Monday, January 30, 2017

Italian exit and the problem of lira shortages

The topic of euro breakup has slowly been trickling back in the news, especially with the potential for Italy leaving the currency union, a so-called Italexit. In this post I want to explore one of the major conundrums that would-be exiteers must face; the problem of banknotes.

Almost all euro exit scenarios begin with the departing country announcing a shot-gun redenomination of bank deposits into a new currency, in Italy's case the lira. The effort must be sudden—if redenomination is anticipated ahead of time, depositors will preemptively withdraw funds from the exiting country's banking system, say Italy, and put them in the banking systems of the remaining members, say Germany, doing irreparable damage to Italian banks. After all, why risk holding soon-to-be lira when they are likely to be worth far less than euros?

Once the surprise redenomination has been carried out, the next step is to quickly introduce new lira banknotes into the economy. Lira deposits, after all, should probably be convertible into lira cash. This is much tougher than it sounds. Consider the recent Indian debacle. On November 8, 2016 Indian PM Narendra Modi demonetized around 85% of India's banknotes. Ever since then the Reserve Bank of India, the nation's central bank, has been furiously trying to replace the legacy issue with new currency. Because a nation's printing presses will typically only have the capacity to augment the stock of already-existing currency by a few percent each year, a rapid replacement of the entire stock simply isn't possible. India, which has been plagued with a chronic shortage of banknotes since the November announcement, is unlikely to meet its citizens' demand for cash until well into 2017. This in turn has hurt the Indian economy.

Like India, any Italian effort to print enough new lira paper to meet domestic demand could take months to complete. Without sufficient paper lira, existing euro banknotes would have to meet Italians' demand for paper money. Under this scenario, Italians would have to endure a messy mixture of electronic lira circulating with paper euros, reminiscent of the old bimetallic, or silver & gold standards, of yore. I say messy because everything in Italy would have two prices, a lira price and a euro price. In some ways this would be similar to the euro changeover period in 2002 when European shops displayed both euro and legacy currency prices on their shelves (lira, deutschemarks, francs, etc). The difference is that in the 2002 changeover the exchange rate was fixed, so the amount of mental arithmetic devoted to calculating exchange rates was minimal. In the case of Italexit and a new lira, the price of the lira would likely float relative to the euro, so the mental gymnastics required of Italians would be much more onerous.

If the Italian government were to attempt to fix this messiness by forcing retailers to accept euros and lira at a fixed rate, then Gresham's law would probably kick in. Because the government's chosen ratio is likely to overvalue the lira and undervalue the euro, Italians would hoard their paper euros (preferring to use them in Germany and elsewhere) while relying solely on electronic lira to buy things. This hoarding of paper euros, and the ongoing lack of paper lira, would likely lead to a severe banknote shortage, much like the shortages that India and Zimbabwe are currently enduring.

Some readers are probably wondering why Italy wouldn't try printing new banknotes ahead of the redenomination date. That way it could engineer a rapid lira changeover rather than a slow one. The problem here is that if Italian authorities take a preemptive approach, odds are that word will leak out that new lira are being printed, and depositors—spotting an impending redenomination coming down the road—will flee the Italian banking system en masse. So we are right back where we started. A successful Italexit requires that new lira banknotes be printed only after the redenomination has been announced, not before.

One technique that Italy might try in order to get lira paper into circulation as rapidly as possible is to use overstamping (described here). Once redenomination had been announced, Italian authorities quickly produce a large quantity of special stickers or stamps. They would then require Italians to bring in their euro banknotes to banks in order to be stamped, upon which those overstamped euros would no longer be recognized as euros, but lira. The window for getting euros stamped would last a week or two, after which the Italian government would declare that all remaining euro notes are no longer fit to circulate in Italy. Stamped notes would function as Italy's paper currency until the nation's printing presses have had the time to print genuine lira paper currency, at which point Italians would be required to bring stamped notes in for final conversion.

