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“Frexit”: Bank Runs, Deposit Blocks, Capital Controls. Any Questions?

"We have some experience in this domain: the example of Greece in the summer of 2015. That is not a happy precedent."

Earlier today, I brought you by far the most exciting news yet from the unfolding French election drama: a video of a topless protester calling bullsh*t on Marine Le Pen’s “fake feminism.”

So maybe not so much on the whole push to secure the female vote.

In any event, the latest polls from France show a slight downtick in support for the far-right “queenpin”. Here are the numbers (via Bloomberg):

  • Le Pen Slips, Macron Gains in Ifop Daily Poll of French Voters
  • These are the results of Ifop’s daily rolling poll for the first round of the French presidential election. The poll shows Macron beating Le Pen in the second round with 61.5% support. First-round support is given after the candidate’s name, the change from yesterday is given in brackets:
  • Marine Le Pen 26% (-0.5)
  • Emmanuel Macron 23.5% (+1.0)
  • Francois Fillon 20.5% (unchanged)
  • Benoit Hamon 13% (-0.5)
  • Jean-Luc Melenchon 11% (unchanged)

I’ve spent what probably amounts to an inordinate amount of time documenting just how badly this is going to turn out for the French population if voters collectively decide to install this raving lunatic as President. Recall what the ECB’s Benoît Cœuré’s said earlier this month:

[Le Pen’s redenomination push] would lead to impoverishment that would threaten the jobs and savings of the French people.

Right. But as I’ve decried on any number of occasions of late, Le Pen won’t tell voters that. She’ll just tell them she’s “restoring France’s monetary sovereignty.”

She’d rather leave her supporters in the dark regarding what exactly the consequences would be of a €1.7 trillion sovereign default and a redenomination of something like €410 billion of IG corporate bonds (well, not all of them face that risk, but you get the idea).

Fortunately for Le Pen, the credit markets have largely shown little interest in expressing the risk inherent in the imposition of a “new franc.” Although, as I noted on Friday, bid/offers on French corporates have moved notably wider than €IG ex-France, which suggests that not all is well:

bidoffers

(BofAML)

Of course as you know, sovereign spreads are far less sanguine and the ISDA basis between the (largely useless) 2003 French CDS and the 2014 contracts has blown out to reflect the risk of a French exit from the EMU:

spreadisda

(BofAML)

Well for those of you who need this spelled out or, in other words, for those who may need to hear from someone other than Heisenberg that a redenomination push would turn France into Greece ca. 2015 overnight complete with bank runs and capital controls, I present the following from a Goldman note out Friday entitled “Managing market tension around a flirtation with Frexit.”

Via Goldman

The election of a ‘populist’ Eurosceptic mandated to change France’s relationship with Europe would pose a significant challenge to the ECB, especially as a ‘clean break’ is unlikely. Practical, institutional and political considerations all point to an uncertain hiatus period. Markets are likely to take a dim view of that outcome.

In our view, it would be difficult for the ECB to implement its “whatever it takes” strategy to contain market dysfunction in this environment. The political context would not permit the large, rapid and potentially unlimited build-up of crossborder claims (specifically TARGET 2 (im)balances) that such a scenario entails.

We have some experience in this domain: the example of Greece in the summer of 2015. That is not a happy precedent. Without a rapid (and unlikely) resolution of political uncertainties surrounding possible Frexit, capital controls and the blocking of bank deposits may well be required.

Underlying this conclusion is an uncomfortable truth for the stability of the Euro area. While politics in EU countries remains national, ultimate monetary sovereignty – a country’s choice of currency – also resides at the national level. By implication, the risk of a politically-induced exit from the Euro area cannot be ruled out. The threat of exit would likely destabilise financial markets. As a result, markets amplify rather than dampen political shocks.

Following the Greek experience, likely ECB responses to market tension in this context are as follows:

The ECB shifts the risks it has assumed in supporting the French financial sector more explicitly onto the balance sheet of the French authorities: (a) emergency liquidity assistance (ELA) replaces bank funding via ECB operations; and (b) the Banque de France buys French government debt on its own account rather than on a risk-shared basis (this is already the case for the bulk of purchases under the APP).

The implication of such an approach is an increase in France’s TARGET 2 liabilities: the Banque de France creates Euro liquidity to purchases French assets and/or fund French banks, which is then redeposited in German bank accounts that are safe from potential re-denomination.

The counterpart to this TARGET 2 liability in France is a German claim on TARGET 2. But the status of such a claim after a Frexit is legally ambiguous, at best. Understandably, a point would be reached where Germany wishes to call a halt to this potentially unbounded accumulation of claims of doubtful (or at least uncertain) value in a new institutional set-up that is being actively entertained by their political partners.

At that point, limits would be imposed on the accumulation of these TARGET 2 balances. In practice, this entails capital controls (restricting external convertibility of French bank deposits) and deposit blocks (restricting the internal convertibility of those deposits).

In principle, the Outright Monetary Transactions (OMT) programme introduced in the aftermath of Mr. Draghi’s “whatever it takes” intervention offers another vehicle for the ECB to support France. But activation of this instrument requires France to enter an ESM programme and accept the implied conditionality. To put it mildly, the political conditions for such an outcome – both in France and in the lender countries – would not be ripe.

Ultimately, the financial chaos (ballooning spreads, market dysfunction, blocked deposits) resulting from the market response to a potential Frexit are likely to change the public’s views. As we saw in Greece, it may take a concrete demonstration of these effects before voters fully appreciate the economic and financial implications of leaving the Euro area. Once demonstrated, the public may ultimately wish to ‘come back from the brink’ of Frexit, so as to preserve the value of their accumulated savings. The alternative would be for the blocked deposits to be converted into a new (depreciated) French currency. 

Any questions?

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