The Inevitable Fading Of The Euro

Includes: BAC, C, FXE, GS, MS
by: Bachar Samawi

Since the introduction of the Euro, first as an accounting currency in January 1999 and later as a circulated currency in 2002, it has become the largest currency in circulation in the world. As of January 2013, Euros in circulation totaled € 882.4 billion (the equivalent of about $1.196 trillion using EUR/USD exchange rate of 1.356 as of January 31, 2013), while total US Dollars in circulation stood at about $1.155 trillion.

Source: European Central Bank

Source: Federal Reserve Bank of St. Louis

Furthermore, the Euro has become the second largest reserve currency in the world after the U.S. Dollar. Since the introduction of the Euro, its percent composition of the world's allocated reserve currencies has risen from about 18% in 1999 to about 24% in 2012, while the U.S. Dollar has fallen from about 71% to about 62%.

Source: Wikipedia

The handling of the most recent crisis in Cyprus has demonstrated that such vast adoption and acceptance of the Euro may actually prove to be unwarranted, and could very well lead to a protracted aversion to such currency both by individuals as well as institutions and countries. As a best case scenario, the growth of the popularity of the Euro may simply slow down and enter into an extended retrenchment phase. As a worst case scenario, the Euro may ultimately be totally abandoned, or its adoption as a national currency may simply be limited to a handful of countries.

Mass adoption of a currency

The international mass adoption of a currency, as evidenced by its rise both as an international reserve currency as well as a globally circulated currency, is primarily derived from public, institutional and governmental confidence in such exchange medium. Such confidence is not necessarily based on the perception that the issuing country/countries is/are immune to economic downturn, malaise, recession or even depression. As a matter of a fact, the U.S. Dollar has risen to the top spot of a reserve currency despite 47 U .S. recessions and 5 U.S. depressions since 1790.

What actually matters most for the rise of a currency is confidence that the sponsoring country/countries have sound policies to deal with inevitable challenges - such sound policies must be fair, consistent, logical, legal, ethical, non-discriminatory, unemotional and most importantly, must foster a sense of security.

It is very unfortunate that the most recent Cyprus crisis has shown that the policies of the sponsoring countries of the Euro actually lack such ingredients, and hence are totally inconsistent with the recent rise of the Euro.

The Cyprus crisis

The recent woes of some Cypriot banks are very easy to understand. In short, the two largest Cypriot banks, Laiki Bank and the Bank of Cyprus, invested some of their customer deposits in Greek bonds, as well as real estate loans (among other business loans). Primarily due to the practical default by the Greek government on its bonds, as well as the default by borrowers on their real estate loans, such banks sustained substantial losses - it is estimated that Laiki lost 2.3 billion euros on its Greek government bonds in 2011, while Bank of Cyprus lost 1.6 billion euros.

Although many European officials have claimed that Cyprus is a "special case," in order to justify their suggested solutions, it is actually a typical case. Cyprus banks have gotten into trouble the same way how all banks get into trouble: by losing money on their investments, and by an increase in the percent of non-performing loans.

Euro's unsound policies - part A

The response to the Cyprus crisis has so far consisted of two solutions. The first solution, later rejected by the Cypriot parliament, consisted of confiscating at least 6.75% and up to 9.9% of all Cypriot bank deposits in order to raise an estimated 5.8 billion euros needed to secure an additional European bailout loan of 10 billion euros.

The policies behind such a solution are:

  1. Unfair - as it would apply to all banks, regardless whether some banks have managed their business well by avoiding such losses or not
  2. Discriminatory - as it was assumed that most depositors are Russians who are money launderers, with the flawed and Dark Ages logic of "guilty until proven innocent"
  3. Emotional - as it was influenced by German elections, and German politicians wanted Cypriot savers to pay the tab because they are "richer" than German savers
  4. Unethical / Illegal - as it is essentially an across the board property confiscation, while Cyprus had touted itself to investors as a safe economy that respects international rule of law in order to attract investors in the first place
  5. Inconsistent / Illogical - as it was a departure form the manner that the Eurozone had previously dealt with other crisis in Greece, Spain, etc...
  6. Fosters insecurity - as it would set a precedent that governments can grab your money in the bank and find ways around the deposit insurance they had previously promised, hence possibly resulting in a run on the bank

Euro's unsound policies - part B

Upon rejection of the solution outlined above in part A, a new solution was presented and adopted, whereby the additional 5.8 billion euros would be raised from large scale depositors at Laiki Bank and Bank of Cyprus. Under such a plan, Laiki Bank deposits in excess of 100,000 euros would be used to offset bad loans at the two banks, while up to 40% of large deposits at Bank of Cyprus would also be used for such purpose. Meanwhile, smaller deposits at Laiki would be moved to Bank of Cyprus in order to shore-up the health of that bank and keep it in business.