But even here Italy runs into a problem. An Italian with a stash of euro banknotes can either bring this stash in to be overstamped, and eventually converted into lira, or they can break the law and hoard said euros under their mattress. Hoarded euro note will still be valuable because they can be used to buy stuff in Germany, France, and in other remaining eurozone members. An overstamped euro, however, which has effectively been rebranded as lira, will be worth much less than before. Many Italians will therefore avoid getting their money stamped, preferring to get more value for their euro banknotes than less. And this means that Italy is likely to suffer a severe cash crunch, with euros being hoarded and new lira unable to fill the void fast enough, yet another manifestation of Gresham's law.

So any would-be euro exiteer faces several ugly possibilities, including a messy period of multiple prices to massive cash crunches.

It is because of these difficulties (and others) that I see euro exit as an incredibly unlikely proposition. The euro isn't a glove, it's a Chinese finger trap—once you've got it on, it's almost impossible to get out.


If there is to be an exit, the most likely one will be the euros without the Eurozone approach. Rather than announcing a new lira, Italy simply says that it will officially leave the Eurozone while continuing to use the euro unofficially. This means that Italian banks would continue to denominate deposits in euros and keep euro banknotes in reserve to meet redemption requests. The euro would still be used by Italian merchants to price goods, and euro banknotes would continue circulating across the nation. The difference now would be that the Bank of Italy would no longer have the authority to print euro banknotes. Instead, Italy would have to import banknotes from the rest of Europe, much like how Panama—a dollarized nation—imports U.S. banknotes from the U.S., as do Zimbabwe and Ecuador. By employing this sort of strategy, all the hassles I wrote about in this post (multiple prices & cash crunches) are cleanly avoided while at the same time an exit of sorts is achieved.


  1. I wrote a post on TARGET2 a few years ago, with a section on banknotes. There’s an issue with respect to the issuance of bank notes in one country and their redemption in another. I’ll paste the whole section here. Maybe you’ve got it covered in your analysis. Or maybe it’s another aspect to be considered in how accounts get reconciled in the event of a hard exit:


    The Special Case of Eurozone Banknotes

    Suppose that the Spanish farmer pays the German manufacturer with Euro banknotes instead (for comparative purposes only; an example involving tourism would be more realistic).

    Here is the payment sequence:

    The Bank of Spain issues banknotes to Santander in exchange for a debit to Santander’s reserve account. Santander issues the banknotes to the farmer in exchange for a debit to the latter’s deposit account. The farmer pays the manufacturer with banknotes. The manufacturer redeems the banknotes with Deutsche bank in exchange for credit to a deposit account. Deutsche Bank redeems the banknotes with the Bundesbank in exchange for a credit to its reserve credit.

    When the Bundesbank redeems banknotes and issues bank reserves, it switches one liability (banknotes) for another (reserves). That liability switch is economically equivalent to an alternative balance sheet adjustment – the addition of a liability (reserves) and the addition of an asset (banknotes). It amounts to the same thing, because the incremental banknote asset cancels out against a previously issued banknote liability of the same magnitude. This representation is as if the Bundesbank held the redeemed banknotes as an asset instead of cancelling previously issued banknotes for the same amount as a liability.

    This revised representation depicts the transaction as if the Bundesbank has a new banknote asset and the Bank of Spain has the corresponding banknote liability (which it issued originally in order to meet the demand for banknotes from the farmer).

    These two entries are analogous to the TARGET2 asset held by the Bundesbank and the TARGET2 liability issued by the Bank of Spain in the earlier case where the farmer/manufacturer transaction was conducted using the medium of bank reserves rather than banknotes.

    The revised presentation in gross asset and liability form explodes the transaction into its logical gross positions, which are obscured in more standard netting when banknotes are redeemed for bank reserves.

    In fact, the ECB uses an accounting adjustment along these lines in tracking the economic effect of the intra-Eurozone flow of banknotes. In our example, the end result in standard accounting terms (including netting) is that the Bank of Spain will have issued more banknotes and the Bundesbank will have issued fewer banknotes (after accounting for the redemption) than would otherwise be the case. This skews the distribution of net banknotes issued when there is a capital flow from one region to another in the form of banknotes. One of the effects of this is that different central banks will earn different shares of aggregate Eurozone seigniorage due to banknote issuance, depending on their share of issuance. In the example, the Bank of Spain will have a greater share than before, and therefore will earn a greater overall share of Eurozone seigniorage due to the interest margin benefit of having issuing more banknotes.


