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  • 8/6/2019 Emu Will the Emu at Risk


    68 / INVESTMENT POLICY Volume 1, No. 5

    EMU How Will the

    Markets PriceBreak-up Risk?

    Neil Record


    IT SEEMS churlish to present a discussion on the possible break-up ofthe euro just as the currency has been successfully introduced. It feelsa little like worrying about cancer or heart disease in a month-old baby.

    Nevertheless, in just the same way that a healthy newborn is likely tohave health insurance provided at birth or while very young, investors in

    euroland will be well served if they do a little early thinking about pos-

    sible difficulties down the road.

    In this article I will present a rather gloomy picture. I do not claim

    that a gloomy outcome is certain, or even likely. But I do claim that it is

    possible. To use another analogy, national defense planning only makes

    sense if planners contemplate, in great detail, the possibility of war.

    Generally speaking, the better the planning, the less the likelihood of war.

    I would like to think that the same argument applies to investment in


    I propose to set out my argument in two strands. The first is the po-

    litical and economic case that the euro is not irrevocable. This will in-

    volve building plausible scenarios that lead to a crisis. I am not the first

    to do this, nor the best.1 (Notes begin on page 79.) The second strand is to

    examine the way the markets will develop to deal with break-up risk.

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    Finally, I will reflect briefly on how investors might control their expo-

    sure in the event of a crisis.


    The legal basis for the establishment of the euro is a series of international

    treaties. The political process by which these treaties arose was spread over

    some 40 years, but in line with official usage, I will call the current legal

    basis the Treaty.2 One of the fundamental characteristics of the Treaty

    is that it states that the adoption of a single currency is irrevocable. As a

    statement of political objective, and perhaps of practical necessity, the

    case is arguable. Certainly, there seems little point incurring substantial

    transactions costs to go into a monetary union that is no more enduring

    than a cheaper and more flexible exchange-rate system. More to the point,

    monetary union does not really bite unless the participants believe it to

    be irrevocable. If the whole point of monetary union is to eliminate the

    possibility of intra-euroland currency risk, then by definition if the pos-

    sibility of a break-up exists, the possibility of intra-euroland currency risk

    is not eliminated.

    But for any student of history, the concept that anypolitical position

    could be irrevocable is implausible. How much more implausible, then,

    when the members of the currency

    union are themselves lively

    democracies, each with a clear be-

    lief in its own sovereignty, and

    each able to elect to power a party

    that could favor withdrawal.

    Now, such talk will not be

    heard in most establishment polit-

    ical parties in euroland members

    and is heresy in official European

    circles. But democracy is unruly,

    and like prices, the political wind changes in response to the needs of the

    people. I plan to demonstrate that the conditions to encourage an elec-

    torate to support a withdrawal party, or to persuade a party in power to

    move to a withdrawalist position, are already present. I further aim to

    INVESTMENT POLICY January/February 1999 / 69

    How Will the Markets Price Break-up Risk?

    Monetary union does notreally bite unless the partici-pants believe it to be irrevo-cable. But for any student of

    history, the concept that anypolitical position could beirrevocable is implausible.

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    70 / INVESTMENT POLICY Volume 1, No. 5

    Neil Record

    show that only very gentle assumptions are needed to prod this scenario

    into life.


    The European Central Bank (ECB) has been designed to be independent.

    There is a clause in the Treaty prohibiting it from taking instructions from

    any European Union (EU) body and from any member state or National

    Central Bank (NCB). It has one monetary policy objective enshrined in

    its constitution ensuring price stability. It has discretion as to how it

    targets that objective (either by direct inflation targeting or by monetary

    base targeting), and the European Monetary Institute (the precursor of

    the ECB) issued a document3 in which it discusses the relative merits of

    the two approaches. The practical result is likely to be a combination of

    the two.


    However much purists might disagree, the heart of monetary policy is the

    management of domestic interest rates. If inflation appears to be getting

    out of control, the ECB knows it has to put up interest rates. If infla-tion seems quiescent, it can let them fall. Simple.

