Nomura Presents The Fair-Value Of European Currencies In A Euro Breakup Scenario

Tyler Durden's picture

As investors proceed happily through the forest that is this week's potentially epic fail, Nomura asks the question on every European is asking - What's in my wallet? Investors holding EUR-denominated assets and obligations face potential redenomination of contracts into new currencies. Based on the current misalignment of the real exchange rate and future inflation risk estimates, the fixed income group sees very material depreciation risks in most of the periphery and one surprise but critically the research enables risk-reward trade-offs on intra-European trades. This potential 'fungibility' issue is exactly what we described last week as a potential driver of stress and Nomura's work provides a framework for quantifying that relative stress. That said, Nomura adds the usual disclaimer: "For full disclosure, we are not regarding the break-up scenario as our central case." But... there is always a But. "But it has become a real risk over the last few months, and a possibility for which investors should now plan."

Belgium, while not entirely surprising to us, faces a dramatic devaluation in a break-up scenario buit it becomes very clear just how concerned depositors and obligation-holders must be in Greece, Portigal, and Spain at a minimum. Even the other (ex Germany) AAA nations will see devaluations.

As for how Nomura proceeds with the valuation of standalone currencies, report author Jens Nordvig gives the following justification:

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, liquidity conditions, as well as issues relating to capital controls, including possible taxes on capital flows. Since our analysis is focussed 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.

And as for the quantification of future inflation risk:

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.


2. Inflation pass through: The degree to which the inflation process is vulnerable to shocks depends on open-ness, 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.


3. Capital flow vulnerability: Large current account deficits combined with a weak structure of capital flows can combine to leave a vulnerable capital flow picture. A vulnerable balance of payment situation may imply 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


4. Past inflation track record. Inflation expectations can have long memory, and past experience 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.

As for the other countries:

Our study has focused on the first 11 eurozone member countries, although the analysis excludes Luxemburg, 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 customized analysis for those countries at a later date.

The report's conclusion:

Our estimates suggest significant depreciation risk for a number of eurozone countries in a redenomination scenario. We estimate that this risk is in the region 60% for Greece, around 50% for Portugal, and 25-35% for a group of countries including Ireland, Italy, Belgium and Spain. At the same time, our estimates confirm the common perception that a new German currency will fare better. In fact, our point estimates point to a slight appreciation potential, although it is marginal and economically not meaningful.


Our estimates focus on a medium-term equilibrium concept, and we recognize that short-term dynamics could see significant undershooting relative to our estimates. This is especially the case, when a break-up scenario would involve capital controls, political instability, and a collapse in existing banking systems.


The estimates should be seen as an initial attempt to gauge the magnitude of possible medium-term equilibrium effects. But more detailed analysis of country specific parameters will clearly be needed to achieve more precise projections.


Regardless of the uncertainties involved, the estimates serve to highlight the significant depreciation risk associated with currency redenomination in a number of countries. And since the risk of a eurozone break-up is no longer negligible, investors will have to add „redenomination? risk to the list of standard risk factors they have to consider in their portfolios.


Our analysis of the legal aspects of the redenomination risk has shown that redenomination risk is high for local law obligations in most break-up scenarios and significant also for selected foreign law obligations in certain break-up scenarios.


The combination of high redenomination risk and the potential for significant depreciations in a break-up scenario should impact risk premia on certain assets already at the current time. More generally, this new layer of uncertainty is likely to impact investor sentiment towards eurozone assets and the Euro negatively in coming months and quarters.

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Mongo's picture

Bullish on bananas!

Oh regional Indian's picture

Looks like the Nordicks will rule the EU.

Imagine what this would do to the FX world? Incomprehensible volatility. Can't happen. Sabers have been drawn for far lesser reasons.

Archduke Ferdie moment might be getting closer.



Mr Lennon Hendrix's picture

All is well on this fair evening

As the white waves crash ashore

The night is quiet, there are no worries

Nor any Nordic boats

-Irish poem

whstlblwr's picture

If you are not happy with immoral hazard and psychopaths taking over America, make sure to register Republican to vote in the primary in January from these states. If you know anyone who lives in these states talk to them of Ron Paul.

