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EURO TRASHED With
the iffy global economy, will the Euro stay strong? |
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The
euro celebrated its 10th anniversary by welcoming Slovakia into its
burgeoning monetary union. The former part of Czechoslovakia became the 16th
country on the continent to adopt the euro as its national currency. Quite an
achievement for an instrument that many critics believed would not survive
more than year. In
many ways these are heady times for the euro. The currency is now used as
legal tender in an economic bloc whose population is bigger and wealthier
than that of the United States, accounting for approximately 31 percent of
total global gross domestic product. From its rather inauspicious beginnings
when the currency unit slipped to less than 90 cents to the dollar, the euro
has appreciated steadily this decade, ultimately reaching a record of 1.60 euros
per dollar. Although the currency has retreated from its highs, it still
takes far more than 100 U.S. cents to buy one euro. Little
wonder then that streets of New York are jam packed with European tourists. I
often see these tourists buy empty suitcases in department stores only to
stuff them with all manner of clothes and electronics as they wander the
aisles shaking their heads in amusement at the affordability of it all. For
Americans, it can be a startling reminder that the buck is no longer King
Dollar. A
SHIFT IN POWER Perhaps
nothing exemplifies this shift of power better than a gathering I attended a
few years back at the German consulate in New York. The consulate had
assembled an august panel of guests from the worlds of academia, investment
banking and management consulting, including the head of operations at the
European Central Bank (ECB), to discuss the future of the euro.
Although speaker after speaker addressed the crowd of investment
bankers and diplomats describing the structural challenges of integrating the
monetary policies of so many disparate nations, when Boris Schlossberg took the podium he
carried a far simpler message. "Ladies
and gentlemen,"he announced to the crowd, "the euro is going up for one
simple reason. The Russian Mafia now demands that all of its ransom payments
be made in euros, not dollars." At first the audience was stunned at the
declasse insolence of his example, but quickly the frowns broke into smiles,
and laughter permeated the room as most people recognized the fundamental
truth of my statement. The market, albeit the black market in that case, had
made its choice - and that choice was the euro. At the time of that presentation, the
euro/dollar (EUR/USD) was trading at 1.20 and would ultimately reach 1.60 a
year later in a near vertical run to the upside as the spot market took its
cue from the black market. |
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GLOBAL
CENTRAL BANKS Aside
from becoming the currency of choice among Russian criminal gangs, the euro
also saw its popularity explode with a more important group of
people - the world's central bankers. Since
the start of the Bretton Woods accord, the dollar has been the undisputed reserve
currency of the world. The greenback serves as the settlement currency in
global trade, and that is the reason every commodity from aluminum, through
oil, wheat and zinc is still quoted in dollars. However,
as this decade progressed and the euro became more accepted and respected in
the global financial system, the dollar's reserve status began to fade. From
a high of 80 percent at the start of the millennium to about 67 percent just
a few years ago, to barely 62 percent currently - the dollar has seen its
share of global reserves erode steadily. With
the euro now representing nearly 40 percent of global currency reserves, it
has become a viable alternative to the buck. And for the first time in almost
a decade, the world has more than one choice to settle its trades. In fact,
Iran has moved completely off the dollar standard and only maintains its
reserves in euro. Although
it pains many in the West to see a rogue nation such as Iran benefit from its
financial decisions, the fact of the matter is that up until now, this has
proven to be a wise trade, and President Ahmadinejad of Iran wasted little
time in rubbing that fact in the U.S.’s face. THE
ANTI-DOLLAR In
all honesty, however, the rise in the EUR/USD is far less a function of the
euro's strength, rather it's the product of the dollar's weakness. As the
euro became a serious alternative to the greenback, it started to trade more
as the anti-dollar than on its own merits. Given
the dire state of the American economy, the anti-dollar view has some merit.
In 2009, both the U.S. current account and the federal budget are expected to
generate deficits of nearly $1 trillion each. That means that under the very
best-case scenario, the U.S. will need to finance more than $2 trillion worth
of debt. Like Blanche Dubois in "A Streetcar Named Desire", the U.S. is
now dependent on the "kindness of strangers." Up to now, that "kindness" has
come primarily from Chinese investors. Of
course China’s actions are not motivated by kindness but rather by
self-interest. China is trying to rapidly industrialize to become the
dominant economic power in the 21st century. To achieve its goal of massive
capital investment, it must earn as much income as possible from its exports.
The Chinese have, therefore, gladly recycled their export earnings into U.S.
fixed-income securities, allowing the U.S. economy to grow and the U.S.
consumer to spend an ever greater portion of his or her income on Chinese
goods. Many
analysts have called this dynamic the greatest case of vendor financing in
human history. In fact, economists referred to this arrangement as Bretton
Woods II. And for most of the decade, the system remained stable, benefitting
all parties involved. However,
Bretton Woods II is no longer working smoothly. The U.S. consumer is tapped
out. Battered by the double whammy of falling home equity and stock prices,
U.S. households lost tens of trillions in net worth during the past two
years. U.S. consumers are no longer spending but rather saving monthly,
trying to service their mounting piles of debt. This
new reality presents a serious dilemma to the Chinese. Not only are they
likely to see their export earnings drop or at very best grow only slightly,
but they will be faced with the difficult challenge of massive unemployment
as Chinese factories shut down. |
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This
course of events will no doubt force the Chinese to divert part of their $2
trillion of foreign reserves toward domestic spending. China has already
committed more than $500 billion to a stimulus package and has virtually
ceased purchasing U.S. agency securities; although for the time being, it
continues to be an avid buyer of U.S. Treasuries. BEARISH
DOMINOS? The
dollar doomsday scenario rests on the assumption that foreign investors will
balk at further financing of U.S. deficits. The Fed will then have to become
the buyer of last resort and monetize the debt ushering in the age of rapid
inflation. Some of the more dramatic bears paint a picture of Weimar Germany
or modern day Argentina or Zimbabwe, where the currency is literally not
worth the paper it’s printed on. This
scenario would, no doubt, cause a run on the dollar, or to put it more
accurately, a run toward the euro. Indeed the dollar bears believe that the
greatest potential risk to the greenback lies in a failed Treasury auction,
which would spook investors to such an extent that it would trigger a massive
outflow from U.S. financial assets. A
CURRENCY WITHOUT A COUNTRY However,
no such scenario has taken place yet. In fact, the opposite has happened.