    Simple for an NCB, but I argue less so for the ECB. The first observa-

    tion to make is that there is no gen-

    erally accepted measure of

    euro-wide (that is, 11-state) infla-

    tion. Inflation series are compiled

    and calculated in different ways in

    different member states, although

    EUROSTAT (the Commission) have

    attempted to iron out those gaps by

    developing Harmonized Indices of

    Consumer Prices (HICPs) . But

    how do you get from 11 harmo-

    nized inflation rates to one inflation rate? Unweighted average; weighted

    average; neither of the above?

    There is no generally ac-cepted measure of euro-wide(that is, 11-state) inflation.Inflation series are compiledand calculated in differentways in different memberstates.

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    INVESTMENT POLICY January/February 1999 / 71

    How Will the Markets Price Break-up Risk?


    There is not yet an answer to that question, but let us imagine a partic-

    ular future scenario and try to assess the ECBs response to it. Suppose

    that a group of Mediterranean member states are experiencing a wage-cost boom, with accompanying rises in their HICP inflation rates. At the

    same time, some northern European states are not experiencing any rise

    in inflation, but if anything a fall towards zero and a concern about de-

    flation. What does the ECB do? It has no way of differentiating between

    the differing regions in its monetary policy, so one size fits all.

    I doubt whether the ECB will ignore the southern boom. If it does, it

    is quite possible that this would be seen as the green light for an output-

    price and asset-price bubble as investors see that runaway economies arenot going to be reined in. More, they could see that membership of the

    euro gives them an implicit exchange-rate guarantee. Apart from the ECB,

    there is no natural circuit breaker for an economy behaving like this. The

    likelihood, then, is that the ECB could only delay for so long before being

    forced into action or being charged with dereliction of duty.

    Once the ECB admits the problem, it has only one instrument mon-

    etary policy. In laymans terms, putting up interest rates. But this action

    has to be agreed in the ECB Governing Council, and let us suppose thata majority of members would see an interest rate rise as harming their

    national interests. They may vote against it. Unfortunately, such a vote

    would be seen by the markets as condoning a soft euro, and the for-

    eign exchange market in particular may respond by allowing the euro to

    weaken. This could fuel the inflationary spiral in the southern states, forc-

    ing the ECB to rethink.

    But putting up interest rates in a slow-growing northern European

    economy, riddled with high unemployment and struggling against de-valued imports from Asia, would be deeply unpopular. Here the inde-

    pendence of the ECB would be severely tested. To what extent could

    legitimate political and electoral calls for some monetary laxity be ignored

    by the ECB? Politicians will rightly argue that the ECB has it too easy.

    Any institution that has only one policy objective, and only one policy

    instrument, is not forced to undertake the weighing of competing de-

    mands that good economic management requires. Indeed, why should

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    72 / INVESTMENT POLICY Volume 1, No. 5

    Neil Record

    the ECB not aim for zero inflation as the euro average? Why should the

    ECB care if that requires 12% interest rates, 25% unemployment, and neg-

    ative inflation in some northern nations? Unemployment and growth are

    not part of the ECBs remit, so strictly speaking they cannot be taken into



    A similarly difficult position could arise from a different set of circum-

    stances. Suppose that the Italian government, under pressure from its po-

    litical supporters and the electorate, does not renew the temporary

    Maastricht taxes that allowed it to squeeze under the 3% fiscal deficit

    criterion. While the Council of Ministers will start to agonize about ap-

    plication of notices, deposits, and penalties under the Stability Pact, the

    ECB will have a much more pressing problem monetary base expan-


    An NCB never really has this problem. It is such an intimate part of

    the government funding system, that it is always in the thick of the ac-

    tion. It may be exasperated by the fiscal antics of its Government, but it

    has prior notice of government debt issues and deep insight into the do-

    mestic banking system. And as the compiler and generator of monetary

    data, an NCB will have all the available monetary information at its fin-


    The ECB is not so fortunate. If the Italian government is borrowing

    too much, it would naturally use its NCB, the Central Bank of Italy, to

    mediate the debt issue. If the ECB gives the NCB an instruction to limit

    its issues of Italian Government debt to the approved level, the govern-

    ment can resort, in fact will have to resort, to all the other myriad fund-

    ing routes available to a sovereign debtor in particular bank credit. This

    is popularly known as printing money.

