How would exchange rates adjust if the euro were to break up?

Publication date: 12 July 2012
Author: Patrick Artus, Global Chief Economist, Natixis

An increasing number of financial institutions and multinational companies want to hedge the exchange rate risk that could stem from a possible break-up of the euro. When the European Monetary System collapsed in 1992-1993, member countries’ external assets and debts were very small, meaning the significant changes in exchange rates had only a small impact on their assets and liabilities. However, external assets and debts of eurozone countries have hugely increased in size since the advent of the euro.

If the euro were to break up now, it would lead to either substantial capital losses or substantial capital gains. To manage this new exchange rate risk, if a company makes losses on assets in a country whose currency depreciates against that of their own, they could for instance offset it by holding assets in a country where the currency would instead appreciate against it.

Consider for a moment what a company in the Northern eurozone must do if it has subsidiaries or production sites in the Southern eurozone. If it was to effectively hedge this exchange rate risk, it would first have to know how the exchange rates of member countries would move if the euro were to break up.

To calculate this, we used a method based on the size of each country’s Target 2 accounts, and also by looking at its gross external assets and debts (since the gross figures represent cross-holding of assets between countries).

Using Target 2 accounts

Target 2 positions of the various national central banks are the equivalent of foreign exchange reserves. If private investors in Germany no longer want to lend to Spain, the German central bank replaces private lenders, and accumulates Spanish assets in its foreign exchange reserves (its Target 2 position with Spain) to maintain a stable exchange rate between Germany and Spain.

Therefore, the size of Target 2 accounts neatly lets us measure what would happen to exchange rates if the euro were to break up. As one may expect, Germany, Finland and the Netherlands are notable creditors in terms of Target 2 accounts, while Spain, Italy, Greece, Portugal and Ireland are notable debtors. If we want to estimate the distortion of exchange rates if a break-up were to occur, these Target 2 figures could lend a great deal to the potential debate.

In our calculations, the reference exchange rate is the exchange rate of each country against the euro just before the break-up. Meanwhile we calibrated the exercise with a 20% depreciation of Spain’s peseta against the former euro. In comparison with the exchange rate recorded before the single currency broke down, one would then have the following exchange rates against the euro: