Euro Well-Bid In Spite of Festering Sovereign Debt Problems

April 8, 2011

Seventeen months is an awfully long time for a serious economic problem to fester and play out over and over again in the news, but that’s how long it has been since Europe’s sovereign debt crisis came on the scene with the revelation that Greek politicians had deliberately and substantially understated debt- and deficit-to-GDP ratios.  Revised estimates put then over 15% and 125%.  Greece’s problems raised big concerns about the euro’s future.  Greece was just the first of several dominos to fall, and each implicated economy has seen its long-term interest rates soar to painful and unsustainable levels on the risk that Greece and others will eventually requires a restructuring of their debt.  Ten-year sovereign debt yields now hover near 13% in Greece, around 9.5% in Ireland, above 8.6% in Portugal, above 5% in Spain and near 5% in Italy. 

The debt crisis has toppled governments in Portugal and Ireland and exposed the shortcomings of existing institutions in Euroland as well as the ability and will of politicians to enact necessary changes to cauterize the situation.  Just yesterday, ECB President Trichet again lamented that the European Council’s latest legislative proposals on economic governance still “fall short of the necessary quantum leap in the surveillance of the euro area which is needed to ensure the smooth functioning of Economic and Monetary Union” and urged “more stringent requirements, more automaticity in the procedures and a clearer focus on the most vulnerable countries with losses in competitiveness.”

Looking back through history, one discovers that most previous experiments with currency unions involving separate sovereignties have broken up eventually over the kinds of impediments that Euroland leaders are grappling to resolve.  To their credit, the designers of the present currency union put a framework together from which it would be extraordinarily costly for members to abandon unilaterally.  These penalties are still perceived to be much worse than the costs of remaining members for now, but investors understand that such may not always be the case.  The euro’s ability to overtake the dollar as the preeminent reserve currency or to just challenge the greenback’s hegemony was hurt badly by the sovereign debt crisis of the group’s peripheral members and by the half-baked remedies offered to mollify investors.  Because of this unresolved situation, a number of analysts at the start of 2011 were postulating that the euro could sink back to parity this year.  Things haven’t worked out that way.

The euro is in fact alive and performing quite well.  Contrary to the euro-phobic predictions, the common European currency at a high today of $1.4446 was 12.2% above its 2011 low, 21.7% stronger than its 2010 low, and 21% above its lifetime mean value of $1.1935.  It was also 16.8% and 6.3% stronger than last year’s lows against the yen and Swiss franc.  These are impressive gains, although they do not fully restore the euro to its mid-November 2009 levels  of $1.4940, JPY 133.43, and CHF 1.5086.  The buoyancy of the euro underscores that its value derives from its parts as well as its whole.  The biggest economies in the union, Germany and France which together comprise almost half of the union’s GDP, are also the healthiest and thus offer real good value.  Germany is expanding about twice as fast as the Euroland economy, and its public finances are among the union’s most balanced.  The largest U.S. states like California, Texas and New York, have some of America’s greatest state fiscal messes.

The euro’s resilience says much about the dollar’s intrinsic propensity to depreciate.  The dollar has been the world’s main paper currency since the Second World War in all kinds of commercial, accounting, and investment uses, and it retains a far bigger share of reserve asset portfolios than any other.  However, that special distinctiveness has not bestowed external strength on the dollar versus other currencies.  The dollar is also at a record low against gold and a 31-year low against silver.  The U.S. government has its own massive fiscal deficit, and European politicians have been more serious about acknowledging and making plans to reduce budget deficit medium-term trajectories than have their U.S. counterparts. 

Of the five factors that are said to influence a currency’s strength, the United States enjoys advantages in economic growth and labor productivity, but Euroland has a sounder current account, a central bank that is more vigilantly committed to price stability, and a better track record of low inflation since the late 1990s.  Obama Administration officials seems unworried about the dollar 15% in trade-weighted depreciation under their watch, while ECB officials appear to welcome euro appreciation as a vehicle that blunts the rising cost of imported commodities and inflation in general.  The long-term secular decline of the dollar since the 1960s and the unit’s continuing fall over the last decade suggest that presumed advantages like relatively faster economic growth are overrated as currency strengtheners.

Euroland is not the only region with a major local problem.  The global recovery in fact has been flying into many headwinds.  Commodity price inflation and levels are starting to approach a point that could clearly crimp activity.  Spikes in commodity prices tend to hurt countries with large current account deficits disproportionately.  Moreover, the elevation of food and energy costs increasingly does not look like a spike, that is reversible, but a rather a shift in long-term trend. Another big uncertainty is the possibility of a U.S. government shutdown.  The last one some fifteen years ago was comparatively brief and occurred in a world that was altogether different in so many respects from now.  So history offers only tenuous guidance regarding the political and economic effects of closing down non-essential U.S. government activities now.  British officials are taking a giant leap into the unknown.  U.K. data have been very mixed, so it remains very unclear how that economy will do in 2011 and how the Bank of England will respond.  Sterling kept pace with the euro this past week even though the policies of the Bank of England and ECB diverged.

Japan’s natural disasters create the greatest uncertainty of them all.  Almost three-quarters of 2011 still must be played out, but March 11 already looms as a critical base date against which to measure all currency and not strictly the yen.  Since then, the dollar has risen 2.6% against Japan’s currency but fallen by 6.0% against the kiwi, 5.0% versus the Australian dollar, 4.4% relative to the euro, 2.2% against the Swiss franc, and 2.0% against sterling and the Canadian dollar. In the quake’s aftermath, the dollar and yen have emerged as this year’s weakest links.  Currency intervention has been utilized to diminish but not halt the rise of several currencies in Latin America and Asia.  The policies of the Fed and Bank of Japan are becoming increasingly isolated from all other central banks, making the yen and dollar good liability candidates for carry trade investing.  The dollar may suffer additionally from ongoing reserve asset diversification as investors conclude that the sky isn’t falling on the euro this year.  Such boldness faces a bigger challenge, which will occur when Spain’s domino falls.  This maybe a bumpy ride in foreign exchange, but that’s not anything new.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.


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