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A Messy Break-Up?

Written by Paul Amery

 –  November 24, 2010 00:32

As the European single currency lurches from one crisis to another, it’s looking like an increasingly strained union of 16 members. But if the euro does end in a divorce, how might this happen? And, from an index investor’s perspective, what would such an event mean?

Many of the benchmarks underlying Europe’s index and exchange-traded funds are based on the single European currency. The most widely followed equity index in the European ETF market, for example, the Euro Stoxx 50, selects its constituents only from companies that are incorporated and listed in eurozone member states. The index is the basis for over €20 billion in associated ETF assets.

And within the European fixed income ETF sector, the largest fund is also based on bonds denominated in the single currency (the iBoxx Euro Liquid Corporates Index, tracked by nearly €4 billion in ETF assets).

The authors of the 1992 Maastricht treaty, which set the basis for the European single currency, did not envisage any possibility of a country’s exit from the monetary union. The 2008 Lisbon treaty, the latest iteration of the European Union’s constitution, is the first to allow (under Article 50) for the possibility of a negotiated withdrawal by a member state.

However, according to columnist Wolfgang Munchau of the Financial Times, it’s by no means certain that an orderly exit, as opposed to a chaotic breakdown, may occur. “The current Lisbon treaty is simply inadequate to deal with the legal and political complexities of an institutional crisis mechanism”, wrote Munchau recently.

Unfortunately, recent attempts to introduce such a crisis management mechanism into the euro’s constitutional documents have resulted in crisis. It’s widely accepted that the attempt in late October by Germany’s Chancellor, Angela Merkel, to incorporate a change into the Lisbon Treaty to allow for a sovereign debt restructuring within the system (i.e., without a country having to leave the euro) was the catalyst for the latest bout of market instability, during which the borrowing rates of several member countries jumped to record highs and which has resulted in a joint EU/IMF bailout of Ireland, following that of Greece earlier this year.

As a result of the adverse market reaction to her proposals, Merkel and her allies in Europe were forced to backtrack on the plan to force private investors to share the cost of bailouts (i.e., by default), but not before severe damage had been done to investor confidence. With the German Chancellor’s proposed rules now on the back burner, it’s unclear what other mechanism to clarify the Lisbon treaty might now be put in place.

How would index providers manage if tensions came to a head and some countries were forced out of the single currency?

A spokesperson for Stoxx, the provider of Europe’s largest euro-related equity benchmark, said that “this is a rather unlikely scenario. However, we always watch closely any economic, political and other situations that might affect our indices. Should something unlikely and unexpected like this happen, we would work closely with the supervisory board to determine what would be the best way to proceed.”

Even though Stoxx’s index rules do not mention the exit of a country or countries from the euro as a possible event, they do specify that “in exceptional cases the supervisory board can add stocks to the selection list and also remove them from the selection list,” giving the index provider considerable leeway to act as it sees fit.



 



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