    To reestablish monetary control, the ECB has to find a way of in-

    structing the Italian Government to increase taxes or reduce expenditure.

    While the ECB can instruct an NCB, it cannot instruct a government. Its

    backstop is to tighten monetary policy to squeeze liquidity out of the

    whole euro system, in effect taking liquidity out ofprudent economies


    nance and underwrite Italys spending spree. This will be unpopular,

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    INVESTMENT POLICY January/February 1999 / 73

    How Will the Markets Price Break-up Risk?

    but the ECB will have no choice. Is this kind of behavior from the ECB

    really going to command the support of the electorates in the majority

    of member states? We will then see how independent the ECB really is.


    The next stage in either of these potential scenarios is a process of disil-

    lusionment. Today we hear from its supporters that the euro is a politi-

    cal project, and that it will succeed because the political will is sufficient

    to make it succeed. But if this is true, and this is the only reason for the

    euros success, then what happens if or when the political will disap-

    pears? After all, political will is not an absolute. Political will means

    what politicians want to do at the moment.

    In democracies, politicians are not independent reservoirs ofwill.

    They are elected for fixed terms,

    and either they keep their elec-

    torates satisfied by reflecting ma-

    jority views in their policies, or

    they are defeated in the polls and

    replaced. If either of the above sce-

    narios occurs, or a plethora of

    other possible difficulties, there

    will be at least one nation whose

    citizens will perceive that member-

    ship in the euro is damaging. In

    both of the cases above, the obvious candidates for this disillusion are

    France or Germany.

    It is possible to imagine that the electorates can be denied access to

    withdrawalist policies for a while. Mainstream parties may continue to

    say that continued membership of the euro is essential, that the costs of

    withdrawal are too high to contemplate, that withdrawal is constitution-

    ally impossible, and that other solutions are available to mitigate the

    problem. But the problem, say rising unemployment as a result of a

    continuous monetary squeeze, is not easily amenable to other solutions

    within the euro straightjacket.

    As the northern electorates get increasingly fed up with interminable

    If either of the above scen-arios occurs, or a plethoraof other possible difficulties,there will be at least onenation whose citizens willperceive that membershipin the euro is damaging.

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    74 / INVESTMENT POLICY Volume 1, No. 5

    euro-initiatives, with rounds of Council of Ministers meetings, and with

    new ideas to mitigate the Italian (or other) structural fiscal deficits, one

    or more political parties begin to offer a radical new approach negoti-

    ated withdrawal. They will argue that withdrawal is an option, that the

    euro is better off with genuinely convergent economies, and that the cost

    of withdrawal will be less than the continual pain of deficient demand

    and high and rising unemployment. It is plausible to argue that such a

    party would gain wide support if the pain was bad enough.

    Before dealing with the denouement, I want to turn to the second

    strand of the case.



    Some participants in the financial markets have already begun to ask

    themselves what happens if the euro is not durable. They may also have

    read some of the skeptical literature.4 Lets assume they come to the view

    that if the euro were to break up, Italy in all likelihood would be an early

    casualty. If Italy left the euro (or if Germany and its economic satellites

    formed a new super euro), they believe that Italy will suffer higher in-

    terest rates and a weaker currency than Germany.

    Many fund managers and corporate Treasurers have been schooled in

    modern portfolio theory and option theory. They understand that finan-

    cial risks can be codified into mathematical models, and with certain as-

    sumptions these models will price risk. They are familiar with concepts

    such as implied volatility,5 and

    they will seek to analyze, quantify,

    and ultimately trade euro break-up

    risk. Interestingly, the mathematics

    of break-up risk have strong simi-

    larities to credit modelling. Bonds

    are priced in part on the credit rating of their issuers, and each issuer com-

    mands a different credit premium. Most issuers have never defaulted, and

    in the case of AAA issuers, the implied risk of default per annum is very

    low say 0.1%. That is not to say that break-up risk is to be confused

    with credit risk. The act of, for example, the Government of Italy de-

    faulting on its debt is independent of the act of the Government of Italyleaving the euro. Far from being related, they are probably negatively

    Neil Record

    The mathematics of break-uprisk have strong similaritiesto credit modelling.

