Buying the euro break up

* Bond buyers positioning for potential Finnish euro exit

* Logistical, legal uncertainties could undermine strategy

By John Geddie

LONDON, July 27 (IFR) - Speculation that Finland may become the first country to exit the euro area and revert to a local currency has been one of the factors touted as driving recent flow into short-dated Finnish paper.

Talk in the market is that hedge funds have started to take positions in Finland in the hope of making profit through redenomination.

"We have seen a lot of flow go through and heard some funds are selling short-dated France and buying short-dated Finland on the view that Finland might be the first country to leave the euro," said Peter Allwright, co-head of the absolute return bond and currency team at RWC Partners.

"There is now a premium on Finnish bonds for the potential of currency redenomination," he said.

Analysts point to the 30bp spread differential between France and Finland in two-years which has emerged over the last week, although they caution that general pessimism about France's economic outlook is also weighing on sentiment.

Given the illiquid and low-yielding nature of Finnish paper in the two-year space, recent activity is unlikely to be solely focused on flight-to-quality but also on investors hoping that their bonds may be converted to a new Finnish currency which would trade above the euro.

Banks confirmed that a similar sentiment is emerging around bids for German paper, where everything below the four-year sector has now entered a sustained period of negative yield.

"I am aware of people talking about positions in Schatz, whereby if Germany leaves the EMU and you get your money back in Deutschmarks then you could make quite an attractive foreign exchange gain", said Luca Jellinek, head of European rates strategy at CA-CIB.

"I haven't actually spoken to investors who have done this trade, but it is a line of reasoning in the market," he added.

FIXIT'S LOGISTICS

Of the two sovereigns, the political rhetoric around a Finnish exit seems more robust.

Finland has proved a constant thorn in the side to eurozone rescue efforts: it has threatened to veto a deal to allow the ESM to purchase peripheral bonds, demanded collateral for its contribution to a Spanish banking bailout, and vehemently opposed the mutualisation of debt or a banking union.

The scepticism of Finnish government officials has been echoed by comments made by economists such as Nouriel Roubini, aka Dr.Doom, who in a report entitled 'Fix it or Fixit - Could Finland be Next?' cited private unofficial estimates putting the potential losses to Finland of continued eurozone membership at 10-15% of Finnish GDP.

But not everyone believes bondholders can profit from a Finnish exit, including the head of European strategy at one of Wall Street's most profitable hedge funds.

The strategist noted the logistical and legal uncertainty around a Finnish redenomination for bondholders.

In the event of any country leaving the euro area, it would not make economic sense for it to redenominate its bonds into an appreciated currency, thereby increasing its liabilities, he said.

He also noted that while the legality around the issue is a particularly grey area, redenomination should cause an event of default.

However, said the strategist, there is one scenario in which a country may wish to redenominate its bonds, and that depends on its financial sector.

"If banks had their liabilities in local currency but their assets (including government bonds) in euros, then the financial system could be faced with instant vaporisation", explained the strategist.

"The government would have to decide whether it would be more costly to recapitalise its banks or redenominate its bondholdings."

Faced with such a dilemma, Finland may consider a recapitalisation of what is a fairly small banking sector the lesser of two evils.

Statistics from the Bank of Finland state that just 3% of holders of government bonds and t-bills are domestic.

Germany, on the other hand, where 21% of bonds are purchased domestically, a large portion of which by its systemic banks, may be more likely to reward the speculators. (Reporting By John Geddie; Helene Durand, Ciara Linnane)