    1. The Bank of Spain then has less Target 2 credits and so there is no increase in seignorage.

    2. On second reading I see that in your comment the banknotes are not directly connected to Target2 and so there is an increase in seinorage interest margin benefit.

  2. ...

    The ECB “normalizes” such effects through the type of accounting modification described. In fact, it recognizes such changes in banknote issuance by charging interest on “excess” banknotes issued and paying interest on the corresponding banknote “assets” that have been redeemed by another central bank. The identification and tracking of such excess liability and asset positions is done by setting normalized levels for shares of banknote issuance for each NCB in the Eurozone, where normal levels are defined according to each NCB’s share of ECB capital investment. The described differential positions are referred to as “banknote adjustment” positions on NCB balance sheets. The general idea is to avoid inequitable distributions of seigniorage benefits that are otherwise attributable to intra-Eurozone banknote capital flows.

    (Using this framework, one can construct an interesting, abstract interpretation of banknotes as financial instruments. Banknotes may be seen as economically equivalent to a securitization of bank reserves. In the example, the sequence starts when Santander exchanges its reserve balances for banknotes. The banknotes can be viewed as a securitized loan of reserves to the Bank of Spain. The customer farmer uses this “banknote bond” as the medium of exchange in dealing with the manufacturer. The manufacturer redeems the “bond” in exchange for a deposit with Deutsche Bank. Deutsche Bank redeems the “bond” in exchange for reserve balances with the Bundesbank. And the Bundesbank “holds” the bond as an asset against newly issued reserves (in the sense of the described alternative accounting representation).)

    The result is the creation of banknote adjustment assets and liabilities that have the same economic meaning (in the sense described earlier as loans of reserves) as TARGET2 assets and liabilities. TARGET2 clears reserve effects through the banking system directly. Banknote adjustment clears the reserve effect transmitted through the medium of banknotes considered as a type of (retail) bond in bank reserves. Banknotes are in this sense a form of securitized bank reserves, used in mobile form largely by the retail sector.

    1. Hi JKH, great summary. That's also my understanding of how the reconciliation of euro banknotes worked across the eurosystem, although you've explained it much clearer than I could have.

      When doing the research for this post, I found out an interesting fact. Although Germany's Target2 credit hit record highs this month, its intra-Eurosystem liability related to banknote issue hit record highs. It stands at ~325 billion, about 40% of its Target credit. Kind of interesting. Any thoughts?

      I didn't go into these issues on the post since I wanted something short. But as you say, come a hard exit the banknote liability/credit position becomes important, as does settlement of Target2 deficits. The problem of getting new lira into the system only compounds all these issues.

    2. I found this to be an excellent reference at the time I wrote my post:

      Tables 1 and 2 are quite interesting. That was June 2011. The Bundesbank position at that time was a banknote adjustment of (163) billion. Negative adjustments as you know are issues in excess of allocation, so in effect the Bundesbank owed that amount to other central banks, and paid interest on it (reducing the gross seigniorage benefit from excess issuance). The bank note adjustment reduced the total Intra-Eurosystem claim of the Bundesbank from a 336 billion TARGET2 surplus balance to a 173 billion net claim surplus balance. That is an interesting net directional effect for Germany.

      I haven’t been following the data lately, but from what you say it sounds like the Bundesbank numbers have grown proportionately since that time, with the directional composition staying similar – a large TARGET2 surplus reduced by a banknote adjustment liability.

      I didn’t dig into the weeds back then or now, so I have no great insight on the explanation for this. Tourism outbound from Germany? It seems intuitively like a very large adjustment for that, but I don’t know. There well may be other factors. I haven’t noticed anything written on this then or now.

      I’ll just point out that the conceptual example I used in my post was directionally reverse to the actual macro case for both Spain and Germany. Germany has been a net issuer of banknotes relative to a normalized allocation and Spain at that time was the opposite. I did that to simplify a same-direction comparison of TARGET2 bank reserve flows and banknote flows.

