Diary

THE END OF THE EURO?

 

THE END OF THE EURO?

Introduction:

With several Euro zone nations on the verge of default and debt restructuring negotiations making little progress the obvious question for international investors is not if but when the Euro zone will end. A closer look at the Euro’s global role in financial markets will not only lower expectations of a complete break up it will also make it very undesirable for the U.S. in the short to intermediate term.

Why would the U.S. be hurt by a Euro zone collapse? As the Euro is currently the only alternative to the USD  as a world currency a collapse of the Euro would cause a massive inflow into USD causing a rapid increase in its trade weighted value hurting U.S. exports and endangering a fragile U.S. recovery. In addition financing rates for the lower rated Euro zone nations would skyrocket causing a deep recession in Europe and spreading an unwelcome economic shockwave around the globe. But a Euro zone collapse may also be good for the U.S. The USD would retake its role as the world’s sole reserve currency reasserting America’s unchallenged monetary supremacy. In addition the inflow of foreign money into the Greenback would not only offer free financing for our trade deficit it would also bring down Treasury yields to near zero making the cost of financing a 15 Trillion dollar debt a lot cheaper. But how likely is a Euro zone collapse and what exactly will happen if the currency were to vanish?

 

Analysis:

Outside the U.S. nothing qualifies more as “too big to fail” than the Euro and the statistics are overwhelming:

1)      The Euro currency has captured a 25% market share of the world’s Central bank reserves compared with 60% for the USD. Central Bank holdings are widely regarded as an indication of a currency’s global importance and financing role. The chart below demonstrates that despite the Euro crisis the USD’s share has been slowly eroding at the benefit of the Euro since its 1999 introduction in the global markets.

2)      Other statistics portray a similar picture. The Size of the U.S. GDP was 14.5 Trillion USD in 2010 compared to 13.7 Trillion USD for the Euro zone*.  The stock of Euro denominated securities outstanding in the international markets (excluding domestic issuance of debt) at constant exchange rates was 32.2% in 2010 compared to 44.2% for the USD.

3)      The Euro zone also accounts for 25% more in global trade volume than the U.S. as most Euro nations are exporting economies (e.g. Germany). Looking at global trade invoicing the USD continues to have a dominant share at 65% compared to 29% for the Euro.

So how can a currency this size simply cease to exist? It cannot and the impact in the unlikely scenario it did would be enormous. The political will among Europe’s largest economies (France and Germany) to save the currency is undoubtedly strong as is the will by the (French dominated) IMF. So if the Euro will remain what are the more likely scenarios in case of a worsening Euro debt crisis? Europe will bail out the Euro by increasing the bailout fund with help from European tax payers and international organizations like the IMF. That being said there are 3 possible break up scenarios that would alter Europe’s currency structure while preserving the currency:

A)     The weaker Euro zone nations are kicked out and return to their legacy currencies. Greece, Portugal and Spain would be able to disintegrate from the currency treaty without endangering the currency Union. Their combined economies account for less than 10% of the Euro zone’s GDP and may actually strengthen the currency in the intermediate term due to a higher fiscal standard for its remaining members. 20% chance.

B)      Due to the economic recession an anti Euro-party may win in local elections and cause a strong Euro zone member like The Netherlands or Austria to leave out of protest. This is unlikely to happen in France and Germany as both ruling and opposition parties support a continuation of the Euro. Only smaller countries may be affected making its impact on the Currency Union minimal. 20% chance

C)      A widening crisis causes one of the big economies, Germany, France or Italy, to leave the Euro. This will cause a major exodus from all strong Euro zone members leaving the Euro as a weak currency for the poorer peripheral countries. The Euro zone would lose between half and two thirds of its size overnight and opponents may call it the end of the Euro. 10%

Most likely is a continuation of the Euro in its current structure without members leaving the currency. Actually, aspiring E.U. members like Serbia and non Euro E.U. members like Poland, Czech Republic, Romania and Bulgaria are still lining up to join the Single currency. Despite its trouble it is by far a better alternative than their own inflating currencies.

 

Conclusion:

The Euro zone may have been around for only a decade but the process of European integration leading to the introduction of the single currency started more than sixty years ago. Europe’s (near) defaulting Euro members Greece, Spain and Portugal are all founding members of the European Union.

 

Throughout its half century long process of reunification Europe has overcome many obstacles and internal divisions to continue on the road of political and economic integration. Two World Wars and the more recent Balkan War have sent a wakeup call to European leaders that there is no way back. To become more competitive on the global stage Europe cannot afford disintegration.  The Euro currency is unpopular and blamed for a lot of its current economic misery but Europe’s leaders will at all cost defend their project also against the will of its own people.

 

Reinier Prijten

February 2012

 

 

 

 

 

 

 

 

 

 

 

*The Euro zone excludes the U.K. but includes smaller non-Euro EU nations whose currency is pegged to the Euro like Denmark and Sweden.

 

Sources:

BIS International Statistics, http://www.bis.org/statistics/

ECB publications, http://www.ecb.int/pub/html/index.en.html