The euro celebrates its tenth anniversary this January, but there has been little to celebrate for this putative reserve currency. Used by 16 of 27 member states in the European Union, the euro is coming under intense pressure on foreign exchange markets as the global economic crisis hurtles on.
Europe's single currency has historically been a safe haven during financial storms, as its member economies were thought to provide a diverse bulwark against economic hardship. Purchasers of the euro were, in theory, spreading their risk across Germany, France, Spain, and other big EU markets. What is more, economic coherence and the coördination of monetary policy were billed as the pillars of supply-side reforms spurring growth and productivity.
That was then. There are now real concerns that the eurozone could split up, or that one of its member states could suffer a sovereign debt default. Traditionally, the spread on government bonds between countries using the single currency are paper-thin. Over the last ten years, the interest rate on, say, Belgian bonds has not been much greater than the safest German government bonds (called bunds). Low bond spreads have been one of the major attractions of using the euro, especially for new EU members looking to finance their domestic spending.
Some analysts, however, claim that the bond spread convergence is misleading, as there is no legal way for one eurozone country to backstop the debt of another. While they may use the same currency, Germany's economic vitality cannot prevent Slovenia from defaulting. As a result, sovereign debt should be analyzed individually, not part of an EU blend.
This revaluation is precisely what now threatens the single currency. The extra yield on Greek government bonds over German bunds has risen dramatically during the financial crisis (not to mention the weeks of social turmoil in Athens). On Friday, Standard & Poor's put Greece's credit ratings on notice for a potential downgrade, sending both CDS contracts and bond spreads on Greek debt to historic levels.
Similarly, both Spain and Ireland have had their credit ratings cut by S&P in recent days. As a result, these countries will have to pay investors a higher interest rate to finance government spending for economic recovery. With European governments scheduled to sell a record €41 billion in Treasuries this week, bond spreads will be on the mind of central banks throughout the EU.
Most analysts are worried about countries at Europe's periphery that might be tempted to opt out of the euro in an effort to pursue self-interested monetary policy. One of the major criticisms of the single currency is that its rising strength (before the financial collapse) eroded the appeal of European exports and put pressure on domestic spending. To complicate matters, many EU governments have policies that automatically link wage increases to inflation. As a result, Italy and Greece are facing acute strains on their federal budgets, with no way to devalue their currency and boost trade.
In a more striking omen, the likelihood that any country currently using the euro will drop the single currency in the coming year is now at 30%, according to the Intrade prediction market. What once may have seemed an unthinkable development is now a significant concern for policy makers across Europe. To be sure, any country that decides to opt out of the euro would face major economic hardship. Investor confidence would plummet, and local citizens would rush to transfer their euro holdings to more stable accounts outside the country. These costs should outweigh any problems with the euro, but there is no way to predict the domestic political pressures that many European leaders might feel in 2009.
If the EU can successfully navigate this next year and prove its mettle in the face of a financial calamity, then it will likely reassure investors that the euro is a bonafide reserve currency. If, however, one of its member states decides to leave the eurozone, it will likely spell the end for the euro as a major fixture on the forex market. Happy 10th, euro, and good luck in the year ahead.
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3 comments:
Also, a poll conducted by Germany's Dresdner Bank in 2007 showed that 62% of Germans favor reinstating the deutsche mark
And back in 2005 Italy's current Prime Minister Silvio Berlusconi branded the euro as a "disaster" and a "rip-off" that "screwed everybody."
I think Germans were quite upset when they left the Dmark, as the country was extremely proud of its currency. This sort of economic nationalism is only heightened in times of financial crisis, as each country wants to address domestic pressures. Obviously Europe's single currency constrains the monetary policy options for states (like Italy) who are struggling.
I think Intrade probably overestimates the likelihood of any country opting out of the Euro because such an event would be cataclysmic for the currency. EU officials would presumably jawbone anyone who thinks about moving back to the lira, deutsche mark, or other.
That said, Ireland is in big trouble, Spain is facing further ratings cuts, and Europe as a whole is facing a tougher recession that the US.
Look at the net public debt of Greece, Spain, Portugal, or Ireland (including commitments) with respect to GDP. I don't have the numbers handy, but I believe all of them exceed GDP by a factor of 1.5 at least.
Now, for perspective, realize that sterling is taking a beating because the latest commitments of Whitehall to back RBS et al. will put net public debt at slightly over 50% of GDP.
This is cause enough to invite a speculative attack. As you imply, these debts are denominated in euros, so there is pressure from these parties to devalue, while the Gerries, with little debt, are with the hawkish Trichet. They have little love for fiscal stimulus as well, evidenced by Merkel's paltry 1% of GDP proposal.
Germany, an over-producer like Japan and China, needs to spur consumption, and a weaker currency would only help. Ed, as a member of the Deutschland diaspora, you may be right -- that is just not in the German "geist".
I think CDS on country risk are overbought due to technical reasons (banks' overweightings of govt bonds due to decreased risk tolerance and raised loan loss reserves), but there are good reasons to doubt the stability of the Eurozone. Remember Black Wednesday when an unsustainable band came face-to-face with large moves of speculative capital. The productivity of Eurozone economies is weakening fast, and business sentiment in Germany is uglier than ever.
Speaking of the GBP, these two currencies are just one more reason to believe the dollar story, for now.
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