    3. "I found this to be an excellent reference at the time I wrote my post:"

      Yes, the Whittaker stuff is excellent.

      "I’ll just point out that the conceptual example I used in my post was directionally reverse to the actual macro case for both Spain and Germany... I did that to simplify a same-direction comparison of TARGET2 bank reserve flows and banknote flows."

      Yep, I got that.

      "Tourism outbound from Germany?"

      Here's one thing I'm trying to wrap my head around. Let's say that the German public likes banknotes much more than other Europeans, so the Bundesbank finds itself printing more notes than other national central banks. They stay in Germany (in wallets and under mattresses) rather than going to Spain, as in your example. Can this give rise to a banknote liability? I don't know the answer.

    4. The banknote adjustment normalizes each individual NCB’s share of aggregate net outstanding Eurozone/Euro banknote issuance according to its capital key share. As I understand it, the calculation is effectively independent of particular patterns of flows of banknotes from the region of issuance to a different region of circulation and/or redemption. It is only the net NCB balance sheet position of gross issuance less redemptions that matters to the calculation - regardless of NCB issuance origin of those notes redeemed.

      Consider a generalization of the scenario you suggest in which it is assumed that there is no inter-NCB flow of banknote issuance/redemption. That means for example that the outstanding net stock of banknotes on the balance sheet of the Bundesbank is entirely a function of the notes it has issued and how many of those same notes have been subsequently redeemed. That said, all notes originally issued by the Bundesbank and still in circulation may or may not still be circulating with Germany - I think you’ve suggested a strict scenario along the lines of the former. So no Bundesbank issued banknotes end up being redeemed at NCBs other than the Bundesbank. And generalizing, no banknotes originally issued outside of Germany end up being redeemed at the Bundesbank. Each NCB is assumed in this way to operate in in a closed banknote economy, so to speak.

      Assume in that scenario that the Bundesbank has issued excess banknotes relative to its capital key ratio of total Eurosystem issuance (as is now the case in fact). Then there is a liability adjustment that is calculated in the same way as occurs now. The aggregate of all such liability adjustments add up to zero across the Eurozone (more or less), with some reflecting surplus issuance and others reflecting deficit issuance relative to the various NCB capital key shares. The corresponding banknote adjustment takes place with the same compensating inter-NCB interest rate consequences. The fact that no banknotes issued by the Bundesbank have left Germany and/or none of those banknotes have been redeemed at other NCBs does not affect the essential nature of the banknote liability calculation and adjustment. Nor does the fact that no foreign NCB issued banknotes have been redeemed at the Bundesbank in this scenario affect the nature of the calculation. The calculation is based only on the net stock of banknotes outstanding on the Bundesbank balance sheet, regardless of the NCB origin at issuance of any redeemed banknotes.

      It’s an interesting question. It seems basic to the adjustment mechanism, but is rather tricky to analyse. I hope my answer is correct – I think so.

    5. That sounds correct to me.

      What do you think of this paper? Could shipments of cash to countries outside of the eurozone (i.e. to Eastern Europe) account for Germany's large banknote liability?

      "In the period from 2002 to 2009, almost three-quarters of all euro banknotes sent to destinations outside
      the euro area were provided by the Deutsche Bundesbank...

      "The prominent role of the Deutsche Bundesbank can be attributed above all to (i) the fact that Frankfurt airport is a major international hub and (ii) to its geographical proximity to Switzerland, whose banks play an important role in the global trading of foreign currency."

    6. Well written piece with interesting detail.

      It seems that Germany and Austria have disproportionate hub roles in the international spoke distribution and redemption of banknotes respectively.

      I don’t recall seeing this sort of information before. The piece is 5 years old, but it appears pretty factual as of that time and hard to argue with.

  3. Probably/Maybe: Announce that Italian bank deposits are now Lira, and no longer legally required to be convertible at par into Euros. So there is a flexible exchange rate between Euro currency and Lira deposits. You could still buy goods with Lira cheques/debit cards, or Euro currency. Then introduce Lira currency as it gets printed.