Don’t speak of end the Fed because most don’t understand meaning of this, but that inflation in gas and food are caused by money printing that he will work to stop.

January 3, 2012 Iowa (caucus)

January 10, 2012 New Hampshire (primary)

January 21, 2012 South Carolina (primary)

January 31, 2012 Florida (primary)

wisefool's picture

Ron Paul must really be scaring the MSM. CNN is actually reporting about radioactive water leaking from fukishima instead.

George Will, a guy I used to repect dropped the "spoiler" tag on the good doctor this weekend. TPTB want Obama to win, (heavens to betsy we got Clinton stumping for gingrich) And obama will win, but the only "spoiling" Ron Paul is going to do is expose the narrative to the sheep who think their votes count.

boiltherich's picture

That is a commercial I can get behind funding, I just watched it and sent his campaign $100 though I am pretty broke.  I just wish everyone here who claims to support Paul would do the same.

By the way, I note that last evening the Obama Show/Nightly infotainment on NBC they had a top story about new poll numbers in a republican poll taken before Cain dropped out, Gingrich at 23% Paul at 21% and Romney at 18% and then they went on to do extensive talking about Gingrich and a little talking about Romney but not a single word about Ron Paul even though he is neck and neck with the leader of the pack.  I can't wait till he pulls ahead of Gingrich after Newt blows up his own campaign yet again (only matter of time before his own sex skeletons come tumbling out of the closet or he sticks his feet in his mouth) but it will be interesting when Paul is in first place and yet the MSM will not mention his name.   

Now I am going online to make my own FORMER DEMOCRAT FOR RON PAUL bumper sticker.

oldman's picture

Dear Whistleblower,

You may vote for this oldman, because he will not vote again this time unless your precious ron paul has the huevos to run as an independent, which he doubts.

Ron sounds good on the one or two issues that he captures the 'imagination' on, but honestly, he is very weak on the more important issues and certainly has little capacity for diplomacy, energy policy, habitat protection, and what we do in the next twenty years about our declining share of the world's markets.

I've listened to him for ten years now and though he raises my energy level with his 'can do' rhetoric, he hasn't had the balls as of yet to step out and take the chance that his own VERY CORRUPT party will cannabalize him.

I'm quite weary of reading all of the 'rah, rah, rah' comments by people who still seem to believe in the broken, bullshit system that you believe can be fixed by a simple lazyman's fluffy dream that your fucking vote is even counted.

I apologize for my crude language and do not mean to be personal but I have been 16 hours walking today and thinking about the hopeless condition of a nation that can only talk of change by mentally mastabatory process of walking once into a polling booth at their leisure and plugging their protest into a computer that has been corrupted by the same stupid broken machine

I'm sorry , but I can't even apologize properly     a very tired oldman

macholatte's picture

Some have said that the Nordic Royals are an extreme power in the banking cartel with roots that go back hundreds, maybe thousands of years and were instrumental in the set-up of central banking and the House of Rothchild. Those bloodlines are comingled with all Royals in Europe.

Fluffybunny's picture

Yes, the Rotchild's are our lackeys.

GNWT's picture

Correct, the Queen of the Netherlands is one of the founders of the Bilderburg Group.

Almost Nordic

Mr Lennon Hendrix's picture

European Royalty is one big inbred family.

SWRichmond's picture

How can the Euro be at 1.34, when all of the constituents are way below it, except one, and the one that is above it is only just a little bit above?

kaiten's picture

And printing presses.

bank guy in Brussels's picture

Cool chart.

A long while ago, I think it was Ambrose Evans-Pritchard in the UK Telegraph, ran stories that some Germans were only accepting euro notes with the code number signifying that they were printed in Germany.

bank guy in Brussels's picture

Below the 'AAA' countries, Belgium is 'best of the rest'.

Not bad for little Belgium, considering.

Instant Wealth's picture



Belgium Z

Greece Y

Germany X

Spain V

France U

Ireland T

Italy S

Luxembourg *

Netherlands P

Austria N

Portugal M

Finland L

Slovenia H

Slovakia E

Cyprus G

Malta F

Estonia D

Nussi34's picture

I mostly have X. All the others I use to buy stuff. Gresham´s law!

