The euro has been in the spotlight lately and has come under increasing pressure due to the problems within the European Union. Some of its member states, mainly Greece, Spain and Portugal, have deficits that are way too big. Members of the European Union are normally not allowed to run yearly deficits in excess of 3% of GDP, the amount of accumulated debt may not exceed 60% of GDP.
This so called “European Stability Pact” has become a somewhat obsolete concept, since many member states are running deficits and debt balances which are significantly above the defined limits. Greece has been in a league of its own, running a yearly deficit of about 12% of GDP and an accumulated debt burden of 130% of GDP but Spain and Portugal do not look much better.
The debt limits defined in the stability pact look increasingly unrealistic. The pact, which was adopted in 1997 never really considered a scenario like the global financial crisis and the subsequent global recession experienced in 2008 and 2009. Also the pact was often criticized for not being flexible enough in terms of addressing the swings of government deficits during an economic cycle.
Interestingly, the pact was promoted by the large member states of the European Union such as Germany and France, however, even they do not seem to be able to remain below the deficit limits. In 2005, the pact and the defined criteria were relaxed by allowing countries to have more flexibility in maintaining fiscal discipline. The actual deficit limits were kept unchanged but a couple of other factors now also need to be considered before declaring a country in excessive debt.
However, again, not even France and Germany are able to stick to the defined and agreed deficit limits anymore and therefore it is more than obvious that the actual pact can’t be enforced, it is still good to have at least some sort of goal defined but these limits have proven to be unrealistic under the recent economic crisis.
I think, however, it would be wrong to call the euro a failure just by looking at the current problems. In just one decade, the euro has become the second most important currency in the world after the U.S. dollar and gained significant value versus the dollar.
The share of global currency reserves held in euro have increased from around 15% in 2002 to about 28% last year, this is a clear sign of success and we expect this share to grow in coming years. In the same time the share of reserves held in U.S. dollars have fallen from about 67% to less than 60% and we expect this share to go down below 50% within then next 5 years. This might not look like a very dramatic move, but in historical context it would be a huge move and for sure add more selling pressure on the greenback.
We believe the euro as well as the U.S. dollar will remain the two major currencies for at least another decade, but other currencies will become more important and we expect a structural appreciation of these currencies versus euro and U.S. dollar. Therefore a sound currency diversification is an integral part of a good long-term offshore investment strategy.
We think the strategic allocation to euro and U.S. dollar should be below 40%, with additional exposures in Swiss francs, Norwegian crowns, Australian dollars and NDF contracts in Brazilian real, Indian rupee and Chinese yuan.
Disclosure: No positions