Currency Watchers Divided Over the Outlook for EUR/US$
To begin, let’s look at the main factors that drove the US dollar up during the financial sector turmoil over the past months. First, the US dollar was cheap going into the summer. Second, though the US have been the epicentre of all the financial sector turmoil, it is still the chosen safe haven for many investors, especially the deep and liquid treasury market. Third, global deleveraging is US dollar supportive. Most of the global debt mountain is US dollar-financed, so unwinding of that debt now results in a demand for US dollars. Fourth, US investors are heavily invested abroad, especially in emerging markets. Repatriation of these funds, as global asset markets are being hit on the back of the problems in the US, is also US dollar positive. And finally, over the past weeks the banking crisis has clearly spilled over to Europe.
However, there seems to be a tug-of-war among currency watchers over the longer-term outlook.
One school of thought sees the US dollar eventually being tackled by a crisis of confidence in the US, its financial system and policy responses. Some in this corner even go as far as to predict the end of the US dollar era, meaning that the US dollar will loose its status as the world’s reserve currency. Since WWII, the US dollar had enjoyed this special status thanks to the size of the US economy, the power of the US military and the depth of US financial markets. This hegemony now looks to be breaking down on all fronts, as the economy heads for recession, the military is stretched and the financial system is collapsing. In the end, the government has to foot the bill for all this.
Although the US government debt stood at only around 30% of GDP going into the credit crisis last year (which is low by developed country standards), fiscal costs of bailing out homeowners and financial institutions have already exploded. This may add hundreds of billions to a budget deficit already expected to hit a record next year. Bailouts of American International Group (AIG), Fannie Mae and Freddie Mac likely will cost more than expected. States are looking to Washington for fiscal help. The Federal Reserve said this week it will begin buying commercial paper, for which the Treasury will deposit money into the Fed. And analysts now say that the US$700bn bank-rescue plan passed recently by Congress may have to be significantly larger, now that the Treasury is not only going to buy disstressed asset from banks, but has also directly recapitalised them as well. Some believe it will take well over US$2 trillion to really fix this credit crisis, which they also expect to widen out into corporate, consumer and municipal debt. Other estimates are lower than that, but on top of this the US also faces tens of trillions of US dollars in liabilities as baby boomers retire.
All this also raises the chance that ultimately the Fed will have to monetarise government debt by buying up government bonds with newly printed money. This might well lead to rising inflation (which might not run into much resistance by US authorities because that would give them the chance to inflate their way out of part of the fiscal debt). For the US dollar, this could be a very risky development, as foreign investors might well loose faith in US assets and demand higher compensation for investing in the US or, even worse, pull back their capital from the US. This would be disastrous considering the lack of domestic savings in the US, which has led to an enormous deficit on the US current account and the necessity to attract massive amounts of foreign capital to finance that deficit. And although the expected rise in US househould savings when the US enters a recession is a positive development for the current account, the mounting dissaving of the government raises the prospect of increasing twin deficits. Like in the mid-eighties, this could lead to a sharp drop in the US dollar’s value.
However, there is also a second school of thought on the US dollars fate that contains those who either expect the US fiscal position to remain controlable and/or the rest of the world to be hit at least as hard with a lag. These analysts reckon US fiscal deterioration shouldn’t be exaggerated. After all, a large part of the government bail out plan for the banking sector doesn’t involve an expenditure, but rather an investment. By buying up distressed assets at low prices, it is certainly possible that the government will even make a profit in the end when these assets can be sold again at higher prices, as has happened before in other countries with similar crises.
They also point out that allthough it found its origin in the US, this financial crisis is a global phenomenon. Via all kinds of derivatives, risks have been spread out across the globe. The crisis has already crossed the Atlantic and toppled some well-known financial institutions in Europe as well. And that, they reckon, will compound on the global firespread of economic weakness. Recent weak economic figures from the eurozone support this view. Equally important, as a leading indicator for future growth, there are mounting signs that the eurozone is also entering a severe credit squeeze, especially since growth in lending to eurozone households has already decelerated sharply. With banks tightening lending standards, it seems just a matter of time that growth in corporate lending will drop as well. In combination with declining domestic spending and lower demand from Eurozone’s main export markets, this will hurt corporate investment as well as employment.
Such developments could very well unleash a vicious cycle of declining economic growth, lower asset prices and an increase in non-refundable loans, banks tightening credit standards even more, etc. Some even expect the banking crisis in Europe to turn out worse than in the US – with leverage ratios of 50 or more, European banks are more leveraged and have a weaker capital base than their US counterparts.
