No currency in betting on the collapse of EMU
18 November 1997
Fears that speculators will gamble on the break-up of EMU during its transitional period have been overplayed, says Clifford Chance finance partner Chris Bates.
Lawyers always think of the worst that can happen - that, after all, is what they are paid for. A question often asked is: what will happen if European Monetary Union breaks up?
The Maastricht Treaty does not contemplate the collapse of EMU or the withdrawal of a participating member state from the single currency. For either of these events to happen an amendment to the treaty would be needed.
The currency union is envisaged as being as permanent as a currency in any existing single monetary area, such as the United States.
But there is, of course, a difference between EMU and other single monetary areas. The participating member states will remain separate sovereign countries with their own economic and fiscal policies and their own economic and fiscal problems, although the degree of economic convergence signalled by their meeting the Maastricht criteria is likely to be accelerated by the fact of EMU itself.
Break-up is likely to occur only in extreme circumstances. There is a huge political commitment behind EMU which is unlikely to be jettisoned quickly or without overwhelming forces. Member states are hardly likely to walk out of a commitment recently entered into because of a few transitional difficulties.
Strains caused by a member state's economic situation are only likely to show after some considerable time. So the transitional period may not in fact be the most risky period.
And contrary to views expressed by some market commentators, the existence of the transitional period does not necessarily make a break-up of the system more likely.
To many, the transitional period sounds horribly like the Exchange Rate Mechanism (ERM), from which the UK had to withdraw. However, the transitional period is quite different. The ERM ties existing currencies to a particular band of exchange rate levels. But in the transitional period, legally, the national currencies cease to exist.
The EU recognises that it is not possible to prevent speculators trading in the different expressions of the euro at rates other than the irrevocably fixed conversion rates. But Article 1091L(4) Regulation makes it less likely. It assures fungibility - for example, that a debt owed in a national currency can be paid in euros.
Unlike the ERM, there will be a single monetary authority for the whole euro zone, which will be broadly indifferent to whether money moves from one part of the euro zone to another.
For example, changes in the stock of deposits denominated in one national currency unit will not alter the overall stock of euro-denominated deposits at national central banks. Issuing more banknotes in one country can be counterbalanced by reductions elsewhere.
If any break-up does occur it is likely to be a messy business. Negotiations are likely to take some time and financial markets will have time to prepare.
A break-up would require legislation, either at EU or national level (or both), to deal with its effects. For example, a country leaving EMU would need to re-establish its own currency and determine the conversion rate by which obligations were converted from the euro (and its various expressions) to its new currency.
Contrary to popular misconceptions, the new national currency might be called something different from the old currency and the conversion rate might be different from the original conversion rates. The old national currencies would have ceased to exist on day one of the transitional period.
Most importantly, it would be necessary to establish rules for determining which obligations should be converted to that country's new currency and which should remain denominated in euros.
It is not possible to predict what those rules would be and whether (in the absence of EU legislation) those rules would be uniformly applied across the EU - let alone in third countries.
The break-up of a single monetary zone creates some difficult legal problems which are not easy to resolve. For EMU, this is true whether a break-up occurs during or after the transitional period.
Some guidance can be drawn from historical precedents as well as the degree of connection of a contract with a relevant state.
However, the key point is that you cannot be certain what obligations will stay in the euro currency (assuming that it continues to exist) and what will change to the new currency, making speculation difficult.
How can you sell short on a departing country's bonds, for example, if you are not certain those bonds will end up denominated in the new national currency. It may be that domestic bank deposits will be switched back to the new national currency, but you cannot be sure - and it is difficult to sell deposits.
The complexity of the problem makes it less likely that anyone would want to try to make money out of unravelling EMU.
You can always seek to protect yourself against the risk of the break-up of EMU, as you can against the risk of the break-up of any single monetary area. Whether there is any money to be made out of it is a different matter.
This article has been adapted from a speech by Chris Bates at the Royal lnstitute for International Affairs EMU conference in October.
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