With Marine Le Pen through to the second round of the French presidential elections, the prospect of Frexit, which is at the centre of her economic policies, is beginning to spook financial markets. While the possibility of Le Pen winning in the second round remains remote, two weeks can be a long time in politics.
When it comes to the implications of a French exit from the European Union, commentators have so far focused on the €1.7 trillion of French public debt issued under French law – which can be re-denominated into francs, if France leaves the eurozone. According to the rating agencies, this would constitute the largest ever sovereign default.
By comparison, Greece’s sovereign debt restructuring, which affected €200 billion of debt held by the private sector in 2011-12, appears miniscule. While the timing of a French default remains uncertain, French sovereign bondholders are likely to flee en masse the moment they realise their baseline scenarios – which do not account for a Frexit – are wrong.
Although a sovereign default of such magnitude could unleash a tsunami of volatility in international financial markets, that is only the tip of the iceberg. The roll-out of a new currency across the economy would create new and unprecedented solvency and liquidity risks, which could cause financial turmoil, if not chaos, early on in the life of the new government.
Frexit would certainly have implications for the debt issued by French banks and corporations, irrespective of whether it has been issued under French law or otherwise. In the case where the debt has been issued under French law, its redenomination in French francs would be automatic. Again, international investors would be likely to flee early on, attempting to cut their losses short. This would cause abrupt drops in French bond prices and collateral values.
French banks and corporations are likely to lose the ability to continue borrowing on international markets, and would have difficulties refinancing existing debt. They would therefore face a liquidity squeeze, which could lead to a wave of corporate insolvencies, contraction of the real economy and rising unemployment.
In the case of debt issued under other countries’ law, the ability of the issuer to honour liabilities in euros or other currencies would no doubt come under question. The solvency of the issuer is clearly dependent on their ability to survive in the new environment. Plus, the issuer’s ability to make payments in foreign currency depends on their ability to circumvent capital controls, which are likely to be introduced soon after if this new government takes office.
Risk of a bank run
Whether they are part of the economic programme of a Le Pen government or not, capital controls are almost a certainty. They would be needed to protect the rest of the euro area from the risk of massive losses that Frexit may entail. This is because French bank liabilities – including bank deposits – would, at some point, be redenominated in the new currency.
Although the French government may think that it can take its time to introduce the new currency, French depositors are unlikely to wait. As the experience of Greece and Cyprus showed, fear of euro exit causes mass withdrawals from the banks as people turn their deposits into cash or other safe havens. And the precedent of measures to limit withdrawals in both Cyprus and Greece, means that French depositors are likely to be even less patient.
A massive bank run is, therefore, on the cards should Le Pen come to power. In Greece, bank deposits declined from nearly €300 billion at the start of the crisis in 2010 to nearly half that amount by mid-2015. To survive these outflows, the Greek banking system became chronically dependent on emergency liquidity assistance (ELA) by the European Central Bank (ECB), which peaked at around €124 billion in 2012.
Given that deposits in French banks exceed €4.1 trillion, a similar occurrence in France could mean that French banks might need over €2 trillion of central bank liquidity. But because of their new level of risk, French banks may be frozen out of the ECB’s standard monetary policy operations. They may, therefore, need to resort to the French central bank for ELA. National central banks in the euro system, however, rely on the ECB to obtain the necessary funds for ELA. So although the national central bank that provides the ELA is the one that bears the risk of such lending, any residual risk is borne by the ECB and other euro area central banks.
Under normal circumstances, the collateral pledged by commercial banks is sufficient to protect a national central bank (and ultimately the rest of the euro system) from ELA losses. But, in the event of a country declaring that it wishes to exit the euro, the national central bank’s position vis-à-vis the ECB and the rest of the euro system becomes dubious.
In the case of Cyprus and Greece, the ECB continued to supply the necessary funds to their respective central banks – because there was a political commitment to remain in the euro. If it came to Le Pen forming a government in France, the ECB would find itself in unchartered territory. The residual risk of any ELA operations borne by the ECB and the rest of the euro system would rise to unprecedented levels.
If the French government is prepared to default on its international obligations, would France’s central bank be allowed to honour its obligations to the ECB? After all, Le Pen pledged to take away its independence so that it could print money to finance government deficits (a cardinal sin for euro area member states, as the EU Treaty prohibits monetary financing). Would the ECB wait until that actually happens before it acts to contain its risks from Frexit?
The ECB would likely consider it irresponsible to supply any liquidity to French banks, in the event that its government is intent on leaving the euro. For that reason alone, France is more than likely to be forced to introduce draconian – and highly disruptive – capital controls, including limits on cash withdrawals from bank accounts, soon after its elections. These could then remain in place for many years to come, while the country is shunned by international financial markets.
French voters would be wrong to think that Brexit, and the relative calm that the UK has experienced since its Brexit vote, is a relevant precedent. In all likelihood, a Frexit would need to be fast forwarded to prevent complete economic paralysis. Even if the new government manages to swiftly introduce its new currency, the French economy would inevitably enter a high inflation environment with disruptive capital controls and a rapidly depreciating currency. This does not even take into account the real costs that increased protectionism, also pledged by Le Pen, would entail.
All this may sound alarmist, but to someone who has experienced the chaos created by coming close to a euro exit in March 2013 Cyprus, it is just common sense. The biggest question mark in my mind this time is what could happen to the rest of Europe when a country that has always been an important part of its core leaves. It is a frightening prospect. Europe, after all, was first and foremost a project for peace, than one of economic and monetary integration.