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    INVESTMENT POLICY January/February 1999 / 75

    correlated; Italy may really struggle to fulfill its euro obligations because

    it cannot inflate its way out of trouble. Once out of the euro, it can re-

    denominate its debt to the new national currency, and can once again

    fulfill its obligations using its tax-raising powers and currency-issuing sta-

    tus. The question of whether unilateral compulsory re-denomination is

    default has already been answered it is not. Investors in German mark

    bonds (and in the other 10 euro countries bonds) have just suffered such

    an event (on January 1, 1999), and the markets have decided that this is

    not default.


    Once the markets have established the concept of break-up risk, it is a

    short step to price it. Lets assume an investor believes that there is a 2%

    per annum risk that break-up will occur, and that break-up would cause

    the price of, say, Italian bonds expressed in euro to fall by 50% (20% cur-

    rency fall, for example, and 30% interest-rate mediated bond-price fall).

    That investor would then demand at least [2% x 50% =] 1% break-up

    yield premium to hold Italian bonds rather than, say, German bonds. The

    arithmetic is much simplified, but it gets to the right order of magnitude.

    What is striking is how high the break-up premium is even for quite

    low (2%) annual risk of break-up. Several surveys have been conducted

    on the markets view of the likelihood of euro break-up.6 Most have come

    up with annual break-up risks in the order of 3% per annum (derived from

    around 10% risk of break-up before 2002). This prices the annual break-

    up risk yield premium at much more than 1%, even on benign assump-

    tions about the impact of break-up.


    Lets take the credit analogy one step further. Prior to the default of a

    struggling bond issuer, the market begins to mark down the value of the

    bonds, marking up the credit premium in the process. The market is

    changing two of its assessments in this process the timing of default,

    which is being brought forward, and the likelihood of default, which is

    being increased. The two have a combined effect that is potent.

    Exactly the same process will occur in a euro crisis. Assuming that

    How Will the Markets Price Break-up Risk?

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    76 / INVESTMENT POLICY Volume 1, No. 5

    prior to the run-up of a euro crisis, Italian bonds were trading at, say, 1%

    yield premium to German bonds (based on the arithmetic and assump-

    tions above), we can roughly chart

    the progress of the deteriorating

    crisis. If the market begins to think

    that the euro cannot last in its pre-

    sent form, then it will radically re-

    vise upward its probabilities of

    failure. If the break-up risk is 3%

    per annum, the market may revise

    this to virtual certainty over, say, a

    two-year horizon. This is 50% risk of break-up in year one and, given sur-

    vival, 100% risk in year two. The probabilities cannot rise any further to

    reflect further deterioration (they are already at 100%), but the time-scale

    could begin to collapse. The market may begin to hang its timing expec-

    tations on a summit, or an election date. As these get closer, the math

    gets alarming.

    Assuming no physical restrictions, investors will remain indifferent

    between countries invested in if they think they will end up with the

    same money. If they believe for certain that a summit scheduled to takeplace in two weeks time will bring about the end of the euro, and that

    this will precipitate a 20% fall in the new currency (lira) versus the euro

    or new mark, then they will require an annualized Italian risk premium

    of 20% x 52 / 2 = 104% just to hold Italian cash. Supposing short-term

    euro interest rates are 6% at the time, then even without a risk premium,

    Italian two-week money-market rates will be 110%. This is likely to im-

    pose severe difficulties (to put it mildly) on the ECB in the conduct of its

    monetary policy, and on the Italian authorities in preventing revolution!The difficulties of interest rates like this will be so severe that national

    authorities will not allow them. But that means exchange controls or gov-

    ernment intervention. Exchange controls are not just practically difficult

    in the integrated euroland economies, but conceptually difficult. How

    would you impose exchange controls between Scotland and England, or

    between New York and Connecticut, and what effect would you be try-

    ing to have? The ECB cannot intervene differentially in one country ver-

    sus another, so there is left the prospect of a national government

    Neil Record

    The market may begin tohang its timing expectationson a summit, or an electiondate. As these get closer, themath gets alarming.

