as flexible rules to be negotiated among the parties.
Certainly, once it is publicized that a member-state is negotiating the introduction of a parallel currency with ECB and the other member states, financial markets and all asset holders potentially affected by the introduction of the parallel currency will evaluate the possibility of moving their local funds abroad, liquidating their assets and taking their money out of the country. Therefore, the credibility of the local government, the ECB and the other EZ states is key to reassure these asset holders that the value of their assets will be preserved according to the outlined criteria. Since such credibility will be difficult to achieve from the outset, temporary capital control measures might also be used until confidence is restored.
As a result, all exporting industries will benefit, while all importing industries would suffer, which is exactly the desired effect: substituting imports for local goods and boosting exports. Yet the overall effect of the devaluation would be a reduction of unemployment, enhanced economic activity, an improved primary balance and, ultimately, growth.
The Example of Greece: Introducing the New Temporary Drachma
Greece has been rigorously following the path of austerity, at least in the view of its government and, even more so, its citizens. However, despite substantial cuts in salaries and spending, the country is still running a primary deficit (around 2% of GDP) and, still, in spite of a radical haircut on its debt to private holders, the prospect that Greece will ever be able to repay its debt in full is dim.
In order to evaluate the consequences of introducing a parallel currency in Greece (the “New Drachma”), we have modeled the effects of this policy on the real economy by varying the exchange rate. We have run different simulations for the exchange rate devaluation using a neoclassical simultaneous econometric model in a two year time horizon for 2011 and 2012 with Greece’s current macroeconomic data as a baseline.
An assumed devaluation of 15% of the exchange rate during 2011 and 2012 would have produced around a 1% increase in GDP growth, composed of a private consumption growth of around 0-0.2%, an increase in exports of around 7% and a decrease of imports of approximately 10%. In this scenario, employment figures are not significantly improved, but its 6.5% deterioration would stop. The unemployment rate would decrease from 22-25% to 20%-22% in our first simulation. The primary public deficit (-4,777 million euros in 2011), would be reduced in this scenario to 1,000 Million euros.
In a second simulation, we estimate the effects of a 30% devaluation of the exchange rate. In this situation, the external trade balance records positive export growth of around 11% and an import decrease of around 13%. Domestic demand is boosted by 5%. Employment figures clearly improve, increasing by around 3% and unemployment decreases to under 19%. Primary public deficit would be brought back to zero, boosted by a reduction in unemployment and an increase in payroll tax revenues from new workers.
However, devaluations of 15% or 30% are not enough to significantly affect gross capital formation, which starts showing positive improvements under a 50% devaluation scenario. Only in this case does Greece achieve a modest primary public surplus and, of course, this surplus is accompanied by better results in terms of external trade (increase of exports around 19% and decrease in imports of 18%), new employment (10% of employment increase and unemployment rate situated around 14%).
Certainly, it is difficult to evaluate the consequences of such devaluation in terms of social conditions and acceptance by citizens; however, recent history demonstrates that these kinds of events have had positive and non-traumatic results in those countries where they have been applied. In the monetary system crisis of 1992-1993 several countries decided to implement substantial devaluations in a very short-time frame. Spain, for instance, reduced its exchange rate against the Deutsch Mark by 20% in 5 months and the United Kingdom devalued the British Pound by 40% in 1930, after abandoning the gold standard. And one has to take into account that Greece’s minimum wage cut [9] trickled through the Greek economy also leads to an (internal) deflation process which we estimate is more than 20% [10].
This analysis shows that the introduction of a depreciating parallel currency can have a substantial positive effect on the debt dynamics of the introducing state and is therefore also in the best interest of the rest of the EZ. The stakeholders in the EZ should consider such a parallel currency approach which combines the advantage of an immediate thorough devaluation with political stability, keeping the troubled membership states within the EZ.
