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BY COSTA VAYENAS
Spare a thought for the late Willem Duisenberg, first President of the European Central Bank. He was mocked during his tenure not only for his spectacular hair but also for his numerous gaffes, which, given the skepticism that greeted the single European currency at its launch in 1999, did little to inspire confidence.
He surely would be proud now, because the euro is stronger than ever. Starting at around 1.18 against the dollar in 1990, the euro slid near to 0.80. But today, at over 1.50, it is roughly 20% overvalued against the greenback.
Yes, after initial doubts, the euro is a success. But let's be honest: it is much more the child of the mighty German mark than of the jittery Italian lira. It has proven itself an anchor of stability during the financial crisis, even keeping a euro-in country, Ireland, from the bankruptcy and depression that was the fate of a euro-out country, namely Iceland. And in the aftermath of the crisis, many battered Eastern European countries seem to recognize that giving up their sovereign minted currencies is not such a bad idea. Or is it?
One doubt often expressed about the euro centers on the heterogeneous mix of countries using it. At the one extreme stands rock-solid Germany, still exporting successfully and offering real competition to the workshops of Asia on the world market. At the other end teeters profligate Greece, whose government debt, already exceeding 100% of GDP this year, is heading for very thin air at over 130% during the next two years, according to European Union estimates. Can it really make sense that such opposites coexist in one currency union?
Actually, yes. Even though Germany might consider the southern European countries a drag on overall European finances, and even though the exports of laggards like Greece are seriously impaired by the euro's strength, we think both countries will stick to the euro.
Consider: if the Germans would opt out, their new currency would skyrocket against the euro (estimates range between 20 and 30%). This would price German exports out of the markets they have fought so hard to win, ultimately leading to an economic depression. And if Greece were to abandon the euro, its new currency would depreciate drastically versus the euro, briskly driving Greece to default on its debt, which, after all, would still be in very expensive euro.
So despite its heterogeneity, the Eurozone is what Germans would call a Schicksalsgemeinschaft, a community joined by a common fate. Hence, the risk of the Eurozone falling apart, as some investors especially from beyond its borders believe, is relatively low. However, there is a caveat: If a country like Greece were actually to default regardless of having the euro or not, opting-out could then become a very appealing choice, since it could reset the country's finances.
This leads to two conclusions. First, regarding their public finances, all Eurozone governments have moral hazard. They know that the threat of exiting the euro would spur other member states to help them if they were near to default. Second, although it is probably the most independent central bank in the world, the ECB does have its limits. If its strong-euro policy threatened to bring on deflationary tendencies that moved one or more member states to default, this could well put the euro at risk. So the common currency has something in common with mythological creatures: its great strength also contains the seeds of its potential destruction.
Costa Vayenas is Head of Emerging Markets at UBS Wealth Management Research.
