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.