Modelling a return to the old currencies

THOUGH the debates and political squabbling will continue to rage on in the gilded offices of politicians and central bankers, we have reached the point where many will be looking at the practical side of a return of one or more of the old European currencies.

But which will be the first to fall? The decapitated states of Italy and Greece are the most likely candidates.

In Barclays Capital’s “Tuesday Credit Call”, it gave a damning judgment of the state of Italy’s debts. According to Barclays Capital economists: “At this point, Italy may be beyond the point of no return”. They suggested that the ECB needed to intervene by printing money in order to buy up Italian bonds. However when the ECB intervened in markets yesterday, the positive effects on the Italian bond yields had a shorter life than the froth on a cappuccino. Barclays highlighted 5.5 per cent as being the point of no return, but 10-year bond yields continued to soar above 7 per cent.

Italy is seen by many as being too big to fail and too big to save. As the third largest bond market in the world, it is unthinkable that it would be able to leave the euro.

On the other hand, it is hard to envisage Greece still using the euro in 12 months time. Whether it is pushed or it jumps, its future as part of the European single currency experiment appears to be nigh on doomed.

As the liabilities of the stricken peripheral Eurozone countries are denominated in euros, they would have to deal with the difficulty of re-denominating the claims into the new national currency – a move that would be very difficult to impose. According to Stephen Gallo, head of market analysis for Schneider FX, this would be hard to put in place, even in the event of capital controls and other controls on moving money in and out of the individual countries. For the cleanest possible return to the old currencies, Gallo says that: “The best we could hope for is the equivalent effect of a string of sovereign defaults across most of the south of the Eurozone area.” Gallo adds: “I doubt very much that you could organise a return to the national currencies in a way that would be anything other than extremely messy.”

Given the sheer scale of the task that a return to the drachma, or indeed any other of the former European currencies would entail, many institutions say that they have yet to sit down and put together atrading strategy for this eventuality. But Geoffrey Yu, director of foreign exchange strategy for UBS has sketched out the direction that an orderly re-peg of a currency would take, based on prior examples: “I assume that there would be a rate at which the Greek drachma would begin trading against the euro, though it would likely be very different from the entry rate, to prevent everyone from squeezing through the door at the same time.” According to Yu, this model would be the equivalent of a 60-80 per cent net present value reduction in Greek debt.

So how would you trade the new currency? Given the state of the Greek economy, the government would need to flood the market with drachmas, giving FX traders huge opportunities. “if the drachma is not pegged to the euro, going long euro against the drachma would be an excellent buying opportunity, as would both going long Japanese yen and going long Swiss franc,” says Christopher Vecchio, currency analyst for FXCM. Veccio points out that the drachma would fall against every other major currency: “Looking back at previous examples, it is clear that new currencies always lose value rapidly, and there is nothing to suggest that this would not also be the case here.”

It is also unlikely that European authorities would simply let Greece slip out into the night, taking its debts with it. If the other member states were to put trade restrictions into place, if would hit the Greek export market and in turn stunt any growth. According to Vecchio, if this happens we would see a positive feedback loop, whereby the Greek government would have to flood the market with even more drachma, devaluing the currency further.

As the European crisis progresses, it will be interesting to see which institutionas start to make real, concrete plans in preparation for this event.

Whatever the political fallout for a country leaving the euro, the opportunities that it will present for those in the forex markets to make or lose a lot of money very quickly will be huge.

Maybe outgoing Greek prime minister George Papandreou will spend his retirement shorting the drachma.