Tough Times For The Euro ? But There Is Time To Sort It Out


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In May 2008 the European Commission issued a press release entitled ?10 years of Economic and Monetary Union: a resounding success but testing times ahead?. Just two years later, many woul

In May 2008 the European Commission issued a press release entitled ?10 years of Economic and Monetary Union: a resounding success but testing times ahead?. Just two years later, many would question the ?resounding success? statement – and probably also consider the ?testing times? warning to be rather an understatement. With the Eurozone now facing an ?existential crisis?, what does the future hold for the Euro?

The 2008 press release admitted that there was ?still work to be done?, including ?both deepening and broadening economic surveillance arrangements to guide fiscal policy over the cycle and in the long term?.

We can see today just how much such work ? and more – is needed.

In an interview with the Financial Times on 13th June this year, EU president Herman Van Rompuy said that ?in some ways we were victims of our success? and that the strong Euro had masked the underlying fiscal problems in the Eurozone. Brussels is now working on a 10-year programme for economic reform and Van Rompuy maintains that European leaders now understand the need to implement necessary economic reforms.

The financial woes of countries like Greece, Spain and Portugal have put great strain on the monetary union. The Euro has come under heavy selling pressure as traders became increasingly nervous about whether the crisis will spread and how far. The currency?s long-term viability has even been called into question.

On 8th June the Euro fell below $1.19 against the US Dollar for the first time in four years ? it had fallen 20% over just six months. Analysts warned that the single currency could fall to parity against the US currency. While this sounds dramatic, let?s not forget that the Euro traded at below $1.20 between its launch on 1st January 1999 until the end of November 2003 and at less than $1 for 29 of these months. From a technical base, the Euro could hold its current level for a while (or even fall lower) and then bounce back.

Let?s also not forget that just six months or so ago the US Dollar was the beleaguered currency.

There is, however, a huge difference between the Euro and the US Dollar ? the US has one government, one banking system and one fiscal policy. The Eurozone has 16. We have a monetary union where one central bank sets monetary policy for disparate economies; economies with divergent needs, agendas, policies etc and which are not well integrated. This is, perhaps, a structural design flaw.

Without flexible exchange rates and the ability to set their own interest rates, Eurozone countries are left with little choice at times of fiscal crisis other than deflation. This is a vicious circle, however, since deflation inhibits economic growth and results in less tax revenue for the government.

This design flaw, together with reckless government spending, resulted in the current Eurozone turmoil. Some commentators believe that the outcome will be that the Euro dissolves. There is however another potential outcome ? deeper economic and political integration.

Could strong countries choose to leave the Euro? Could weaker countries opt or be forced out?

There is currently no legal mechanism to opt out or to expel a country. Such a move would also impose significant costs to the real economy and banking sector in these countries.

If a Eurozone State quits or defaults its financial future could be called into question. A default or exit would probably result in lasting damage to lenders throughout the region.

Germany in particular would suffer, because although its economy is relatively robust, its banking industry is finely balanced and still struggling to recover from the financial crisis. Any change in the configuration of the Euro could push its banks over the edge. The German government is unlikely to countenance the break up of the Euro.

It is therefore unlikely ? though not impossible ? that counties would leave the Euro or force another state out.

We could see an outcome with fiscal centralism and deeper political union, where the structural flaw of the Euro?s original design is addressed and the EU parliament is given power to control the actions of its Member States by withholding funding or stipulating how funds are to be used. Euro debt could be issued from Brussels rather than by each country.

Much political courage and diplomacy would be needed ? but there is considerable political commitment behind the singe currency.

The ?750 billion rescue package has staved off the liquidity crisis facing Portugal, Italy, Ireland, Greece and Spain, and while it does not fix their solvency issue it has bought time for them to address their fiscal policies (albeit in some countries they are very daunting) and for institutional reform of the Eurozone.

Assuming that the issues are resolved and the crisis passes, in our opinion the Euro should pick up again ? fundamentally it is not a weak currency. In aggregate, the EU?s fiscal position is healthier than the US or UK and unlike them has both a balance of payments and current account surplus. Russell Investments have done some modelling which shows that while the Euro will continue to weaken if the EU political turmoil persists, if you remove this factor it is close to fair value with the US Dollar.

There is also a silver lining to a weak Euro. For the first time in years many of the Eurozone key exporters are price competitive on the world stage. A deflated currency will also give southern European countries more chance of reflating their economies.

There are tough times ahead for the Euro. In the short term we can expect it to remain weak. The longer term is more uncertain but potentially we could end up with a stronger Eurozone. The currency fluctuations we are seeing at the moment do not in themselves determine the Euro?s future; rather what will matter is how successful governments are in reducing their debt levels and imposing prudent fiscal policies.

By Bill Blevins, Managing Director, Blevins Franks

14th June 2010

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