The Inevitable Fading Of The Euro: Brexit

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Summary

The events of Brexit were inevitable, as per our article of 2013.

If U.K. exits EU, competitive factors would entail the U.K. to want to mitigate EU's economic success.

The euro could retest its all-time lows.

On May 25, 2013, when the EUR/USD was trading at 1.29, we published an article on Seeking Alpha titled: The Inevitable Fading Of The Euro, whereby we stated:

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....

...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...

...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...

As such forecasts materialized, we have received many requests to revisit the topic in light of Brexit. In short, Brexit will result in further fading of the euro, possibly testing EUR/USD 1.00 level, while we would not be surprised if the euro (within the next three years or earlier) again tests its November 2000 lows of EUR/USD 0.84.

In this article, we will not revisit the qualitative properties lacking for the euro, which were closely examined in our article of 2013, which would ultimately handicap the mass adoption of the euro. Instead, we will specifically look at the impact of the newest phenomenon: the exit from Europe by an economically sound country, the United Kingdom, which is a net contributor to the funding of the European union.

Lost Budget Contributions to the EU

Whereby, in the past, the euro had suffered from the implication of the exit of an economically troubled country such as Greece, or even Cyprus, from the European Union, the exit of an economically sound country from the European Union should result in multiples of negative reverberations. This is irrespective whether such country has already adopted the Euro or not.

The United Kingdom currently contributes on a net basis about GBP 8.5 billion to the EU's budget. As the U.K. exits the EU, such contribution will disappear. Furthermore, in case Scotland, Ireland, and Wales end up leaving the U.K. in order to remain in the EU, and whereby such countries currently receive on a net basis about GBP 945 (based on 2014-2020 average estimates), then the EU budget will find itself short about GBP 9.4 billion (a shortfall of about 8% from its current level of about EUR 143 billion). Such shortfall would increase further in case the EU's contributions to Scotland, Ireland, Wales have to increase in order to make up for potential economic and contribution losses resulting from a potential secession from the U.K.

Annual net contributions to the EU budget by U.K. country, 2014-2020

Source: The CER Commission on the U.K. and EU single market

Contraction of EU total GDP

According to the World Bank, the GDP of the EU region is estimated at about $18.51 trillion as of 2014. The U.K.'s GDP of $2.99 trillion is the second largest contributor to such economy after Germany. In case the U.K. exits the EU, the EU's GDP excluding the U.K. would be $15.52 trillion, hence 16.2% lower. Although the EU would still be a formidable economic power, such power is substantially diminished by the exit of the U.K.

The EU would lose influence in its foreign policy, with direct impact on military efficiency, trade, export, supply chain and investment. Cost of financing would most likely increase in the EU, due to such related associated risks. Such conclusions were also reached by Global Counsel. HSBC estimates that the EU GDP growth rate would be about 1% to 1.5% lower in 2017 than it would otherwise be. We believe such assumption is quite optimistic, and assumes no contagion effect from Brexit.

Political Instability in Europe

The primary reason for the creation and origin of the EU was to foster a climate of political stability and reduce the prospects of wars, after Europe had fought two devastating world wars. Although Brexit does not imply that war will return to Europe, it does elevate such risk. Such elevation in political risk, no matter how small, will have some negative effect on the euro. When compounded by some forecasts for contagion, investors will demand yet a higher premium for such risk. Most recently, following Brexit, Soros stated that EU is set for disintegration. Irrespective whether such vision materializes or not, the mere fact that it is contemplated would weigh heavily on the euro currency.

Global Competition

Although competition currently exists amongst European companies for domestic market share as well as international markets, such competition is somewhat moderated through the EU, with a clear mechanism for conflict resolution and intra-Europe free trade. Upon U.K.'s exit from the EU, and based on the Leave campaign's own claims that the U.K. would be free to negotiate more favorable trade agreements, economic/trade competition and potential conflicts could arise between the U.K. and EU.

Naturally, as the U.K. seeks to establish itself as a dominant economic powerhouse outside of the EU, there is an increased risk that the U.K. will also possibly seek to economically weaken and divide the EU; if the U.K. has determined that it is in its own best interest to be outside the EU, why would the U.K. believe that an economically strong/efficient united EU that excludes the U.K. would be in the U.K.'s own best economic interest? Logically, in order for the U.K. to dominate economically and competitively on a global scale, an economically weakened Europe would be in the U.K.'s best interest. Certainly, the U.K. may not want the EU to totally fall apart economically, as that would also affect U.K.'s exports to the EU; nevertheless, the U.K. would want to keep the EU in check, and would prefer to ensure that the EU's global competitive muscle is mitigated.

Euro Target

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 1.10.

EUR/USD from 1999 to 2016

Source: FXtop

Since the euro's introduction in 1999, most fundamentals for the currency are weaker today than at any other time. Qualitative factors required for a super reserve currency are lacking at best, as provided in our article of 2013. In addition, with the exit of economically sound countries, such as the U.K., and the weighing of troubled countries, such as Greece, the euro today is simply not what it was envisioned to be at its creation. Furthermore, in case of future economic debacle in an EU country as had occurred in Greece (and most likely to occur again sometime in the future), the remaining countries after the U.K.'s exit will have less economic assets to steer such an event.

Given the preceding, we expect the euro to drop to EUR/USD 1.00 and possibly to revisit its all-time lows of EUR/USD 0.84.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.