Troubles in the Eurozone?

07.12.10

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The future of the Eurozone and its single currency was squarely back in the spotlight following the ?85 billion bail out of Ireland and fears that contagion will spread to Portugal, Spain and Ital

The future of the Eurozone and its single currency was squarely back in the spotlight following the ?85 billion bail out of Ireland and fears that contagion will spread to Portugal, Spain and Italy. Risk premiums on Spanish and Italian bonds reached record Euro highs and Portugal also warned about risks facing its banks, exacerbating the Eurozone?s debt crisis.

There are also concerns that the region will increasingly become a two speed economy, with countries like Germany and France recovering well from the economic downturn but the ?peripheral? nations still struggling. The downside of the ?one size fits all? policy has been highlighted and the weaker economies do not have the ability to devalue their currency to increase their exports and in turn boost economic growth.

Unsurprisingly, speculation immediately re-surfaced about whether the Eurozone can survive the latest debt crisis. The various hypothetical scenarios include countries being expelled from the union, the southern countries opting to leave or Germany deciding to leave to stop having to bail out other nations. Analysts began to discuss the possibility of a two-tier Euro.

In reality there is no mechanism for a country to leave the Eurozone, voluntarily or otherwise, and the cost of doing so would be prohibitive.

For example, Professor Iain Begg of the London School of Economics explained that if Germany were to revert to the Deutschemark it would be a ?disaster? for the country as the currency would appreciate furiously and its exporters would be priced out of the market.

No one has any interest in the Euro collapsing, he said, ?certainly not German manufacturers, certainly not Greek debtors, certainly not the Irish banking system? I continue to see the Euro as part of the solution, not the problem?.

Simon Derrick, chief currency strategist at Bank of New York Mellon, said the mostly likely outcome ?by far? is that a lasting political compromise will be reached and the Euro will continue in its current form.

While the reputation of the Eurozone has been further tarnished, the determination of EU leaders and the European Central Bank (ECB) to protect the single currency should not be underestimated.

ECB President, Jean-Claude Trichet, has been at pains to dispute the speculation. On 29th November he insisted:

?I don?t believe that financial stability in the Eurozone could really be called into question.?

He told the European Parliament that market pundits were underestimating the ?soundness? of Eurozone and the determination of its member governments to cut debt. He accepted that the area was in a ?very difficult period?, but pointed out that the performance of the real economy was proving ?better than forecast? and that governments were getting to grips with their deficits.

At the Bank?s monthly monetary policy meeting on 2nd December, it sought to reassure the markets by promising that it would support the region?s troubled banks with further liquidity for as long as necessary.

The ECB had started purchasing bonds through its Securities Market Programme after Greece was bailed out in May, and the programme was due to expire in January. It will now continue until at least April.

Markets had initially been disappointed because the bank did not announce any plans to increase the amount allocated for its purchases of government bonds. So far it has spent ?67 billion on this programme, but there had been calls for an increase to as between ?1 and ?2 trillion.

On the other hand, some analysts pointed out that that helping finance government deficits is outside the mandate of the ECB and a large programme of debt purchases would be ?a very slippery slope? for the bank. If it does have to resort to this in the future, it is not a decision it will take lightly.

Trichet told a news conference that bond purchases would remain ?commensurate? with market conditions and that the Bank is ?constantly alert? and that the Programme is ?ongoing, I repeat? ongoing?.

Traders soon reported that the Bank had begun its most aggressive purchase of government bonds since May, so while it may not have announced any increase in the amount it would make available, it has speeded up the pace at which it is buying the bonds.

The news brought down the cost of borrowing for Portugal and Ireland and the Euro improved against Sterling and the US Dollar.

Stockmarkets also appeared to be satisfied, with European and US shares making it their best two-day gain in months, aided by positive US news as well as the relief rally in Europe. The FTSE Eurofirst 300 climbed 1.6%, which was its biggest two-day gain in five months.

Of course, there are still choppy waters ahead for the Eurozone. While Portugal has insisted it does not need a bail out, so had Greece. Increased divergence in the economies of the central and peripheral Euro members would further highlight the disadvantages of the ?one size fits all? policy.

However the balance of the EU?s rescue package of ?750bn agreed in May is still available and buys time for EU leaders and policy makers to improve fiscal centralism and deeper political union and to address the structural flaw of the Euro?s original design. Much political courage and diplomacy would be needed ? but there is considerable political commitment behind the singe currency.

By Bill Blevins, Managing Director, Blevins Franks

3rd December 2010

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