Instant Wealth's picture

... could be wise, to use the Y´s first.

Nussi34's picture

Most of the EUR 100 notes that I get here in Germany are from Italy. I try to get rid of them ASAP!

Peter K's picture

Always look to see the letter on the Euro. For some reason, can not get an X for the life of me. Anywhere. Glad I am not the only one with this problem.

turtle777's picture

This has been debunked, even Ambrose admitted to it. I can't find the link right now, but the gist is this:

The X only signifies that Germany commissioned those notes to be printed. It does NOT mean it was actually printed in Germany. Theoretically, Germany could commission notes to be printed in France.

Many smaller EU countries don't print their notes themselves, so they would commission notes to be printed in Germany. The Euros would show the country code, but the printing of a German facility (e.g. P for Giesecke & Devrient in Munich.)

In short, the country code is not useful to determine "good" or "bad" Euros.

Peter K's picture

Hugh Hendry noticed this phenomenon in Germany too.

Manthong's picture

I thought they solved all those pesky problems.

RobotTrader's picture

If we close up today.

NYSE Summation Index will turn back up.

Mo-Mo players will have no choice but to chase stocks again on the long side.

Gloomsayers will be watching the tape climb up and up with their jaws agape.


mktsrmanipulated's picture

Robo trader is your real name joe kernan or david faber.....keep breaking out the pom poms

GNWT's picture

Markets - Robo is correct, do not fight the tape, higher highs and higher lows mean buy, the trend is your friend.

Pay attention, short your instrument on two hourly lower lows, lower highs or three, plenty of time for all this.

All counter moves are like the movie Jackass, just a matter of how high we lift the garbage bag before we drop it.

Irish66's picture

just 4 more days of this, you promised

DaBernank's picture

I'm bullish cheap Greek holidays!

Bobbyrib's picture

So if the EU broke down right now, everyone but Portugal would have a stronger currency than the dollar? I saw this on CNBC momentarily. I thought they said this was broken down in Euros, not dollars. This would be in comparison to dollars right? IIGS would have a stronger currency than us? I must be seeing something wrong.


Nothing real here's picture

The ratios are relative to the current Euro, not the dollar.  Ergo, the German DM would be 36% stronger than it currently is within the  Eurozone.   You have to believe the DM would be much higher relative to the dollar. 

France and Austria would also be stronger.  Club Med would be much weaker. 


Bobbyrib's picture

Wow you answered my question one minute after my post (on purpose or by accident). Edit: Nevermind, you answered my question in your post.

Nussi34's picture

No the ratio is how many USD you get for one COUNTRY-EUR.

Nussi34's picture

Fair value for a new Greek currency, whether reviving the drachma or not, would be almost a 60% depreciation, to around 57 U.S. cents, he said.

falak pema's picture

so do the germans have the longest ones? This should please M****! True 6" guaranteed or refunded. She is not very demanding. Which will make her very euro compatible. Difficult times for all Euro males, no moules frites every day, no Trappist beer! No chardonnay and pinot noir!

Bobbyrib's picture

Chimay is good shit too.

mktsrmanipulated's picture

ES keeps rallying but euro doesn't.....cant wait till those fucking algo scumbags eat it

RobotTrader's picture

Macy's now printing 3-yr. highs.

Where is the recession?

Dick Darlington's picture

The recession is in the real world.

Poetic injustice's picture

You're braindead.
How your exclamation corellates with topic?

aleph0's picture



So rather than letting nature take it's course by reverting back to the Legacy Currencies,  the Euro will live on with about a 25% devaluation IMO.

This  would  conveniently put it at  ca.  1:1 with the USD.

Coincidence ?

... it would have been interesting to feature the USD and GBP into that graph
... and of course Gold.


Elwood P Suggins's picture

Irrelevant.  They obviously haven't heard yet that Merkozy kissed the Euro and made it well.

achmachat's picture

As always.. the lovely "island" of Luxembourg simply doesn't exist!