Following Chancellor Merkel and President Sarkozy’s meeting on Monday, the German long-term view of the Euro is clearly an important step closer. There are huge hurdles to overcome, both before the crucial EU Summit on Friday and afterwards. There is also still a very high risk that the whole plan will come crashing down within days on a lack of economic and political legitimacy. The break-up option still looks the most likely scenario given that the damage sustained already is too great to be repaired.
For now, however, let’s imagine that the Eurozone area does survive intact. What would be the implications for the Euro? Overall, it would have to be a weak currency and any political deal to salvage the Eurozone would not lead to sustained Euro gains.
The pivotal and over-riding fundamental factor is that the Euro area simply has no chance of survival if there is a deep recession. The democratic ties that keep countries functioning politically would simply unravel in the event of a further downturn. The deflationary policies forced upon the peripheral economies will not be sustainable for much longer and there will have to be some escape valve. If currency devaluation is ruled out via EMU exit, then there will have to be a stimulus through monetary policy and a weaker Euro. If both options are ruled out, then there will be a high risk of a dark road towards non-democratic solutions.
There have been clear hints that the ECB will take a more aggressive stance if there is an agreement on a move towards fiscal union. The German and French governments have been careful not to put excess pressure on the central bank, but it is clear that there is an unspoken agreement that the ECB will step-up bond purchases and relax monetary policy. Any form of quantitative easing would put the Euro under medium-term pressure. The German government will insist on fiscal discipline and a combination of tight fiscal policy and very loose monetary policy would also be key factors in keeping the Euro weak in the medium term.
The second area of vulnerability has already materialised as there will be the threat of credit-rating downgrades. Standard & Poor’s has already warned that credit ratings in all the Eurozone countries are liable to come under review and there would be a severe loss of credibility if none of the countries had an AAA rating. In relative terms, the damage would be lessened by the parlous state of the US and Japan, but sovereign wealth funds would hardly be flocking to the Eurozone, especially if there were a series of downgrades.
There are still severe difficulties within the European banking sector as unrealised losses on peripheral bonds continue to increase. A sharp rally in Spanish and Italian bonds has lessened the immediate damage slightly, but the banking sector overall still faces further contraction as lending is cut to help preserve capital. It is telling that banking stresses actually increased on Monday. There is little chance of any significant improvement as many European banks would remain hobbled in a zombie state over the next few years.
There would still be the risk of capital outflows from the Euro area. At current valuations, the Euro is not attractive enough to compensate for the longer-term economic and political risks. To draw private capital back and lessen the risk of flows into alternative currencies, valuations will need to be substantially more attractive; in other words the Euro will need to be a lot weaker.
There will be strong political opposition to treaty changes as individual countries react to a further loss of sovereignty. Even if treaty changes are narrowed down to the 17 Euro-member countries there will be a rough ride in parliaments and popular protests will continue to increase. There would be a strong probability that President Sarkozy himself will be the most prominent casualty of popular revolt by losing next year’s Presidential election. Markets will have to price-in substantial political risk premiums.
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