I have been thinking about what would happen if Spain were to leave the euro. I confess I know very little about the legal and political implications about a euro exit, and although I have heard often enough that it is impossible to leave the euro, I don’t think anything such thing can be true about a sovereign nation. It may be difficult, it may be messy, and it certainly will be unpleasant, but it can happen.
But aside from legal issues, there are a number of economic and financial considerations that I base on my 15 years of trading the sovereign debt of defaulted and restructured countries and my addiction to financial history. Here are the things I considered as being relevant to any break-up.
1. First and most obviously if Spain leaves the euro its debt burden will soar. If Spain left the euro and returned to the peseta, the peseta will immediately fall, and as it does the peseta value of the euro-denominated debt will rise commensurately. Let us assume that when this happens Spanish external debt is 110 per cent of GDP. In that case a 20 per cent decline in the value of the peseta will immediately raise the debt to 137.5 per cent of GDP and a 50 per cent devaluation of the peseta will raise the debt to 220 per cent of GDP.
2. By how much will the peseta devalue? You might think this is a question about how 'overvalued' the Spanish euro is (15 per cent? Twenty per cent?), but in fact the debt burden itself determines the amount of the depreciation because of the way it forces certain types of investor behaviour. In the end the amount of depreciation will have nothing to do with economists’ estimate of the amount of peseta overvaluation.
Why? Because a devaluation will the lock the country into a self-reinforcing cycle in which a devaluing currency forces up debt, which forces Spanish businesses and households to hedge by buying euros and selling pesetas, which forces down the peseta further, which causes even more hedging, and so on, so that the peseta will drop down unrestrainedly until investors believe Spanish assets are cheap enough that they begin to counteract peseta hedging by buying pesetas to acquire Spanish assets. The structure of the balance sheet, in other words, is what determines the amount of the devaluation, and countries with a great deal of external debt are likely to see their currencies fall far below any 'rational' level.
If Spain were a developing country, I would argue that given its debt level the peseta would fall at least 50-70 per cent (and so its debt burden would triple), but because it has a credible legal structure (I am assuming no radical party wins the election before a euro exit), a decline of 30-40 per cent might be enough to set off foreign buying. My guess, in other words, is that if Spain left the euro with a centre-right or centre-left administration, the peseta would likely drop no more than 30-40 per cent. This still will cause an already unbearable debt burden to become impossible, especially because interest rates will immediately rise.
3. This, by the way, highlights the importance of the political process and the speed with which Spain decides on its strategy. The longer it takes for Spain to arrive at a decision to abandon the euro, and the more bitter the fight to get there, the greater the likelihood of a radical right or left party taking power, in which case the euro might not stabilise at a 30-40 per cent discount.
4. There might be a way to limit the drop further. Over the longer term I think a more tightly organised Europe -- with a single currency and a real fiscal centre -- is good for Europe and the world, and a euro exit might even be just the way to achieve this. If Spain were credibly (this means with full German support) to commit to returning to the euro within, say, five years, at a predetermined level -- for example one implying a 20 per cent depreciation over five years -- Spain might be able to get most of the competitive benefits of a depreciation without giving up the benefits of monetary and economic integration. It would be a 'stable' departure from and re-entry to the euro.
5. However much the devaluation -- whether it is catastrophic or orderly -- debt would surge. There is a foolish belief that as long as we can find a way to roll over the debt, the debt burden itself does not matter -- but of course it does, for two reasons. First, resources must be appropriated from some part of the economy to service the debt; and second, debt creates financial distress costs that can far exceed the actual cost of the debt.
Spain must restructure its debt burden to a 'reasonable' level, which means a level at which the mechanisms that create financial distress are minimal. High levels of debt, remember, force creditors, businesses, household savers, household consumers, and policymakers all to act in ways that increase balance sheet fragility and reduce growth, not because they are evil but because they are rational. For this reason countries that are perceived as having too much debt never grow until the debt burden has been resolved. It is in everyone’s interest that Spain immediately receive a significant debt haircut or else it will not return to growth and the devaluation will have been wasted. I would argue that Spanish external debt should be reduced to 60 per cent of GDP and payments stretched out between 10-30 years.
6. Significant debt forgiveness doesn’t mean equally significant losses for creditors. Financial distress costs are triggered by the perception of a high probability of default. Spain’s creditors, of course, will hate to see their claims on Spain sharply reduced, but this is almost certainly going to happen anyway (I don’t think Spain has much chance of 'growing' its way out of its debt burden without debt forgiveness), and if done in an orderly way, it is possible to compensate creditors for at least part of the debt reduction without incurring financial distress costs.
Spain can replace debt claims with a different set of claims whose payment schedule is positively correlated with economic performance. Instruments that pay according to GDP growth, the performance of the stock market or land prices, for example, are the right way to line up the interests of the Spanish economy with those of the creditors. These are not unprecedented -- Argentina provided GDP warrants on its defaulted 2001 debt -- but they are used far too little. If a devaluation plus a sharp cut in Spanish debt causes Spain’s economy to come roaring back, as it most certainly will, creditors will be paid on the basis of how well the economy does, and can eventually recover a substantial part of the value of their original claims.
This is a very important point that few understand. High fixed claims will continue to drag down the economy because they increase the probability of default, and an increase in the probability of default sets off the self-reinforcing process of financial distress, in which agents behave in ways that worsen the debt burden, and worse debt burdens create pressure for agents to exacerbate their adverse behaviour. But this doesn’t happen with high variable claims that are correlated with how well the economy does (like equity in a company, which cannot create financial distress costs). These claims are high when Spain can pay and low when Spain cannot, so they do not increase default probabilities at all. For this reason they will create absolutely no financial distress costs.
7. If Spain were to eliminate financial distress costs and lower its domestic costs by 20 per cent with a devaluation, the economy -- at least part of whose poor legal structure has been reformed under Mariano Rajoy -- would almost certainly soar, clocking in growth rates of 5 per cent or more for several years. Spain has not completely wasted the crisis. It has implemented very serious reforms -- especially labour reforms -- but these reforms were aimed at old distortions in the Spanish economy and had nothing to do with the current crisis, which is caused by excess debt and an uncompetitive exchange rate.
I go to Spain often to see my family (I will go there this Thursday, for example). It is incredibly frustrating to see how terribly Spaniards are suffering, especially in the south, where my family lives. To add insult to injury, Spanish suffering is being blamed on old stereotypes -- their fiscal irresponsibility and their laziness -- when in fact Spain was among the most fiscally responsible countries in Europe before the crisis and Spanish workers worked more hours every year than did the Germans.
Spain clearly has a lot of serious policy problems -- and way too much corruption -- but these problems pre-date the crisis and pre-date Spain’s joining the euro. They have nothing to do with the current crisis, which was primarily the result of a demand imbalance in Germany. As I argue in my last blog entry, both the explosion in Spanish consumption before 2008 and the surge in Spanish unemployment after are automatic consequence of a savings glut for which Spain bears no responsibility.
Spain, in other words, cannot resolve its crisis on its own. It requires concerted action by Europe, and especially by Germany, in order to bring down unemployment. Germany cannot play its role because this must involve debt forgiveness, and Germany will not be prepared to acknowledge the need for debt forgiveness until German banks are sufficiently capitalised to recognise the obvious. There are no winners here; Europe’s demand deficiency means that there will be high unemployment somewhere, but Spain can decide how to distribute the cost of adjustment by deciding whether or not to remain inflexibly within the euro.
Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management. He blogs at China Financial Markets, where a longer version of this article first appeared.