Continuing Greek crisis means euro is still facing a long fight for its life

THE blowing out of the Greek bond yields this week brings the Greek government’s debt crisis closer to boiling over. Having met its funding requirement for April, the Greek government may have a few weeks to decide on its next step. That said, with every incremental increase in Greek bond yields a decision either to resort to the EU and/or the IMF for funding, to default on its debt or even to remove itself from the Eurozone comes closer. Now that the EU has played its hand, the Greek government’s options have narrowed. Clearly last month’s announcement of a support mechanism from the EU has not had the desired effect of calming market nerves. It had been hoped that the presence of EU support would be enough to push yields on Greek debt down to levels at which the Greek government could afford to issue.

However, Germany has made clear that hand-outs are off the agenda and there is uncertainty how the EU support plan would operate in practice. With or without support from the EU, the bottom line remains that after years of fiscal mismanagement the market has little confidence that Greece can swallow the necessary austerity measures and slash its budget deficit. Investors continue to demand a high-risk premium to hold Greek paper, which is incompatible with the government’s need to contain funding costs in order to meet its deficit cutting targets. Yields on 10-year Greek paper this week moved close to 7.5 per cent, almost 300 bps above Irish debt and around 440bps over German. By contrast, the Greek government may be able to win funding from the IMF at closer to 3.5 per cent.
The fact that Greece can resort to the IMF for funding reduces the risk of outright default. However, any decision by the Greek government to go cap in hand to the IMF would depend on the terms that would be imposed. Without doubt the IMF would maintain the pressure for budgetary reform, suggesting that Greece would be unable to avoid an extended recession. A re-structuring of Greece’s debt would also be a likely consequence and this is likely to raise the hackles of Greece’s creditors, 23 per cent of whom reside in the UK and Ireland. As a consequence, any indication that the IMF may be brought in could intensify the selling pressure in Greek bonds. Not only that, but IMF involvement may increase speculation of Greece pulling out of the euro, potentially for a temporary period.
A weaker currency for Greece would provide a competitive boost and ease the pain of austerity. With or without the IMF this option is likely becoming increasingly attractive. In the “fat” growth years the impact of the strong euro exchange rate on the Greek economy was softened by the benefit to the Greek government of being able to issue debt at German-like rates. This incentive has now been removed. The Greek-bund 10-year spread has returned to levels not seen since before the start of the euro in 1999, suggesting that a return to a cheap currency must now appear more attractive.

The uncertainties surrounding Greece’s crisis clearly raises the risk of contagion to other Eurozone members with large funding requirements, Portugal in particular. Curing a country’s funding woes is a slow grind, which suggests that these issues could dominate the market’s attention through the summer and beyond. The euro is clearly vulnerable on the risk that these budget difficulties will prove that monetary union without fiscal union will ultimately prove unsustainable in Europe at this time. That Germany is being more nationalistic and less euro-centric on the issue of bank-rolling the Eurozone will give fodder to its opponents. These uncertainties suggest that a move in the euro towards the long-term average of euro-dollar at 1.18 and potentially below may be on the cards in the coming months.

A complete break-up of the Eurozone on the back of fiscal stresses would be the worst case scenario for the euro but may not be the only option. It is also possible that the Eurozone’s list of members might look different after this crisis. This would necessitate some clever political manoeuvring, but if core Eurozone members could, if they needed to, reassure the markets of the credibility of a Eurozone without Greece, the euro could ultimately push higher as a result of this crisis.

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Since the start of this year euro/pound has traded a £0.9150 to 0.8600 range. Both currencies have suffered from poor fundamentals and CFTC data suggest that speculators are maintaining large short positions of both the euro and pound. Against this backdrop it does not seem surprising that neither currency has been able to muster sufficient support to trend higher against the other. That said, sterling is still 19 per cent weaker against the euro relative to its level at the end of December 2007 and 26 per cent weaker than the average euro/pound rate since the euro’s inception in 1999, suggesting that the pound is undervalued. Sterling may be bogged down by the fear of a hung parliament but the euro remains tarnished by the Greek issue. The UK’s election uncertainties may be resolved on 6 May. If the UK electorate return a market friendly Tory government next month, euro/pound could adjust lower.