# How will German bonds be repaid if Germany leaves the Euro?



## Fergal (13 Jun 2012)

A worried saver buys 100 EUR German bonds
Before the bond matures, Germany leaves the Euro and creates Duro as its new national currency.  The Duro is created with an initial conversion exchange rate of 1 Duro = 1 Euro.  All German savers now have Duro in the bank accounts
Later the bond matures and 1 Duro is now  = 2 Euro.
According to the "Lex Monetae" concept, how will the bond holder be repaid?

The issue may be complicated by the fact that the Euro still continues to exist after Germany leaves it.  Most Lex Monetae discussions describe the scenario where the old currency ceases to exist when a country changes currency. And I'm not clear which law applies to German bonds - EU law or German law.


Scenario 1: The bond holder is repaid 100 EUR (or 50 Duro).  
Argument-1A: The contract is in EUR and EUR still exists so EU law applies. Germany merely converts 50 Duro in EUR.
Argument-1B: You should be paid 100 Duro's worth of money *at the time of the initial conversion rate.*  Therefore you don't benefit for the Duro's subsequent increase in value.

Scenario 2: 200 EUR (or 100 Duro).  Argument: As German law applies to the bonds then you should be repaid in the currency of the state.

I'll be buying more German bonds if the answer is Scenario 2 - would greatly appreciate any opinions as I haven't been able to find anywhere that applies the theory into an example such as the above.  The difference between argument 1B and 2 is quite subtle.


----------



## Chris (13 Jun 2012)

Essentially they will do whatever suits them, but I would say it is more likely that they will not punish bond holders that they will want to sell more bonds to in the future. 
Bear in mind that Germany has financial trouble as well it just hasn't hit the head lines as it isn't get as bad as other countries.


----------



## Fergal (13 Jun 2012)

Thanks Chris.

Definition of Lex Monetae from Morgan Stanley

 "Lex Monetae is an internationally  recognized legal concept. It requires that no party may default on a  contract if a government alters its national currency, using a  particular conversion rate. Amounts specified in the contract will  simply be redenominated to the new currency by using the specified  conversion rate. "

Unfortunately, this definition doesn't make it clear what the rate will be - the initial conversion rate or the current rate at the time of maturity.

I'm surprised that you expect the Germans to do what suits them - isn't it a legal matter regarding the interpretation of Lex Monetae applied to the unusual case of the old currency still being legal tender in EU law?


----------



## luckystrike (16 Jun 2012)

there is zero possibility for the germans to leave the Eurozone.  Just think for a moment:  If they reverted back to the german deutsche mark this would increase dramatically in relation to the euro and make their exports uncompetitive [most of their exports are to other eurozone countries].  So you see nothing is simple in an interconnected and tangled economy we live in.  For instance, the Germans couldn't really care less about letting Greece drown in its debt but their banks have invested in lots of Greek debt so they can't really let it go down.


----------



## smiley (16 Jun 2012)

luckystrike said:


> there is zero possibility for the germans to leave the Eurozone.  Just think for a moment:  If they reverted back to the german deutsche mark this would increase dramatically in relation to the euro and make their exports uncompetitive [most of their exports are to other eurozone countries].  So you see nothing is simple in an interconnected and tangled economy we live in.  For instance, the Germans couldn't really care less about letting Greece drown in its debt but their banks have invested in lots of Greek debt so they can't really let it go down.



+1 for some common sense.


----------



## Chris (21 Jun 2012)

luckystrike said:


> there is zero possibility for the germans to leave the Eurozone.  Just think for a moment:  If they reverted back to the german deutsche mark this would increase dramatically in relation to the euro and make their exports uncompetitive [most of their exports are to other eurozone countries].  So you see nothing is simple in an interconnected and tangled economy we live in.  For instance, the Germans couldn't really care less about letting Greece drown in its debt but their banks have invested in lots of Greek debt so they can't really let it go down.



This is simply not true and completely ignores the impact on imports. If Germany left, then yes the Deutsche Mark would rise and in the very short term exports would increase in price making them less attractive. But import costs would go down meaning that a country that virtually imports all its oil and gas and a large part of its electricity will have much lower input costs allowing businesses to lower their operating costs and prices charged. Food, medical, computer, electronic imports would all go down in price.
It is also not true that most of their exports are to euro zone countries. All you need to do is look at the annual reports of some of Germany's largest manufacturers. For example BMW, 70% of revenue comes from non-European countries and that figure doesn't deduct sales to the UK.
From the founding of the GDR to the 90s the Deutsche Mark was always one of the strongest in the world, which is precisely why it was such an economic success. If a strong currency were to lead to failure then Germany would never have been an economic success. Fact is that the German economy was doing better underr the DM than has web doing with the Euro.


