Daniel Lacalle

Op-ed (CNBC): France exiting the euro would be the largest sovereign default in history with serious contagion effects

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A few days ago, David Rachline of the far-right National Front party in France said that “the debt of France is about 2 trillion euros ($2.1 trillion), about 1.7 (trillion euros) are issued under French law, which means that it can be re-denominated.”

The economic program of the National Front specifically calls for the exit of the euro and the creation of a new currency, the French franc, which would be “closely” linked to the euro while allowing the government to undertake “competitive devaluations” making the transition in an “orderly way”.

There is only one problem. It does not work. There is no “orderly exit” from the euro. It is an oxymoron.

This would be the largest credit event in history and would create a massive contagion effect throughout the euro zone. The euro, obviously, would suffer from the break-up risk, so the fallacy of the “closely linked” second currency is simply a joke. Both would collapse in tandem.

The risk is already evident. The French-German yield spread has reached the highest level since 2012 despite the European Central Bank’s (ECB) massive quantitative easing. The ECB has bought more than 255 billion euros of French bonds.

This mirage of an “orderly exit” ignores that the French financial system, which carries assets more than three times the size of France´s GDP (gross domestic product), would be severely damaged from the impact of the credit event.

A financial system that already suffers from weak net income margins and more than 160 billion euros in non-performing loans, would collapse as these bad loans escalate and the losses in the banks’ bond portfolios eat away their core capital. This would inevitably lead to Greek-style capital controls and bank runs as the entities would lose liquidity support from the ECB.

This French exit from the euro would also mean the collapse of France’s pension and social security systems, which are mostly invested in sovereign bonds, the destruction of the savings of millions of citizens, and the bankruptcy of thousands of French small companies.

Let us remember that more than 40 percent of France’s government debt is held by the French savers, pensions and institutions, who would suffer the bulk of the losses from the default. No, there is not an “orderly exit”.

Banks’ outstanding home sovereign and sub-sovereign securities represented 6.4 percent of total assets in the EU, according to Standard & Poor’s. A credit event of this magnitude, and the subsequent contagion risk throughout the euro zone, would lead French and European banks and SMEs (small- to medium-sized businesses) to collapse.

The thought that sinking the currency and defaulting is going to improve the French economy is based on three myths:

That a default will not affect new credit and access to future financing. To think that a default would help France borrow more and cheaper is simply ridiculous.
That citizens would not be affected. Not only would savings and pensions be destroyed, access to credit from SMEs and families disappears, even if they want to invent a thousand public banks printing paper.
That the new economy would be stronger. Covering the large imbalances of the French economy with devaluations and a default harms the productive economy, leaving a weaker and less dynamic economy that leaves a global reserve currency to become a regional one. Import costs soar, and its main trade partners would suffer from the domino effect.
It is terrifying to see that citizens are led to believe in these fake magic solutions. No amount of money printing from the ECB would mitigate the impact of an effective default in France. Someone should tell Marine Le Pen that her plan has already been carried out. By Argentina, and its currency lost 13 zeros in 40 years.

— Daniel Lacalle is the chief investment officer at Tressis Gestión.

 

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