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    INVESTMENT POLICY January/February 1999 / 77

    attempting to do so. But when the national government is not the issuer

    of the currency, it is actually quite hard to work out what intervention

    would mean or how it would be done.

    ECB bank notes will be printed centrally by the ECB and will not dis-

    play individual country identifying features. They are therefore ideal

    hedges against own-country devaluation. Coins will have identifying na-

    tional features, and will be minted in individual countries. Their useful-

    ness in a crisis could be rather less, and that opens the possibility that

    notes and coins could trade at different prices (that is, a 10 euro note

    would trade at something more than 10 Italian-minted one euro coins).


    The financial markets will recognize early that the leverage in any break-

    up play is in the bond markets. Just as the 199698 Italian conver-

    gence play took place in the bond

    markets, so the putative diver-

    gence play will use the same mar-

    ket. The leverage is again in the

    math. A 5% coupon 20-year bond

    will trade at 100 when the prevail-

    ing 10-year interest rate is 5% per

    annum, but at 57.4 when the pre-

    vailing 10-year interest rate is 10%

    per annum. As long as there is per-

    ceived to be a possibility, however

    remote, that the domicile of a bond could be the determinant of whether

    its value stays at 100 or falls to 57, the market will use its credit-pricing

    models to price in its concerns about the stability of the euro area. We

    will therefore have a sensitive and sophisticated measure of independent

    best guesses of the euros survival or demise. The problem for policy-

    makers is that the bond markets are very unlikely to always price the risk

    of break-up at zero. The ECB, therefore, far from dealing with a level mon-

    etary playing field across Europe, will face the prospect of a major aspect

    of country-specific interest-rate management being taken out of its hands.

    It is possible thatthe authorities

    either national governments or

    How Will the Markets Price Break-up Risk?

    Just as the 199698 Italianconvergence play tookplace in the bond markets,so the putative divergenceplay will use the samemarket. The leverage isagain in the maths.

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    78 / INVESTMENT POLICY Volume 1, No. 5

    the ECB may decide that significant interest rate differentials are

    politically unacceptable. They may then intervene in the markets to con-

    tain the differentials, a policy that is fraught with dangers in the event of

    a break-up. But they may be unwittingly aided by a large sector of the pri-

    vate economy the banking sector.


    Euro banking regulators and auditors have been instructed by both their

    national governments and the EU that there is no longer any currency

    risk in intra-euroland assets and liabilities. This is a concrete reflection of

    the need for perceived irrevocability discussed above. However necessary

    this may be, it does inadvertently create an apparently riskless arbitrage

    for euroland banks. This is how it works.

    Let us suppose that the financial markets regard the euro as carrying

    a small but positive risk of break-up. Let us also suppose that this trans-

    lates into a break-up yield premium for Italian-domiciled bonds versus

    German-domiciled bonds of, say, 25 basis points. Note that this is nota

    credit premium, but a pricing differential for identically rated credits. If

    there are also credit differentials between bond issuers (like, say, between

    German Government Bonds and Italian Government Bonds), then these

    will be on top of the break-up premium.

    That such a premium should exist is a green light for euroland banks

    to take the yield profit out of this spread. They can structure their port-

    folios to be credit-neutral, but still make 25 basis points per annum out

    of a risk that does not exist. The regulators and auditors will not pass

    adverse comment. Indeed the banks reporting structures may even deny

    regulators and auditors the relevant information.

    In the event that a crisis does arise, the more the markets become con-

    cerned that the euro is vulnerable, the more profit the banking sector

    can make out of playing this arbitrage. If the euro survives, then so will

    the banks. If it collapses, even in a controlled and negotiated way, then

    the banks will be left with a mass of liabilities in strong currency domi-

    ciles and assets in weak currency domiciles. It is quite conceivable that

    the scale of the arbitrage will be sufficient to bring the more marginal

    banks to their knees. And in the worst case, where the break-up is slowand painful, and where the scale of the exchange-rate and interest-rate

    Neil Record

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    INVESTMENT POLICY January/February 1999 / 79

    adjustments needed is high, then the whole euroland banking system

    could collapse. I need not dwell on the consequences of such an event.