Again, the policies behind such a solution are:

  1. Unfair - as it makes absolutely no sense why deposits from Laiki Bank should be used to shore up deposits of another bank, as such solution would result in an even larger loss for the depositors of Laiki Bank had their losses been limited to Laiki's losses
  2. Discriminatory - as large depositors of Laiki Bank are being discriminated against by being treated differently from large depositors at the Bank of Cyprus
  3. Emotional - as Bank of Cyprus is being treated more favorably than Laiki Bank, possibly due to the fact that it is 84% owned by the Republic of Cyprus, while Laiki is over 80% privately owned
  4. Unethical / Illegal - as the pledge by European countries to insure all bank deposits up to 100,000 euros is not being covered by the governments who made such pledge, but by large depositors at Laiki Bank, with additional needed funding coming from large depositors at Bank of Cyprus. If the manager of a hedge fund that had lost his investors' money returned such money either by stealing funds from another hedge fund, or by using money from other investors (hence a Ponzi scheme...), such manager would face criminal charges and end-up in prison.
  5. Inconsistent / Illogical - as the winding down of Laiki Bank is not being handled as a bankruptcy case would typically be handled. In essence, Laiki Bank's assets should be used to offset Laiki Bank's liabilities, and any shortfall for insured depositors should be covered by the government, while any shortfall for Laiki's uninsured depositors beyond their insured amount should be at risk of loss up to Laiki's own exposure.
  6. Fosters insecurity - as large depositors are discouraged from placing their wealth in a bank, in fear of such wealth being used in the future to pay off smaller depositors in case of crisis, hence resulting in a possible run on the banks by large depositors

The future of the euro

As evidenced in the handling of the Cyprus crisis, the issuer countries of the Euro have demonstrated unsound policies in time of crisis. Such unsound policies mean that the Euro is unworthy of being the highest circulated currency in the world, nor being the second most popular reserve currency behind the U.S. Dollar.

During the next several months and years, an aversion to the Euro by individuals, institutions and governments could materialize, as evidenced in Russia's recent declaration that they may review the share of the Euro in their reserves. According to Interfax, and as reported by Reuters, when asked whether the situation in Cyprus was a reason to reduce the Euro share of Russia's reserves, Russian Prime Minister Dmitry Medvedev replied:

I would like to answer in an optimistic way but I have to say that this is a reason to think about it.

This is big money but for us, as for any other country, predictability is important, while the proposal (to levy a tax on bank deposits) was not only unpredictable but is evidence of a certain inadequacy,

Since its introduction at a EUR/USD exchange rate of about 1.15 in January 1999, the Euro had initially weakened to about 0.84 in November 2000, but had appreciated as high as 1.59 in July 2008, while currently trading at about 1.29.

Source: Yahoo Finance

Given the dire state of European economies, with a record unemployment rate of 11.9% in the eurozone area, while much higher at over 26% in Spain and Greece, in addition to unsound Euro policies by the Euro's issuing countries, the Euro can possibly revisit its launch rate of EUR/USD 1.15. During the next several months, the current crisis in Cyprus would lead to a substantial contraction in Cyprus' GDP, which could also affect Greece and Spain, as well as other euro region countries. This could accelerate Euro divestiture, and if such European economic contraction becomes protracted, while the U.S. economy maintains its current momentum, it would not be surprising for the Euro to test its lows of November 2008 as the U.S. Federal Reserve exits current monetary easing by raising U.S. interest rates.

U.S. financial stocks

In an article we published on October 23, 2012, "4 financial stocks that could go even higher," we expressed our opinion why shares of Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), Citigroup (NYSE:C) and Bank of America (NYSE:BAC) could continue to move higher, in continuation of our previous similar outlook of September 28, 2012, as outlined in our article "4 financial stocks doomed to trade higher."

Such conclusions were driven by reasonable P/E ratios, expectations for a continuation of an accommodative Federal Reserve monetary policy, as well as the expectation for sound policies by the European Central Bank.

Company Appreciation since 9/25/2012 Appreciation since 10/19/2012
Goldman Sachs 30.15% 19.5%
Morgan Stanley 34.26% 27.18%
Citigroup 40.97% 33.33%
Bank of America 37.73% 21.78%

Source: values calculated from data (dividend and split adjusted) provided by Yahoo Finance

Company Forward (Dec 2013) P/E multiple on 9/25/2012 Forward (Dec 2013) P/E multiple on 3/22/2013
Goldman Sachs 9.09 10.72
Morgan Stanley 8.51 10.51
Citigroup 7.25 9.79
Bank of America 9.81 12.41

Source: values calculated from data provided by Yahoo Finance

Since September 25, 2012, there has been substantial appreciation in such share prices, whereby all such shares appreciated anywhere between 30% and 41% as evidenced in the above table. Furthermore, forward P/E multiples for December 2013 have also expanded from a range of 7.25 - 9.81 on September 25, 2012, to a range of 9.79 - 12.41 on March 22, 2013.

Given the substantial appreciation in the share prices of Goldman Sachs, Morgan Stanley, Citigroup and Bank of America, the noticeable expansion in their P/E multiples, the expectation for a possible winding down of accommodative Federal Reserve policy as U.S. unemployment rate declines, as well as the troubling introduction of unsound European Central Bank policies, we believe it is time to book profits on holdings of financial shares by selling out of long positions. In addition, readers who share our opinion may also want to establish short positions in the Euro vs. the U.S. Dollar, preferably through the purchase of Euro puts (or puts on FXE exchange traded fund) in order to limit downside risk.

Disclosure: I am short MS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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