Tuesday, May 25, 2010
Euro: risks outnumber the benefits
The last two weeks were not happy days for the euro. The aid package drawn up by heads of government and state over the weekend of 8/9 May with the support of the ECB and the International Monetary Fund only succeeded in stabilising the single currency briefly. There then followed seven days of decline, with EUR-USD crashing down at 1.2144 last Wednesday. Some of the dust has settled since then, and prices have recovered to around 1.24.
This calm resulted firstly from technical factors: EUR-USD was heavily oversold by any standards. Secondly, massive intervention by the Swiss National Bank to bolster the euro may also have played a role; the SNB is currently trying to keep EUR-CHF above 1.40. And in the short term, the euro may have been supported by some weaker US economic data and by signals from the Fed that a tightening of monetary policy is not an urgent priority for now.
Although the euro has stabilised for now, it remains extremely vulnerable to further declines in value. On the one hand, it is difficult to assess whether the rescue package will indeed function in an emergency. If, for instance, the national parliaments reserve the right to decide on support on a case-by-case basis, this package is less likely to restore confidence among investors. And the ECB’s promise to keep the sovereign debt market functioning by purchasing bonds also sounds half-hearted. That is why there are still latent fears of European government bonds defaulting.
This might explain why the demand for liquidity on the money markets has increased sharply again.
On the other hand, even if the tension on the bond markets subsides, the budgetary cuts will probably come at the expense of growth. This suggests that the ECB will continue its expansionary monetary policy and leave its low interest rates unchanged. Whatever happens, the euro has little to offer for investors for now.
However, the scenario “long spell of eurozone stagnation on account of tough austerity measures” is not necessarily the full picture. While tough consolidation would probably dampen domestic demand, the decline in the value of the euro is likely to bolster exports. In recent weeks, the euro has lost value not only against the US dollar but against most non-European currencies. On a trade-weighted basis, the euro has shed around 8.5 % in the year to date (EUR-USD by 13.7 %), according to ECB calculations. So for the first time since 2005, the euro’s external value is approaching a level that many economists would, at least roughly speaking, consider to be fair. This should boost international competitiveness and fuel exports, especially in a reasonably dynamic global economic environment.