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Euro is living on borrowed time as the problems keep stacking up

As the EU faces existential threats such as national self-interest, anti-austerity populism and deepening hostility to Brussels, the euro is heading into troubled waters

PUBLISHED : Monday, 03 October, 2016, 12:18pm
UPDATED : Monday, 03 October, 2016, 10:40pm

The euro has been enjoying a good spell of much needed exchange rate stability over recent months, holding on to fairly tight trading ranges, especially against the US dollar. For some, it has raised hopes that the currency is over the worst of its recent crises and is entering a new age of stability. It is a popular misconception.

The currency might have defied doomsayers’ calls for an early demise in the last few years but economic and political problems keep stacking up. Euro-zone policymakers might have cheated disaster with unprecedented monetary stimulus in the last few years, but the single currency is still living on borrowed time. A day of reckoning still beckons in the future.

Even European Central Bank President Mario Draghi admits the ECB’s ultra-expansionary policy of low interest rates and money printing has limitations, warning that economic imbalances threaten to destabilise the euro zone unless properly addressed. An underperforming economy, high unemployment and deep inequalities of wealth and opportunity risk ripping the bloc apart.

The euro has been spared from Brexit fallout so far, but any hint of additional Eurexit tendencies would spell endgame for the currency

This is not being lost on the euro zone’s political critics nor is it being ignored by the markets. The flood of QE money from the world’s central banks might have blanked out exchange rate volatility for a number of major currencies, but the euro is not settling into a sea of tranquillity by any stretch of the imagination. If anything, the euro is heading into a currency storm fairly soon.

Politics could play a very big part in the process especially as Europe heads into a cycle of key elections next year, especially in Germany and France. Britain’s Brexit vote has thrown all the old cosy notions of uninterrupted European unity and integration into disarray. Trends of national self-interest, anti-austerity populism and deepening hostility to Brussels are now on the rise and not just in economically disadvantaged countries like Greece, Portugal and Spain.

More worrying is the deepening euro scepticism evident in the heart of Europe. German Chancellor Angela Merkel has suffered a string of recent election defeats thanks to her pro-EU stance, and the rising popularity of the EU-phobic National Front in France could pose a serious threat to future European stability if they score successes in next year’s elections.

Anything which threatens the EU’s economic and political status quo also poses a major danger to the euro’s existence. It means markets need to pay close heed to opinion polls for growing signs of deepening political fractures. All it would take would be one country to break with the EU or EMU for the euro to fall apart quite quickly. The euro has been spared from Brexit fallout so far, but any hint of additional Eurexit tendencies would spell endgame for the currency.

Anything which threatens the EU’s economic and political status quo also poses a major danger to the euro’s existence

This is one of the reasons why euro-zone policymakers, especially the ECB, are not taking any chances with the application of super-loose monetary policy. With Europe’s growth potential looking so anaemic and inflation expectations still hovering close to zero, the euro zone seems likely to be lumped with negative rates for a very long while yet.

With the Federal Reserve poised to tighten US interest rates again and more ECB easing on the cards, it is no surprise that currency market bears continue to believe an imminent euro collapse is waiting in the wings. The widening gap in relative interest rate expectations between Europe and the US is making the euro/dollar exchange rate look extremely top heavy right now.

Confidence in the currency has been on the wane for a while, especially with long-term holders continuing to scale back their euro holdings. In the last six years, the euro’s share of world currency reserve holdings by central banks has fallen from a peak of 28 per cent in 2009 down to around 20 per cent at the end of June. The euro has been falling out of favour with investors thanks to weak fundamentals and poor returns.

This is why events unfolding in Europe surrounding Germany’s biggest commercial lender, Deutsche Bank, are beginning to unnerve financial markets and cast new doubts on the euro’s durability. Investor sentiment is on a hair trigger and any hint that Europe might be facing up to a possible ‘Lehman’s moment’ closer to home could have catastrophic consequences for euro perceptions.

It could be the spark that unleashes a new wave of investor revolt against the single currency. The euro could end up moving out of the frying pan into the fire.

David Brown is chief executive of New View Economics

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