The euro may stabilise and re-enter reserves portfolios of central banks
The Oscar for best performance among currencies in 2012 should certainly go to the much-critiqued euro. As recently as the first half of the year, most analysts were predicting a dip in its exchange rate to well below 1.2 to the American dollar, since euro zone’s sovereign debt crisis intensified. In fact, it traded above 1.32 to the dollar for much of last week and seems to head higher. The consensus now seems to be that it has fairly strong support at the 1.25-1.26 levels. This is despite the fact that the region is still mired in a recession and some of the macro-data prints seem dismal. Industrial growth, for instance, that released last Monday (January 14) for the region in November, contracted 0.3 over October and 3.7 in year-on-year terms.
A number of things have resurrected the currency’s fortunes. For one, European policymakers put in place some fairly bold measures last year to prevent a collapse both in the euro zone and its currency. The OMT (outright market transactions) programme introduced in September 2012 gave the European Central Bank an unlimited mandate to print money and buy sovereign bonds of a badly overstretched economy as long it agreed to accept fiscal consolidation measures specified by the European Union (EU). OMT is yet to be used but has effectively taken away the tail risk of a blow-out in the region coming on the back of sovereign.
Besides the proposal (yet to be ratified) to recapitalise capital-short banks directly from a centralised bailout facility, the European Stability Mechanism (ESM) suggested that EU officials were keen to disentangle fiscal stress from stress in the banking sector. The ^100-billion funding line given to Spanish banks in June 2012 was concrete evidence of the effort to ensure that fiscal pressure need not invariably morph into a banking crisis.
The turn in the sentiment towards the currency is not through better stress-management tools alone. European officials have been at pains to point out that key macroeconomic parameters for the periphery have improved dramatically over the past few years. This is particularly true of the current account deficits that have shrunk on the back of fiscal austerity. Wage rates in the peripheral economies have declined, buttressing their competitiveness in the process. The markets seem to have finally recognised this and reflected this in a new trading range.
It is possible that a “risk-on” anti-dollar episode will bid the euro up further from its current level. Whether it will sustain these elevated levels is really the question. Before getting too bullish on the currency, it is important to go back to the fundamentals, particularly the fact that the region is in recession — it is difficult to reconcile currency appreciation and a contraction in the real economy.
Besides, there is the enduring question of a “fair value” of the euro, a level that balances the interests of the beleaguered South and the relatively resilient Northern core. The analytics or the arithmetic behind this calculation isn’t easy, but analysts who like to frame the problem this way seem to suggest that this fair value lies somewhere in the 1.20-1.25 range. A sustained breach of this range could land the region in trouble yet again.
What can bring about a correction in the euro from current levels? For one, the sovereign debt crisis in euro-land is far from over, and while the stress can be handled better, it does not mean that countries will not need hefty amounts of central assistance this year. The markets have been predicting the possibility of Spain, a heavyweight compared to say Greece, having to turn to the central facility, ESM, for assistance. It incidentally has fairly large bond redemption commitments at the end of April and July. Greece and Portugal may also need funds. Were all this to happen, it would put some of the risks associated with the region back on the table and trigger selling pressures.
The other driver for correction could be the German national elections due in September. This needs to be put in context. While the region’s policymakers have devised mechanisms to handle extreme stress and prevent implosion, a lot more needs to be done on the so-called “structural” reform front. This includes the creation of banking union that would have a common deposit insurance facility and a resolution fund to tackle bank failure. The final step would be a working fiscal union that would enable common bond issuance in which the region as a whole and not an individual sovereign issues bonds. All this can happen only if Germany, the biggest economy in the union, plays ball. As the elections approach, markets could start pricing in the possibility of a change in regime that could act as a drag on policy change. This could pull the euro down.
The euro has survived and the prospect of an overstretched economy like Greece leaving the union has dwindled. A quick recovery in the economy might not be possible, but if it successfully navigates some of the impending risks and gets some of its long-term policies going, it would start regaining some of the sheen it lost over the past couple of years. Thus, it is likely to stabilise as a currency and re-enter the reserves portfolios of central banks and asset allocations of private investors. But before forecasting sharp appreciation on the back of these trends, it is important to remember that too much appreciation is against the best interests of Europe.
The author is with HDFC Bank. These views are personal
The claim that greater integration, not faster growth, will protect Europe’s safety nets has lost credibility