Special FX Report – Budget crisis threatens the EUR and EMU
Concern about default risk in Greece, Portugal and Spain has generated a reappraisal of risk and dampened demand for the EUR as an alternative reserve currency to the USD. Increased risk of debt default in peripheral European nations has some analysts suggesting that European Monetary Union (EMU) may be at risk. European credit default swaps widened to a record level Friday in Europe. This means that the cost of insuring against debt default in Greece, Portugal and Spain continues to rise. Financial markets see a 30% chance of a debt defaults in Greece over the next five years and a 20% chance in Portugal. The default spreads narrowed a bit Monday as EU and G-7 officials tried to calm investor fears with a pledge to closely monitor the Greek debt situation. Many analysts believe that the EU has little choice, if necessary to eventually bail out Greece, Portugal and Spain, but uncertainty about the potential cost of a bailout and the impact of the bailouts would have on the international image of the EUR are taking its toll. The EUR traded at an eight month low Friday .Rumor that a €20bln Greek bailout plan may be in the works sparked a sharp rally in the EUR Tuesday. An announcement of a Greek bailout plan may add additional support to the EUR in the short term but it may not be enough to offset concern about additional debt default risks throughout southern Europe. Reuter’s reports that EU governments have decided in principle to help Greece if Greece makes progress in reducing its deficits. A German spokesperson denies the Reuters report.
The introduction of the EUR was based on monetary not political union. The diversity in EU governments and politics makes it more difficult for the EU to address economic crises like the current risk of sovereign debt default in Greece and peripheral European nations. The current EU debt crisis presents a potential threat to the success of EMU. The first of these threats is the diverse economic and political factors in EU countries which make the one size fit all ECB monetary policy difficult to implement. Last week the ECB said that EU debt troubles will complicate ECB policy outlook and implied that EU debt worries could prevent the ECB from pursuing its exit strategy at this time. Tuesday, Bloomberg news reports that the ECB may be forced to delay its exit from conventional monetary policy because of Greek fiscal troubles. As the larger and stronger European economies emerge from recession and keep federal deficits relatively in check peripheral EU countries are faced with weaker economic outlooks and rising budget deficits. In December the ECB said that it was beginning to exit from extraordinary monetary policy measures. The economies of peripheral Europe may require more accommodative monetary policy as deficit cuts hurt growth. ECB policy may become handcuffed by deficit troubles in peripheral EU countries. Trichet tried to deflect these concerns Tuesday and sounded hawkish. Trichet said that anchoring inflation expectations is key as the global economy recovers. ECB’s Nowotny said there can be no ECB bailout for Greece because Greece is under EU regulations and there is no authority for government bailouts in the ECB charter. Nowotny says Greece must solve its own problems and any plan for a bailout will be determined by political decisions of EU governments. He went to express concern about possible risk of debt contagion.
The main focus at this time is Greece. Greece announced plans to reduce its deficit from 12.7% of GDP to 2.8% GDP by 2012 proposing a number of spending cuts. These actions by the Greek government have been met with approval by the EU commission but the spending cuts have also sparked union strikes in Greece opposing the spending reductions. The converse has taken place in Portugal. Portugal has opted to increase spending to try to boost its economy. EMU was founded on the principle that countries that join must adhere to the limitations the stability pact. The stability pact requires EU governments to seek a GDP debt ratio of 3%. It’s not clear how EU officials will deal with the divergent response to budget shortfalls in Greece and Portugal but this divergence illustrates the continued difficulties of incorporating monetary union in the absence of political union.
Last week Newsweek published an article which says that the current EU debt crisis will make the EMU stronger. According to this article even if Greece, Spain and Portugal eventually elect to leave EMU these countries represent only 18% of the EU GDP. The author of the Newsweek article suggests that the EU would not break up if weaker members leave and would break up only when stronger members no longer see gains from EMU. Germany has emerged relatively unscathed from the global credit crisis. Working to resolve the debt crisis in southern Europe may make European Union stronger. According to Newsweek the EU may emerge with closer political union and create a more competitive Europe as the debt crisis is resolved.
There is growing concern that risk of sovereign debt default in peripheral European countries could lead to the Lehman Brothers type debt crisis. ECB President Trichet said that the EU should not be punished for Greece’s budget shortfalls. According to Trichet these shortfalls are much less than the US and Japan and the entire EU GDP debt ratio is 6%. This compares with 10% or higher in the US and Japan. We suspect that EU and the IMF will likely step in to prevent a debt default in peripheral European nations but uncertainty about the willingness of these richer EU nations to bail out their weaker partners has contributed to diminished attraction of the EUR as an alternative reserve currency to the USD. Since the EU deficit crisis emerged, central banks have been reducing exposure to the EUR and this is the biggest risk to the EUR. According to EU President Rompuy Europe needs an economic government. We agree.