IS THE EURO CRUMBLING?
By Gordon Platt
Major reform is needed, but whether the political will is there to make large scale changes remains to be seen. The alternative may be the end of the eurozone as it now exists.
Koester, FiREapps: When one country pulls out of the euro, it is over
Europe’s leaders have been dancing around major economic and financial problems in the eurozone—making minor changes to address specific ills rather than opting for deep seated reform. The question is whether a fundamental solution is in the works and what the alternative will be.
G20 ministers promised “a strong and coordinated international response to address the renewed challenges facing the global economy,” including the European debt crisis, at the meeting in Washington in late September of the International Monetary Fund and World Bank. They noted that the eurozone was working to expand the 440 billion euro ($600 billion) bailout fund for Europe’s debt-burdened countries.
Amid fears over a possible Greek default, the European Central Bank (ECB) this summer began an emergency operation to buy Italian and Spanish government bonds to keep the crisis from spreading. Nevertheless, some analysts have become significantly more bearish about the euro and many of them expect the situation in the eurozone to continue to deteriorate.
Wolfgang Koester, founder and CEO of corporate FX solution provider FiREapps, says a potential euro breakup could happen quickly. “Once one country pulls out, it’s over,” he says. “Eurozone leaders are buying time, but they will reach a point where the political pressures are too great to continue with the euro experiment as is.”
Koester predicts that there will be a restructuring of the euro some time next year. “A smaller group of countries, including Germany, France, the Netherlands and Austria, will be included in the new euro,” he says. He has been warning of a potential euro breakup, he adds, for the past two years.
Although Koester’s views on the future of the euro have been echoed far and wide, they are not universally held. Opponents of this view are just as vocal in their defense of the future of the eurozone.
According to the Barclays Capital Global Macro Survey conducted in September, one in four (24%) of investors believe the European debt crisis will result in a breakup of the euro area. A much greater number (60%) of respondents polled believe that fiscal union will eventually take place, although the majority of those believe it will come only after massive monetization of sovereign debt by the ECB.
SWISS PEG STUNNER
In June 2010, FiREapps announced an early warning system for a euro breakup scenario. The EU-RX solution provides enterprise-wide risk transparency by currency and by country. “CEOs and CFOs of multinational companies today cannot keep pace with the events in global currency markets and face foreign currency risks to which they don’t have complete visibility in a timely fashion,” Koester says.
Many corporations were stunned in September when the Swiss National Bank (SNB) set an exchange rate cap on the Swiss franc, in effect pegging it to the euro, to stop Switzerland’s economy from sinking into recession. The central bank said it would no longer accept an exchange rate below 1.20 francs to the euro.
“The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities,” SNB chairman Philipp Hildebrand said.
"In the short run the SNB is bound to defend [the Swiss franc] robustly, meaning that the Swiss franc is a much less attractive hedge"
– Paul Robinson, Barclays Capital
The dollar has become a more attractive hedge for euro area risks because of the floor imposed by the SNB, says Paul Robinson, head of Global FX strategy at Barclays Capital in London. The peg “might not hold in the long run, but in the short run the SNB is bound to defend it robustly, meaning that the Swiss franc is a much less attractive hedge,” Robinson says. “Foreign exchange is a zero-sum game, so some other currency must benefit, and we do not agree that it is an alternative European currency such as the British pound or the Norwegian krone. The dollar looks far more attractive.”
Until recently, many investors have been frustrated by the resilience of the euro against the dollar, given all the problems in Europe, Robinson says. European policymakers have generally done what was necessary to stabilize concerns in the short run, he says. What’s more, the European Central Bank has kept the anti-inflation faith. The dollar has been weak because of both monetary policy and the structural problems in the US, according to Robinson.
While the relatively hawkish stance the ECB has taken over the past year or so has been a crucial support for the euro, the likelihood of a rate cut has increased significantly, he says.
BAILOUT FUND LIMITATIONS
There are two main problems facing the euro area in the short run, Robinson says. First, many investors think that a restructuring of Greek debt is only a matter of time. Second, there is increasing pressure on the way for Spain and more particularly Italy, and the market is not convinced that the European Financial Stability Facility (EFSF)—which was created in May 2010 to enable the eurozone to raise funds in the capital markets for financing loans to member states—will prove enough to stabilize the situation.
The lower house in the Bundestag, the German parliament, voted in favor of expanding the powers of the bailout fund, as agreed at the European summit meeting in Brussels in late July. Germany has benefited greatly from expanded trade since the euro was introduced, says Dennis Gartman, editor and publisher of The Gartman Letter advisory service. “However, Europe’s problems have not been solved with the expansion of the ECB’s and the EFSF’s balance sheets; they’ve simply been papered over, and ‘papering’ is always and everywhere a temporary and stopgap measure,” he says.
GREEK EXIT CALL
Nouriel Roubini, co-founder and chairman of Roubini Global Economics and professor at the Stern School of Business at New York University, says it is time for Greece to default in an orderly manner on its public debt, exit the eurozone and return to the drachma to restore solvency, competitiveness and growth.
“Default and exit will be painful and costly, but the alternative of a decade-long deflation and depression would be much worse, economically, financially and socially,” Roubini says in an analysis distributed to select media.
Greece can exit the monetary union in a disciplined manner if systematic mechanisms are used and appropriate official finance is provided, Roubini says. “Like a broken marriage that requires a breakup, it is better to have rules—divorce laws—that make separation orderly and less costly to both sides,” he says. “Being stuck in a marriage of convenience that is not working any longer is more costly and painful than an orderly and civilized breakup.”
While some analysts have estimated that the cost of exit from the eurozone could be as high as 40% to 50% of gross domestic product for the country that is leaving, Roubini says “such estimates appear to be vastly exaggerated and based on utterly flawed assumptions; losses could be much smaller if the process is orderly, if official support is maintained, if debts are converted in an orderly manner into the new local currency, and if sharp currency depreciation rapidly restores economic growth.”
The risk that a Greek default and eurozone exit will lead to high inflation or even hyperinflation in Greece is also vastly exaggerated, Roubini says. “The same claims were made about Argentina when it defaulted and moved to a floating rate,” he says. “But even in a country like Argentina, with a long history of inflation and hyperinflation, the move to a float did not lead to hyperinflation, as some scaremongers had wrongly predicted.”