----------



## daheff (22 Jun 2012)

Chris said:


> This is simply not true and completely ignores the impact on imports. If Germany left, then yes the Deutsche Mark would rise and in the very short term exports would increase in price making them less attractive. But import costs would go down meaning that a country that virtually imports all its oil and gas and a large part of its electricity will have much lower input costs allowing businesses to lower their operating costs and prices charged. Food, medical, computer, electronic imports would all go down in price.


 

Its a bit more complex than that. The exchange rate is effectively a function of demand and supply. As the Bundesbank has had a strict policy of containing inflation they have restricted the supply of Deutschemarks (DM) (prior to the Euro). As a result of this and the strong export led economy they have (meaning those buying the exports also had to 'buy' DM to pay for the exports), the exchange rate meant a strong DM.

So while lower input costs would mean a lower price being able to be charged by Germany companies, a lower sales price would drive up demand for exports, meaning a higher demand for DM, driving up the exchange rate -increasing the cost for people buying the exports. This all levels out a point.

German exports are doing *better *under the Euro for a similar reason as the Euro is not as 'expensive' as a DM would be. Thus German exports are booming.


In the above regard, the whole exchange rate thing is a bit chicken and egg...what comes first. Its not the only thing in play though (interest rates, economic expectations etc).



To answer the OPs question (i think there was one!)- the amount/currency repaid for German bonds in this scenario is all hypothetical until it actually happens (unless there are specific clauses written into the bond issuing documentation -and with them being German there possibly could be!).


----------



## ringledman (22 Jun 2012)

There was a good article a couple of weeks ago in the FT that essentially said,- if Germany leave the Euro then why on earth would they pay back foreign creditors in Deutchmark II when they can merely pay back in devalued Euro's as per the contract obligation.

Local business' and depositors would probably be repaid in Deutchmark II but not foreigners. Makes perfect sense.

Buying bunds is not necessarily the sure fire safe bet many think. The interest rate is negative and there is no guarantee of being repaid in a stable currency.


----------



## Spear (22 Jun 2012)

luckystrike said:


> there is zero possibility for the germans to leave the eurozone.



Nothing is impossible and such notions should not be dismissed. Hardly anybody on this site a couple of years ago would entertain the possibility of a euro break up.


----------



## Chris (28 Jun 2012)

daheff said:


> Its a bit more complex than that. The exchange rate is effectively a function of demand and supply. As the Bundesbank has had a strict policy of containing inflation they have restricted the supply of Deutschemarks (DM) (prior to the Euro). As a result of this and the strong export led economy they have (meaning those buying the exports also had to 'buy' DM to pay for the exports), the exchange rate meant a strong DM.
> 
> So while lower input costs would mean a lower price being able to be charged by Germany companies, a lower sales price would drive up demand for exports, meaning a higher demand for DM, driving up the exchange rate -increasing the cost for people buying the exports. This all levels out a point.


You are right that there is an eventual balance, but the German Bundes Bank was renowned for a relatively tight monetary policy which kept its currency strong from the late 40s to the late 90s. It was because of this strong and stable currency that the economy did so well.



daheff said:


> German exports are doing *better *under the Euro for a similar reason as the Euro is not as 'expensive' as a DM would be. Thus German exports are booming.


The German economy was doing better prior to the Euro, German GNP averaged an increase of 2.3% from 1990 to 1999, while from 2000 to 2010 it averaged 1.1%.



daheff said:


> In the above regard, the whole exchange rate thing is a bit chicken and egg...what comes first. Its not the only thing in play though (interest rates, economic expectations etc).


No it's not a chicken and egg situation. The looser and less stable the monetary policy the more difficult it is to make economic predictions, making life more difficult for businesses. The perfect example is Germany after WWII and the US during the industrial revolution where strong currencies prevailed.
Both interest rates and economic expectations are ultimately influenced by monetary policy.


----------



## Fergal (1 Jul 2012)

Thanks Ringledman and dahuff, I suspect that you are both correct.  I found a very interesting article written in 1998 (I'm now allowed to post URLs) "When the Euro falls apart" by Hal S. Scott from Harvard Law School.  He discusses exactly this dilema in section "ii. Replacement of the euro with national currencies".  Hal's conclusion is very close to dahuff's last paragraph above.  It also suggests that internally(domestic) and externally (foreign) held bonds may get different treatment.

An article at "bondvigilantes" in Jan 11 2012 takes it for granted that German bonds will be repaid such that the bondholder enjoys significant capital appreciation. 

For what it's worth, I bought the bonds and the trader advised that many others are doing likewise.  I'd expect there to be a lot of interest in this topic!


----------

