Frexit Would "Go Beyond a Lehman Moment" - Deutsche Bank
- Brexit creates complacency amongst voters on potential Frexit risks
- Deutsche Bank identify €46 trillion unhedged gross cross-border currency risk
- EUR/USD to fall to 0.95 within a month of Le Pen win
Growing support in polls for French presidential candidate Marine Le Pen has exerted strong downside pressure on the Euro in February.
On a trade-weighted basis, the Euro has fallen to its lowest level since March 2016.
"The FX market fears an election victory of the eurosceptic candidate, who wants to hold a referendum on France’s EU membership and replace the euro with a basket of national currencies. Political support for the common currency is thus crumbling," says Antje Praefcke at Commerzbank in Frankfurt.
It has been suggestesd that a key reasons for Le Pen's ascent it the apparent ease with which the UK economy has weathered Brexit (so far).
In a landmark interview at the end of 2016, Marine Le Pen held up the example of how the UK economy has shrugged off Brexit as a template for what French voters might expect from a similar EU exit in France.
“They told us that Brexit would be a catastrophe, that the stock markets would crash, that the economy was going to grind to a halt, that unemployment would skyrocket. The reality is that none of that happened,” remarked Le Pen.
Brexit has set up a misleading precedent for French voters who may be thinking that a Frexit would carry similar minor risks argues Deutsche Bank’s Macro Strategist Alan Ruskin.
With Le Pen starting to make advances in polls for the crucial second-round of the Presidential vote, markets are becoming increasingly concerned with the Euro sliding and the yield paid on French sovereign debt rising.
And so they should argues Ruskin who notes that comparisons between Brexit and Frexit are dangerous as they overlook the crucial currency element which differentiates the UK from France - membership of the Eurozone:
"Perhaps the most misleading aspect of Brexit, is precisely that it is setting up complacency on potential Frexit, among both the voting public and nationalistic political classes in France and abroad. Make no mistake, there is the world of difference between tearing up bilateral and multilateral trade agreements, and, unwinding a monetary union as far reaching in scope as the EMU project.
"It is the difference between a benign global risk event and something that has the potential to go beyond a "Lehman’s moment'".
Were France to exit the Euro it could mean a break up of the entire Eurozone and lead to the end of the single currency as we currently know it.
The Deutsche Bank strategist points to the massive 46 trillion Euro unhedged gross cross-border currency risk that would materialise were the Euro to collapse.
Ruskin also argues that under a Frexit event all the negative economic consequences which did not attend on Brexit would in fact happen – i.e in the words of Le Pen, “the stock markets would crash, that the economy was going to grind to a halt, that unemployment would skyrocket.”
But these negative effects would in themselves would “presumably exert some policy restraint,” says the strategist who believes the outcome will force national governments to enact the much-needed policy changes Europe has so far been lacking.
It would be impossible to get the genie back in the bottle, however, and even if the Eurozone backed off from jettisoning the Euro, markets would never fully trust its integrity again. European debt would immediately have to reflect more risk, at least of currency exposure within its rates.
Even if Frexit is avoided the risk remains of further instability as the union halts its march to closer integration which is a requisite for a successful single currency.
Unprecedented Implications for Global Risk Should Eurozone Break
If the Euro were discarded there would be a volatile readjustment phase in which cross-border capital stocks would suddenly be exposed to currency risks as national currencies were reintroduced.
i.e. what country A has deposited in country B suddenly gets a new price based on a new exchange rate.
In effect, no-one has calculated the degree of cross-border currency risk within the Eurozone except in the case of Greece where there has been a real threat of the Drachma being reinstated.
The sheer lack of any accurate estimates would cause the initial panic, according to Ruskin.
“When it comes to FX exposure under a break-up, assets and liabilities should not be netted out, precisely because all the major participants - corporations, financial, and household - are apt to have made only very limited attempts to net-out their asset and liability exposures by country. One exception may be cross-border exposures to Greece, where the market has periodically contemplated a Grexit,” says the Deutsche Strategist.
In most cases, especially in the periphery, national denominations would devalue heavily versus the currencies of the core or Northern Europe.
The shock from these changes, especially in terms of the ability of debtors in the periphery to meet their newly recalculated repayment obligations to creditors in the core (which would become substantially more costly), would cause a huge risk event in financial markets, and have the potential makings of another crisis.
“Even FX balance sheet ‘mismatches’ that are a small fraction of this number have the capacity to cascade through the financial system with unprecedented implications for global risk,” says Ruskin, of such an event.
The first major cause of market alarm in the event of the Euro being phased out would be the lack of exact knowledge on the size of the risk.
Gradual Transition Away from the Euro
The next problem would be how the monetary authorities would deal with a breakup on a practical level, to ameliorate the impact of an Eurozone breakdown.
One option would be to phase in national currencies and at the same time gradually phase of the Euro, such that both currencies would be running concurrently.
Euro’s might be used exclusively for cross-border transactions, whilst national currencies for domestic payments. Such a dual scheme might help take the trauma out of the transition.
Ruskin also mentions the long ‘lead-in’ time for all the negotiations of the breakup and legal loose ends to be tied up, which would allow time for a more gradual transition to take place.
Euro Sharply Lower on Frexit
Ruskin concludes with a gloomy reiteration of the official Deutsche Bank forecast for the EUR/USD, which is for the pair to decline to 0.95 by the end of 2017 – however, he emphasises that the forecast does not assume a Frexit and in the event of a Le Pen victory the forecast would be brought forward to only a month after the election result.