    My answer to this question is two-fold.

    If the euro does break up in anything other than the most benign way,

    then there will likely be very severe knock-on consequences for investor

    confidence. The global nature offinancial markets will ensure that if, for

    example, there is a banking crisis in Europe, it will spill over to North

    American banks. In the general confusion, equity markets worldwide are

    likely to be hit. Whether U. S. bonds respond in sympathy or display safe

    haven properties is anyones guess.

    Investors euroland assets, particularly bonds, are obviously at most

    risk. The key for investors is to ensure that they are clear what will hap-

    pen to the currency of denomination of their bonds if there is a break-

    up. If an investor believes that EMU will never collapse, then he should

    take the premium, wherever offered, to hold weaker currency bonds.

    Again, this decision should be separated from the credit-quality decision.

    If an investor believes that EMU break-up is possible, he should ex-

    amine the detailed domicile of each bond category and ensure that if any

    yield premiums are received, he is happy with the premium/risk trade-

    off. The position to avoid is one of ignorance. To be unclear of the domi-

    cile of your bonds, and to be unclear where any enhanced yield is coming

    from, is to court danger.

    Finally, if I am proved wrong, and no break-up premiums appear in

    the bond market, then my advice is clear buy German or other strong

    northern European bonds, and refuse to buy southern European bonds.

    This is as close as you will ever get to a free lunch, and the chances are

    that someone else is paying for it without realizing or caring.


    1. The first, and still the best, is The Crash of 2003 An EMU fairy tale,

    David Lascelles, Centre for the Study of Financial Innovation, December


    How Will the Markets Price Break-up Risk?

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    80 / INVESTMENT POLICY Volume 1, No. 5

    2. The Treaty, in official EU circles, refers to the totality of all the relevant

    treaties (principally Rome and Maastricht) covering the EUs constitution.

    This official use of the singular Treaty rather than Treaties is a little odd.

    The Treaty of Rome in 1957 established an entity called the European

    Economic Community, while the Maastricht Treaty (agreed in 1991 and im-plemented in 1993) established a very different entity called the European

    Union, of which monetary union was an integral part.

    3. EMI: The Single Monetary Policy in Stage Three. Elements of the monetary

    policy strategy of the ESCB (February, 1997).

    4. Thinking the unthinkable about EMU, edited by John Arrowsmith,

    National Institute of Economic & Social Research, March 1998.

    The consequences of EMUs failure, Neil Record, Record Treasury

    Management, January 1998.Could EMU be blown up by a speculative attack? Ravi Bulchandani,

    Morgan Stanley Dean Witter, March 1998.

    Economic and Monetary Union: Thinking the Unthinkable The Break-

    Up of Economic and Monetary Union, Charles Proctor and Gilles Thieffry,

    Norton Rose, March 1998.

    EMU crash: the consequences for financial markets, Bernard Walschots,

    Rabobank, February, 1998.

    Could speculation break EMU apart?

    Martin Brookes, Goldman Sachs,January 1998.

    1 January 1999: and then what? Credit Suisse Private Banking, December


    Event risk under monetary union, David Theobald, JP Morgan, October


    EMU break-up risk: thinking the unthinkable, Ken Wattret, Paribas, August


    5. The creation and destruction of EMU, Walter Eltis, Oxford University,

    Centre for Policy Studies, August 1997.

    Implied volatility is that market price volatility which, if input to a stan-

    dard Black-Scholes option pricing model, would produce the option pre-

    mium that is observed to be trading in the market.

    6. A survey by David March of Fleming (November 1997) put the expectation

    of an EMU break-up between 1999 and 2002 at 10%. A Europe-wide Paribas

    survey at the same time put the same risk at 7%, and 17% after 2002.

    Incidentally, for UK respondents the expectation for break-up at any time

    in the future was 66%, compared to a Europe-wide figure of 24%.

    Neil Record