The eurozone is experiencing the biggest challenge since its inception – it is currently at the worst point of the debt crisis that started two years ago. Contagion has already spread to Ireland, Portugal, Cyprus, Spain and Italy; and even France is starting to feel the pain. The crisis recently has also started to spread to the European credit institutions – which are getting a big hit on their bond portfolios – thus creating a need for further capital injections from a market that is already short of cash and reluctant to take further risk.
The unwinding of fiscal imbalances, asset bubbles and over-leverage is a protracted, painful and disinflationary process. Without control of monetary policy, crisis-hit countries are forced to adopt large and unprecedented medium-term austerity measures, which, as we saw during the LDC (less-developed-country) debt crisis in the 1980s, are especially painful for the poor and underprivileged. There are examples in the past of debt crises that were successfully overcome, mainly with external help, but past episodes involved countries with the power to control their monetary policy – and in all occasions a devaluation of their currencies and/or increase of the money supply were basic steps in their struggle to regain competitiveness.
However, countries in the eurozone have delegated their monetary authority to the ECB, which has the sole responsibility for the price stability of the whole euro area. With Germany, the largest partner, growing at the fastest pace since the end of the global recession in 2009 and commodity prices shooting through the roof, the eurozone average for inflation remains above the two percent ECB target (close to 2.5 percent), thus forcing the ECB to paradoxically start hiking rates during a severe debt crisis.
This places an extra burden on the highly indebted countries in the form of increased borrowing costs and a loss of competiveness due to the higher exchange rate of the euro.
Surprising the market
Surprisingly, despite the widespread debt crisis the euro has been able to appreciate since the start of the year against all but one (the Swiss Franc) of its other major counterparts. It appreciated between two and three percent against the Japanese yen, British pound and even the Australian dollar, while against the US dollar the gains are around nine percent for the year.
This has come as a big surprise to many market participants and prominent analysts, who had been predicting huge losses for the common currency at the start of the year. We are of the view that both economic and psychological factors have contributed during the last months to keep the euro at elevated levels.
First there is the fact that politicians in Europe are slowly but steadily coming to terms with free market dynamics. The political leaders in Europe have realised that blaming the speculators for the crisis (as they did last year) was doing no good. Retaining investor confidence is the key to progress; and rational economic and political leadership, lack of political corruption, transparency, and accountability are the key to overcoming the crisis.
The German and French economies were booming until recently, with EU trade surplus doubling and German business confidence climbing to all-time highs just a few months ago. What's more, in spite their problems, peripheral countries have started the process of bringing their houses in order with meaningful measures which, while painful in the short term, will prove very beneficial in the medium and long term.
US loss is EU's gain
In economic terms, the reason for the euro's persistent strength has more to do with the apparent weakness of the US dollar. The US authorities – both the Fed and the Treasury – are ‘unofficially' (but obviously) targeting a weaker dollar; and all their actions during the last years are in divergence with the policies adopted in the eurozone.
The US strong dollar policy has over the years been downgraded to a ‘benign neglect' policy, and finally to a weak dollar policy. The ECB this year started hiking interest rates, while the FED has only recently finished its second round of quantitative easing – with US interest rates stuck at zero percent until 2013.
The markets are already pricing a good chance of another round of bond buying in the US.
Traders have also recently realised that not even the US is immune to political games and uncertainty. The debt limit debate and the resulting downgrade of the US AAA rating were a psychological wake-up call to all those who used to believe that the mother of capitalism would not risk market turmoil because of internal politics.
The US twin deficits are also gradually and steadily getting out of control, and the US authorities are behind the curve compared with their European counterparts in the process of bringing them back to a viable level. The US presidential elections are approaching and therefore we will not expect any unpopular measures to be taken within the next year; it follows that the budget deficit will continue expanding at unsustainable levels for the foreseeable future.
In this environment we expect that investors will continue using the cheap dollar to fund their investments, putting even more pressure on the currency. The lack of a credible and liquid alternative to the US dollar makes the euro the only other choice – especially for high- growth economies like China, Russia and India. These countries' central banks remain huge buyers of the euro in an effort to diversify their dollar holdings, stemming on the one hand from commodities, US dollar denominated income and active intervention in the currency markets to avoid their domestic currencies appreciating too fast too soon and keep their exporting competitive advantage intact.
Consequently, as long as the US authorities continue their current policy of targeting a weaker dollar and do not deal with their unsustainable deficit path, while the risks of a eurozone-breakup or default do not materialise, the long term trend of the euro against the US dollar is bound to remain upward.
Charis Charilaou is Executive Director at TFI Markets
