Euro weighed down
Until recently, the euro had remained surprisingly resilient despite a marked escalation of the euro-zone debt crisis. Through the end of October, the euro had gained 5% against the dollar for the year. But since then, doubts about the euro-zone’s survival have increased and the euro has trended lower. The early-December European summit wasn’t enough to reverse this trend, and the euro is now trading near this year’s trough. In our view, Europe’s single currency has little upside potential without a major shift in European politics – which we don’t envisage happening anytime soon.
Cracks begin to appear ?
The US Federal Reserve has already been engaged in two rounds of quantitative easing (QE) since the 2008 crisis. The monetisation of US debt has weighed on the dollar. Conversely, the European Central Bank (ECB) has been reluctant to ease monetary conditions through asset purchases, and has only recently stepped up purchases of peripheral government bonds in the secondary market to prevent yields from rising further. While bond purchases are welcome and necessary to stabilise the European financial system, they inevitably lead to a deterioration of the ECB’s balance sheet.
Parallel to the bond purchases, the ECB has increased its liquidity provisions to Europe’s struggling banks. In doing so, it has taken in as collateral an array of debt securities issued by some of the euro-zone’s weakest countries – namely Portugal, Ireland, Italy, Greece and Spain. The increased risk that the ECB’s balance sheet could deteriorate further in the event of significant debt restructurings should also show up in its currency.
European banks still large and highly leveraged
?European banks are enormous compared to the size of the euro-zone economy and currently hold assets equivalent to approximately 235% of GDP. This compares to only 75% for the US. As demonstrated in the case of Ireland, a large banking sector can easily overwhelm a sovereign’s credit rating. Therefore, as euro-zone governments provide more support to ailing banks, the likelihood of credit-rating downgrades increases. The euro, which in essence is an average of all euro-zone local currencies, should depreciate to reflect a deterioration of credit quality.
Next stop, recession
?European banks have to go through a long process of de-leveraging that will add downward pressure on economic growth in coming years. While the current fiscal position of the euro-zone as a whole is better than that of the US, macroeconomic indicators are pointing to a considerable recession in Europe in 2012. Thus, although the IMF is currently forecasting that euro-zone debt to GDP will start declining from 2013 onwards (compared to the US, where it will continue rising due to the lack of a credible fiscal consolidation plan), this scenario is based on positive growth forecasts for euro-zone. If actual growth is less than the IMF’s optimistic projection – with the cost of financing up and de-leveraging almost obligatory, this looks increasingly likely – the euro-zone debt situation would deteriorate quickly. A worse-than-initially-expected fiscal position ultimately translates into a reduction of credit strength for the single currency.
Reserve status under threat
?Since its introduction, the euro has benefitted from its status as a reserve currency and a potential substitute to the dollar. Numerous foreign-exchange managers and central banks diversified away from the dollar and into the euro as the ECB gained credibility as an independent bank during its first 10 years of existence. Recently, however, this status has taken a knock as investors have begun to question the viability of the European single currency. It is no longer clear that the peripheral countries will remain committed to their multi-year plans of fiscal austerity. The probability of a euro break-up has increased and, as it is no longer certain that the euro will be backed by all the current members of the euro-zone in the future, investors should demand a risk premium.
Limited upside for euro?
Continental European leaders have shown their intention to move towards a fiscal union. This is a necessity if the euro is to survive in its current form. However, the move will be gradual and significant progress will only be achieved in the face of further crises. In the meantime, the ECB will be compelled to expand its balance sheet further in order to provide stability to the euro-zone financial system. Furthermore, it’s almost certain that the euro-zone will be in recession in 2012 and the credit quality of European sovereigns and banks will deteriorate further. All in all, we see limited sustainable upside potential for the euro.