    The medium of account will get a bit messy.

    1. What about the legal wording of loan contracts, how would the outstanding balance be repayed and redeemed, and the case of a borrower who's has an across the border income that is in Euro.

    2. Nick, that's a creative workaround. It's like a central bank that uses indirect convertibility, except done by commercial banks. As you point out, doesn't solve the messy problem of multiple prices, and as Dinero points out it brings up some other interesting issues.

    3. Yes the exchange rate exposure and loan contracts. On entering the Euro a borrower who had an across border income in a different currency allready had an excjange rate exposure. But on leaving, the exposure would be novel to the borrower and so what is the legal justification for the lender to expect payment in a dfferent currency to that denominated in the loan contract.

  4. Partially disagree.
    If Italy leaves the Eurozone, its banks (by definition) do not have access to ECB tender windows, on which most of their liquidity backstops depend. Banks in dollarized nations for that reason have way lower leverage ratios and higher cash buffers, since they cannot rely on a central bank to provide them with liquidity in exchange for less liquid collateral.
    I once had a post on these effects, touching the difference between Emerging banks and "western banks", just in case you are interested,

    In my opinion the Eurozone can only be left the other way round, i.e. by those nations having an "alpha" central bank, i.e. Germany
    People would have no incentive to withdraw Euros in Germany, as they would be looking forward to recieving DM-Mark, whereas PIIGS would countinue to use the Euros. The cash shortage effect, as you describe would not occur...
    (There still wold be uncertainty, as it is not clear how the Target balances would be settled)

    1. The could become IOUs between National central banks with maturity length and settlement currency decided by the NCBs. They could even agree to net off parts of balances as the oppurtunity arrises.

    2. Viennacapitalist,

      "If Italy leaves the Eurozone, its banks (by definition) do not have access to ECB tender windows, on which most of their liquidity backstops depend. Banks in dollarized nations for that reason have way lower leverage ratios and higher cash buffers, since they cannot rely on a central bank to provide them with liquidity in exchange for less liquid collateral."

      Fair points. If Italy manages to bring back the lira, then Italy's banks would have access to the BoI's lending facilities, which is different than in a euro-ized situation in which the banks would have no access whatsoever to a LOLR.

      Doesn't solve the lira banknote problem though.

      "In my opinion the Eurozone can only be left the other way round, i.e. by those nations having an "alpha" central bank, i.e. Germany
      People would have no incentive to withdraw Euros in Germany, as they would be looking forward to recieving DM-Mark, whereas PIIGS would countinue to use the Euros. The cash shortage effect, as you describe would not occur..."

      I agree that its different if Germany leaves. I was thinking about writing on this point too, but the post was already a bit long. I partially disagree about your point about cash shortages, though. If Germany left, there would be a cash shortage, but it would be suffered by all the remaining countries, not Germany. Not only will Germans want deutsche marks, as you point out, but so will Greeks, French, Italians, etc. So euro banknotes will flood into Germany for conversion, leaving Greece, France, Italy, etc with large paper money shortages.

  5. @ Dinero,
    good point, however in which currency would those NCBs be denominated? If denominated in, say, the DM-Mark this would have an impact on foreign indebtness of the exiting country and might lead to a default. If denominated in the weaker currency, the hard currency country central bank would suffer a drastic loss and would likely need to be recapitalized. Politically a mess
    @ JP Koenig.
    It might not be possible do redenominate all Euro liabilities such as international bonds for instance or derivative liabilities, for these you need access to hard currency liquidity (a problem the Panamaian bank in all likelyhood does not have in this dimension) Further, it might be politically difficult to redenominate loans on the asset side: say an exporter's Euro loan gets redenominated into Lira - this is a significant wealth transfer, your voters might not like - especially, if their deposits are significantly reduced in purchasing power overnight.
    Money is not neutral, which is why these things are very difficult to decide...

  6. I wonder. Why would Italy have to redenominate the euros in bank accounts to the new lira? That would be absurd, because with that would be generating a massive flight of the Italian banking system