The Future of the Euro in Question

At the beginning of this year, I wrote a Money and Markets column entitled “Will the Euro Become the Most Hated Currency for 2010?“

At that time, the euro/dollar exchange rate was about 5 percent off of its 2009 highs. And we were just months removed from hearing the constant and broadly espoused opinions suggesting the euro would become the world’s next primary reserve currency — replacing the troubled U.S. dollar.

But the focus of global investors was starting to shift …

Concerns were beginning to turn away from the “minor hiccup” of a debt-restructuring surprise in Dubai, and toward the fiscal deficit problems in the Eurozone — specifically Greece.

Meanwhile, the euro bulls were still beating their drums …

The overall consensus was still advertising the pullback in the euro as an attractive buying opportunity. In fact, the median forecast of 43 economists polled by Bloomberg was calling for the euro to trade at 1.51 to the dollar by the end of March (a little more than a month from now).

But as I pointed out in my January 2 column, this type of market scrutiny surrounding sovereign debt can snowball quickly. In short, these problems have a history of being contagious and spreading throughout the world.

Since then …

The dollar doesn’t look so bad! And the euro has dropped another 5 percent and looks increasingly vulnerable to a break-up, or at least a structural change, of the monetary union. To sum up, it’s a decisive moment for the future of the common currency.

No-Win Situation …

With Portugal, Ireland, Italy and Spain all under the hot spotlight and the Greek situation worsening, European leaders stepped in last week in an attempt to stem the negative pressure on the Greek bond market and the euro. They said they would support Greece — a verbal commitment to do whatever was necessary. Yet they gave no details on how.

Nevertheless, a bail-out of a fellow Economic and Monetary Union (EMU) member country is a direct violation of rules set forth in the Stability and Growth Pact, the principles upon which the euro was built.

When questioned over the past month, the European Central Bank and European leaders consistently rejected any notions of a bail-out. But it appears they’ve ultimately conceded to the danger that Greece is presenting to the stability of the monetary union.

Perhaps this is why …

The Bank of International Settlements shows that European banks have $2.1 trillion exposure to sovereign debt of the weakest EMU countries (Portugal, Ireland, Greece and Spain). And it’s my guess that that exposure has only been exacerbated by the European Central Bank’s answer to “extraordinary monetary policy.”

Instead of overtly buying their own government debt, as is done by the U.S., Japan, the UK and many other countries, the European Central Bank’s liquidity strategy was to provide unlimited easy money to European banks — unlimited 1-percent funds for one year.

What did those banks do with the money? They bought up sovereign debt of the weak-link EU members, i.e. backdoor quantitative easing.

Credibility Damaged …

Regardless of the outcome, the euro’s creditability has taken a major hit.

First off, the integrity of the EMU is diminished when fiscal constraints are ignored. Secondly, the enforcement of those policies has been exposed as unenforceable. So countries have no incentive to responsibly manage their fiscal situation.

Instead, they can simply take cover under the broader monetary union, without suffering an attack on their currency.

Irreparable Moral Hazard …

“Europe cannot afford to rescue Greece.” — Otmar Issing

This week, former executive board member for the European Central Bank, Otmar Issing, wrote an op-ed piece in the Financial Times. He warned against a Greek bailout and, further, questioned the viability of the euro.

Here’s what he said …

“Starting monetary union without having established a political union was putting the cart before the horse.

“Once Greece was helped, the dam would be broken. A bail-out for the country that broke the rules would make it impossible to deny aid to others.”

Confidence Broken …

Just as European leaders were trying to stem the tide of negative sentiment and the sense of urgency and imminence surrounding the Greece situation, the Greece Finance Minister said publicly that they’re trying to change the “course of the Titanic” … an ominous statement for a situation so central to the future of the euro.

Then to add to the Eurozone’s problems, a controversy recently broke out exposing off-balance-sheet funding that Greece engaged in through “special currency swap” agreements with Goldman Sachs and other investment banks.

Several Eurozone countries are under investigation for their currency swap agreements.

These special currency swaps appear to have allowed Greece to hide debt to gain entry into the currency bloc in 2001. Furthermore, other weak Eurozone countries are now being scrutinized for participating in similar accounting shenanigans.

To Sum It Up …

I’ve warned repeatedly that following such a widespread global economic crisis, synchronized with a financial crisis, the looming damage and time bombs would likely linger.

That’s why I’ve been recommending aggressive, long dollar exposure and short exposure to those currencies most vulnerable to global financial market shocks.

The global economic crisis has left the Eurozone with uneven economic performance. Some countries are recovering, many are not.

And that means countries with damaged balance sheets and a bleak outlook for growth are stuck. With a one-size fits all monetary policy and currency, they lack critical tools to work their way out.

So you can expect more problems ahead for the euro.

Regards,

Bryan