Economist.com

Leaving the euro zone

Exit fee

Nov 24th 2005
From The Economist print edition

The credit-rating consequences of quitting the single currency

WILL all the 12 countries in Europe's single currency remain members in three or four decades? The question may seem imponderable. But euro-area governments floating 30- or even 50-year bonds are asking investors to ponder it nonetheless. Anyone lucky enough to hold one of Italy's 30-year sovereign bonds, for example, might want to consider how likely Italy is to repay them, should it ever quit the single currency—as some in today's governing coalition might like. As a service to the forward-thinking, Standard & Poor's (S&P), a rating agency, has offered a speculative answer.

The repercussions of exit would depend on the reasons for leaving. S&P assumes that countries such as Italy and Greece would want to regain their own currency only to debauch it. Both have lost competitiveness since the 1990s. Italy's unit labour costs are projected to be 27% higher by the end of 2006; Greek costs have increased by almost half. In S&P's simulations, the Italian government announces a surprise exit from the euro on the last day of 2006, and promptly devalues the new lira by 27%. The Greeks devalue by 49%.

Both countries would thus recoup, at a stroke, the competitiveness they have lost. Unfortunately, their debts would still be payable in euros. Italy's public debt would jump, at a stroke, from 108% of GDP to 138%; Greece's from 107% to 161%. Neither government would service these debts without strain: Italy's credit rating would drop from AA- to A-. Greece's would drop from A to BBB-, only just investment grade.

Why couldn't euro refugees simply redenominate their debts in the new lira or drachma? After all, they had to convert their debt into euros when they joined the currency club. The difference, as S&P point out, is that the lira and drachma then ceased to be, and the euro was their legal successor. If the Italians or Greeks left, the euro would still exist, and their creditors would still expect to be repaid in it. Redenomination would count as repudiation.

Leaving the single currency would cause the coinage of some ugly new words: lirafication, or worse, drachmisation. The economic consequences would not be pretty either.