Although the U.S. has had absolutely no problem financing its debt at
interest rates hovering near 0 percent, Europeans have had a much harder time
selling their bonds. U.S.
Treasury auctions have consistently produced a greater than 2-to-1
bid-to-cover ratio, but at the start of 2009, a German bund auction of a
measly €6 billion failed to attract enough investors, sending fixed-income
investors into a panic. Why are the Europeans experiencing such difficulty in
financing their government spending despite a much better balance-sheet
position than the U.S.? The
answer goes to the core of the fundamental structure of the euro. The euro
stands alone in the world as a currency without a country, and that makes it
particularly vulnerable in times of economic stress. Currencies are unique in
the investing world because they are both economic and political assets, and
it is often that political component of the market that many traders tend to
ignore at their own risk. The
primary fear among investors is that the eurozone will not be able to mount
an effective unified response to the current economic crisis. Because every
member of the monetary union holds a large degree of autonomous political
power, the danger of each country in the European Union working at cross
purposes is great. Indeed
traders saw a troubling example of this dynamic in late 2008 when Ireland
unilaterally guaranteed all bank deposits within its borders, triggering a
stampede of capital inflow into the Emerald Isle that forced Germany quickly
to follow suit in order to avoid massive outflows. Although
the U.S. can marshal huge Federal resources to stimulate the economy at a
moment’s notice, the confederate structure of the eurozone is decidedly
weaker. Furthermore, the top three economies in the eurozone - Germany,
France and Italy - comprise the majority of economic output and,
therefore, determine the fate of the region as a whole. Among
those three, Italy is clearly in the worst shape. Governed by Silvio
Berlusconi - a man who has been involved in so many corruption
investigations that he could make Bernie Madoff blush - the Italian
economy is a unique blend of dynamic private industry and hopelessly inept
public sector. The country's debt-to-GDP ratio is more than 100 percent, and
the only way it maintains its AAA sovereign rating is due to its membership
in the EU. Italian politicians are notorious for threatening to bolt from the
union, and although their threats are hollow - for were they to pull out,
their currency and bonds would instantly collapse - their words do tend
to worry the currency market. |
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Italy,
in fact, stands at the epicenter of the North/South divide in the eurozone.
The prosperous, frugal North has contributed a greater portion of its assets
to the union than it has received in benefits. As the economic situation in
the region begins to worsen in 2009, the tensions that have lain dormant
during the past decade may erupt into serious political conflict, especially
if the countries of southern Europe resort to massive deficit spending that
exceed the agreed upon limits of 3 percent. WILL
THE ECB BUCKLE? Yet
although the South is likely to feel the strongest impact from the oncoming
economic contraction, the North - especially Germany (the region’s engine
of growth) - could also experience massive economic turbulence in 2009. In
the wake of economic reforms initiated by the Socialist Chancellor Gerhard
Schroeder and under the current tutelage of center right Chancellor Angela
Merkel, the German economy has seen a remarkable renaissance. Despite hugely
disadvantageous exchange rates and one of the most expensive labor forces in
the world, the German economy has remained an export juggernaut, supplying a
vast array of capital goods to emerging-market nations of Southeast Asia and
the Middle East. But
it is precisely this reliance on its capital goods production sector that may
prove to be Germany’s undoing. One of seven jobs in Germany depends on the
auto sector, which is now experiencing its worst downturn since the Great
Depression. Even Toyota reported its first annual loss in 70 years of
operation. Hampered by the double whammy of high exchange rates and
collapsing consumer demand, German car manufacturers are almost certain to reduce
their employment rolls in 2009. Up
to this point, ECB President Jean Claude Trichet and other ECB members have
strongly resisted the move of other G-4 central bankers toward a 0 interest
policy. Part
of the reason for their hawkish posture has been the relatively buoyant state
of German labor markets. Even as the eurozone GDP plunged into negative
territory, German labor demand continued to grow. But in December 2008, that
positive dynamic changed. German unemployment rolls increased for the first
time in three years. If
this is indeed the start of a trend change, Trichet and company will have no
choice but to lower rates toward 1 percent in 2009 - a move that is sure
to weigh heavily on the euro as the year progresses. THE
END OF THE EXPERIMENT? In
2009, the future of the euro looks particularly perilous as the single
currency may be tested by the economic crisis gripping the globe. Since its
launch, the euro has been an unqualified success ushering in an era of
financial stability while lowering transaction costs for the populations of
the 16-member union. The euro now represents the largest unified economy in
the world and has become a true alternative to the dollar as the prime
reserve currency for central banks. But the euro experiment transcends
finance. It is an extraordinary diplomatic achievement in human history. Only
a bit more than half a century ago, many of the eurozone members were mortal
enemies bent on each other’s destruction. Now, it has become the first
successful example in the history of humankind of a currency without a
country, spurring calls for imitation from the Middle East to Southeast Asia. At
its core, the euro represents the ultimate in cooperation among people and
stands as a testament to the values of liberal democracy. It would be truly a
sad occasion if this grand experiment disintegrated amid the economic and
political pressures it faces today. |
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