Summary
Only our suggestion of a parallel currency combines the advantages inherent in the internal devaluation and exit policies: it provides instant devaluation while staying within the euro community with a defined schedule for full reintroduction of the euro as the sole legal tender. Key to the success though is that upon embarking in negotiations on such a policy with a member state, the ECB and the EU communicate together with the local government that all its equity values at the moment of the cutoff date will be preserved in euro and only the value creation going forward will be subject to the parallel currency and as such to the devaluation. Clearly, there are intricacies as to how to define the equity value; but, this can be done in a sufficiently transparent and acceptable manner: for those who are faced with long-term obligations in euros (receiving income in the parallel currency) the local Central Bank can compensate. This refers mainly to the banks and long-term renting and leasing.
The new parallel currency has to be managed in terms of inflation; however, the local Central Bank can, in conjunction with the ECB, use a broad array of tools to this effect. The introduction of an exchange-centered swap market for hedging the parallel currency to the euro will be one critical element of such arsenal.
Finally, our modeling has shown that such an immediate devaluation will have positive effects on employment, primary deficit and GDP as compared to the alternative of not devaluating immediately and accepting a long drawn out process of internal devaluation.
Bibliography
Boesler, M., 2012: “INTRODUCING THE ‘GEURO’: A Radical New Currency Idea To Solve All Of Greece’s Problems”. Bussines Insider, May, 20th 2012.
Bossone, B. and Abdourahmane Sarr , 2011. “Greece Can Devalue AND Stay in the Euro”. Economonitor, July 7th, 2011.
Markusen, J. R. and Venables, A. (2000) “The Theory of Endowment, Intra-Industry and Multi-National Trade”, Journal of International Economics 52: 209-234.
Read more: http://www.businessinsider.com/introducing-the-geuro-a-new-parallel-currency-to-solve-all-of-greeces-problems-2012-5#ixzz2LiceUx2V
Mundell, R. A., 1961. “A Theory of Optimum Currency Areas”. American Economic Review 51 (4): 657–665.
Mundell, R., 1973. “A Plan for a European Currency”, In Johnson, H. G. and Swoboda, A. K. (eds.), The Economics of Common Currencies: Allen and Unwin, p.^pp. 143-172.
Notes
[1] See a comprehensive discussion of those options, Roger Bootle, Leaving the Euro: A Practical Guide, 2012, in: Wolfson Economic Price MMXII
[2] And the ongoing discussion will continue whether the current external debt is too high to allow the return to a sustainable growth path.
[3] One famous example about how this effect can be mitigated by dual currency is the example of the city ofWörgl inAustria between 1932 and 1933. This model effectively worked with a negative interest rate, and fostered continuous spending, boosting local activity (see also Buiter, W., 2009[3]).
[4] Dirk Meyer, 2011: Das Konzept der Parallwährung für die Eurozone, IFO-Schnelldienst 23/2011, p. 12.
Bossone, B. and A. Sarr (2011), “Greece Can Devalue AND Stay in the Euro”,http://www.economonitor.was; and Boesler (2012)
[5] The Economist, 2011: “Breaking up the Euro. How it could happen; why it would be horrible”. November, 10th 2011.
[6] A similar approach to that outlined by Michael Vogelsang, Die temporäre Doppelwährung als Anpassungsinstrument, ifo Schnelldienst 23/2011 – 64. Jahrgang, who suggests preserving all asset positions in euro if notified to the tax authorities; however, he does not specify how that practically should be achieved.
[7] Capital flight and speculation could obviously still happen should the countries’ fundamentals deteriorate further – failure to generate a surplus – or if creditors are unwilling to concede significant write-offs.
[8]See detailed table showing the appropriate treatment of the different asset/contract types in, Wolfgang Richter, Carlos A. Abadi, Rafael de Arce Borda: EURO OR DRACHMA? OR BOTH? A temporary parallel currency concept (exended version)
[9] Reduction of 22%, and 32% in the case of those under age 25
[10] Comprehensive figures for this are not available, but we estimate that compensation (including the black market) for employees and freelancers has been reduced by at least 20%.
