By: David Veitch
A likely move to the downside for EUR/USD in the medium term.
In a classic fable, The Tortoise and the Hare, an overconfident hare is beaten in a race by a tortoise, who upon winning declares, “Slowly does it every time." The moral of the story is that the hare’s short-term “sprinting” strategy was no match for the well thought out plodding of the tortoise. Aesop, the Greek author of this fable, would have had choice words for economic policymakers around the world today as they grapple with how to kick-start their economies. Many have embarked on a process of competitive devaluation, where policymakers have taken action to quickly weaken their currencies in an attempt to boost exports. Recent events such as Japan’s intervention and the Federal Reserve’s comments, which left the door open for quantitative easing, show that economies around the world are actively devaluing their currencies.
Such hasty reactions by policymakers to the foreign exchange market would not have been to Aesop’s liking, as he would have preferred a more gradual depreciation of currencies. Competitive depreciation by many of the world’s largest economies has made Europe the proverbial tortoise; a lack of action has led the euro to appreciate versus many of its counterparts. Since EUR/USD’s low of 1.19 in June, the euro has shot back and is currently hovering at 1.36.
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Despite the euro’s appreciation versus its counterparts, this trend is unlikely to last: or more aptly, it cannot afford to last. Given the number of threats the Eurozone faces, it is likely the euro’s trend will reverse, with the possibility of it testing new lows in the medium-term.
A Lack of Competitiveness
In what is becoming a more globalized market with each passing day, the ability for countries in Europe to compete globally is crucial to growth. One could say that European competitiveness is divided into the haves and have-nots. Germany, representing the former, is undoubtedly Europe’s most competitive economy. Policies which are more market-friendly relative to the rest of Europe have led Germany to become very competitive on the world stage. One only needs to look to the generally accepted benefits of “German engineering” or brands such as Mercedes, SAP, and Adidas, to be reminded of this. Germany has benefitted well from its Eurozone inclusion. It is without question that had Germany opted out of Eurozone inclusion, the Deutsche Mark would have appreciated greatly vis-à-vis the euro over the past year, and Germany’s recovery would not have been as strong.
On the other hand, the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) are the “have-nots” of European competitiveness. This lack of competitiveness has crept up over time and is exacerbated by government policies, such as the high-cost of firing workers in Spain. Part of this lack of competitiveness is a result of these countries’ being members of the EU in the first place. Upon joining the EU, real interest rates fell for the PIIGS based on the belief that integration would lead risk to disappear. This drop in real rates helped fuel spending and construction booms, notably in Ireland and Spain, which pushed up costs, making the economies less competitive. Going forward, it is necessary for these countries to become competitive in order to emerge from the recession and service their current debt burdens.
Generally, there are three methods of restoring competitiveness: increasing productivity, wage cuts, and currency devaluation. Increasing productivity, possibly by improving EU integration, is a sure-fire way to increase competitiveness, yet it is easier said than done in the short-term. Same with wage cuts; these are currently unrealistic in the context of Europe’s left-leaning attitudes and given the fact that nominal wages are in general sticky downwards. The only effective way of restoring competitiveness at this time is for the euro to depreciate beyond its current level.
A Cacophony of Crises
Putting aside issues of the PIIGS’ aggregate competitiveness, it is crucial to look at specific problems facing individual countries in divining the euro’s future. While problems may be unique to each country, all share the same desire in seeing a positive outcome. For if one country’s government were to experience turmoil, the market’s wrath would no doubt reign on all of the PIIGS, possibly in the form of a sudden stop of capital.
The Death of the Celtic Tiger
Ireland, having taken the spotlight from Greece over the last several months, is risking financial crisis in the aftermath of the global economic slowdown. Ireland was described as “the most overheated economy” in the run-up to the slowdown, when economic growth and bank credit enabled a construction boom. A structural government deficit grew; then the bubble popped, unemployment rose, and incomes fell, leading to lower government revenues and a ballooning deficit.
Ireland’s government debt is on course to reach 100% of GDP, not counting the various liabilities it has taken on from the banking sector. These liabilities, which could potentially add another 30% of GDP to government debt, are troubled assets guaranteed by the government under a “bad bank” called the National Asset Management Agency (NAMA). While the assets (commercial property loans) backing these liabilities could further sour, this is somewhat unlikely given the considerable (approximately 50%) haircuts which the assets were given when transferred from the private sector banks’ balance sheet.
Ireland has been making headway on fiscal consolidation, leading Credit Suisse to describe the government’s initiative as “progressing extremely well.” However, one must be suspicious of any progress that has been made. Ireland’s economy, where extra-Euro (outside the Eurozone) exports make up 52% of GDP, is particularly leveraged to the value of the euro. Given that much of Ireland’s recent recovery has been attributed to the euro’s decline in value, any substantive progress on the deficit likely hinges on a weak euro; anything else would risk stalling the economy.
The current financing picture for the Irish government is positive. Unlike Greece, there is not a substantial amount of debt maturing in the near future. This was one of the contributing factors to the strong bond sales on September 21 when Ireland successfully borrowed €1.5 billion, leading to a reduction in Irish yields.
Greece’s Lingering Problems
“Efforts have staved off the sense of emergency, but the euro zone’s underlying problems are not easily fixed.” – The Economist
There is much to be negative about in regards to Europe, without even mentioning Greece. The Greek crisis, which hit its climax in the spring, was temporarily relived with a €110 billion bailout of Greece by the Eurozone and IMF, as well as the establishment of the €440 billion European Financial Stability Fund (EFSF) to act as a backstop for peripheral governments.
Forecasts currently call for a 15% economic contraction in the next two years. Given the austerity restrictions of the IMF, there is little room for Greece to manoeuvre; perversely, this restriction on government spending will negatively affect its ability to service its debt as its long-run growth picture will worsen. Speculation has abounded that Greece will restructure in the near future. S&P warned bondholders that they may only receive 30-50 eurocents on the euro, PIMCO sees substantial default risk, and the market has priced in a 75% chance Greece restructures in the next five years. With such a grave task ahead for Greece, it would not be surprising to see the Greek populace demand a restructuring, rather than years of austerity inhibited-growth.
Nowhere but Down?
When the euro was first created, it was said by Milton Friedman that it would not last through Europe’s first recession. Cited as contributing factors were limited wage flexibility and labour market mobility. Also, countries no longer having control over their own currency’s destiny via their own printing presses and being expected to hold to the Maastricht Criteria were two problematic factors. These problems are now coming to the fore as deleveraging, deflation, and restricted government spending bode negatively for Europe’s medium-term growth, and for the euro’s existence.
The question is, at what point does it make sense for countries saddled with debt to abandon the euro? A lack of competitiveness cannot be solved for the PIIGS in the short-term without currency devaluation. Also, unless growth picks up considerably, defaults on government debt, much to the IMF’s chagrin, will one day be the best option.
If the euro continues to appreciate, these European problems will be exacerbated, potentially leading countries to fall further into fiscal trouble. A reawakening of the Europe debt crisis would surely bring another wave of European deprecation in the medium-term.
On the other hand, if the euro reverses its current trend and depreciates in the medium-term, growth will resume, competitiveness will increase, and the prospects for the monetary union will significantly improve.
There truly is only one way for the euro to move in the medium-term, and that is down. Cognizant of the USD’s and Yen’s depreciations, it may be best to play the euro through selling not just one pair, but several. A short EUR/USD, EUR/JPY, EUR/GBP, and EUR/CAD would provide diversification in case another bout of devaluation comes from a single country.
Disclosure: No positions