Now that the banking crisis has spread out to Europe and the continent is on the brink of a – perhaps deep – recession, the talk of the day among economists lately has been that ultimately the sheer existence of the European Economic and Monetary Union (EMU) and the euro might be put to the test. It is widely recognised that the eurozone is not a so-called optimal currency area (OCA). An OCA is defined as an area where the economic conditions necessary for countries to adopt a single currency exist. Basically, to fit the definition, an area should:
Most economists agree that the eurozone does not meet these criteria sufficiently. The late Milton Friedman once said that the euro would problably not survive the first real crisis in Euroland. A systemic banking crisis would certainly qualify as a situation that has the potential to undermine the European monetary experience.
Now how would that play out? An EMU and a single currency obviously means a single monetary policy for all member states and no opportunity for one member to individually adjust its exchange rate with other nations. The restrictions for an individual member state to respond to an economic downturn or crisis go even further, because the Stability and Growth Pact – in theory – puts a ceiling on budget deficits in the eurozone.
However, faced with a crisis of this magnitude the Stability Pact will soon be breached or even buried. What the union lacks is a well-integrated fiscal system to smooth out economic divergences between member states. There should be a centralised fiscal policy in place that will transfer resources to countries that are hurt the most. For such a fiscal transfer however, political union is needed, which the eurozone is still a far cry from being.
To be sure, recent developments have shown encouraging signs of increased political pro-activeness and coordination between members in attacking the banking crisis. France, Germany, Spain, the Netherlands and Austria committed €1.3 trillion (US$1.8 trillion) to guarantee bank loans and take stakes in banks, with Italy putting forward ‘as much as is necessary’. That has silenced many eurosceptics who have been pointing lately at the lack a coherent pan-eurozone strategy and the apparent increase of ‘beggar thy neighbour’ policies (measures taken in one country that can easily aggravate problems in another, for example large numbers of savers transferring their capital to a country where more solid guarantees were on offer).
However, the lack of fiscal integration and an official system of fiscal transfer still contains the risk that an individual country will hit its fiscal ceiling before the end of the crisis and subsequent recession. That is where the ultimate threat for the survival of the EMU leaps to centre stage. For such a country to continue to be able to use fiscal means, the last resort would be to monetarise its debt, effectively meaning its central bank printing money and buying government bonds. However, individual member states don’t have a central bank anymore that has the power to do that and the European Central Bank (ECB) is most likely not inclined to do so. Consequently, some commentators reckon such weak members will want to break free of the monetary restrictions of the EMU and, in the process, also regain the power to devalue their currency.
Others however consider the risk of a collapse of the EMU to be low. A weak country with high government debt would be unwise to leave the EMU. If it did, its currency would almost inevitably tumble against the euro. Since the country’s debts are denominated in euros, its debt-servicing commitments would explode. The authorities could convert these debts into their own currency, but that could destroy any remaining confidence investors may have in the country.
Even so, a collapse of the EMU can’t be ruled out altogether. However, if that were to happen, it will probably not be the result of the weaker members stepping out. Rather, a different course of action is more likely. The ECB will come under growing pressure to stimulate the economy by monetary means and the fiscal rules of the Stability Pact will be undermined. Lax fiscal and monetary policies can ultimately lead to higher inflation. At that point, not the weak but the strong countries with a preference for price stability may consider leaving the EMU. Strong members can more easily do so, since their new currency would probably appreciate against the euro, meaning that their debt servicing commitments would actually come down.
Both the euro and the US dollar have their own structural weaknesses. Whether or not the recent downward move in euro/US dollar will continue going forward seems to depend on whether all the global efforts of governments and central banks to prop up the banking system will prove sufficient to increase risk taking in financial markets:
ECR Research believes that confidence might return to the markets for a while, but that it will not stick. The world has yet to fully experience the negative consequences of the banking turmoil for the real economy. Both the US and the eurozone are now at the brink of recession. We expect a further fall in economic growth that will lead to continuing problems for the banking system in the form of all kinds of non-refundable loans and a further drop of asset prices, as well as an overall deflationary environment. That will continue to lay bare the lack of fiscal integration in the eurozone. Also, with the Fed Funds Rate already at 1,5%, the Fed is pretty much approaching the end of its rate cut cycle, whereas the ECB still has ample scope to lower interest rates now that growth and inflation are declining. Consequently, we expect euro/US dollar to continue its decline towards 1.25 over the coming months to quarters, although with occasional sharp spikes to the upside.