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EURO STATES’ STRIFE ADDS TO VOLATILITY

JANE FOLEY
RESEARCH DIRECTOR, FOREX.COM

DURING 2009, the main story in the currency markets has been the decline of the dollar, dictating the movements of many dollar pairs. Euro-US dollar was driven almost exclusively by dollar fundamentals while issues this side of the Atlantic remained decidedly less relevant. But over the past couple of weeks, bad news emanating from several Eurozone member states has drawn traders’ attention back to Europe and put negative pressure on the euro.

There are likely to be more skeletons in the Eurozone’s closet and no doubt critics will pounce on these to remind us of the failings of a monetary union. But although the Eurozone is unlikely to break down, there could be enough bad news over the course of 2010 to ensure a rocky ride for the single currency.

So what might create volatility in the euro? The biggest issue for the region is the state of some members’ public finances. The Maastricht Treaty criteria that underpin the monetary union are designed to ensure that it is structurally robust – any country joining has to reduce its budget deficit to 3 per cent of GDP and lower its debt to 60 per cent of GDP. These rules should have imposed fiscal reform but some states managed to sidestep reform ahead of entry.

Many countries benefited as yields on their debts converged with Germany’s in anticipation of their Eurozone membership. The lower cost of debt financing was, for some countries, a huge budget subsidy which took the pressure off the need for structural reform. Countries that failed to carry out sufficient reform ahead of joining the euro should have used the growth years to increase the efficiency of their budgets. But it was easier for some to put their heads in the sand and enjoy the reflected glory of the credit boom instead.

But the recession has opened up cracks in a number of countries’ budgets, which some economists have argued was inevitable. While a stressed budget is not confined to Eurozone countries only – just take a look at the UK – there is no exchange rate flexibility to help relieve some of the pressure. Ireland, Greece, Spain and Portugal will have to get through their budget crises with an exchange rate that is inappropriately strong for their domestic situations. They may also have to suffer interest rate hikes a little sooner than they might want.

From the market’s viewpoint, the best resolution for a country with an uncomfortably high budget deficit is a process of painful spending cuts and revenue raising measures. Ireland looks on course to do just this if its recent budget is anything to go by. The Greek government has launched a charm offensive, stressing that it intends to cut its 2010 budget deficit by 4 per cent, half derived from spending cuts and the other half through revenue increases. But corruption had left the market sceptical that Greece will be able to implement reform. Credit ratings firms are also unconvinced – both Fitch and S&P have announced downgrades for Greece this month. Talk that stronger countries will bailout weaker states also highlights the risk that failure to reform will again be papered over.

Given a high risk of more bad news from Portugal, Spain, Iceland and the Baltic states, weaknesses in parts of the Eurozone’s banking system could be exposed. It is possible that the euro could be on the back foot for months.

A weaker euro should be welcomed by the European Central Bank – recent strength in the euro had pushed the Eurozone’s effective exchange rate close to an all-time high and undermined the outlook for Eurozone exports. What monetary authorities hate is currency volatility, so there is a huge incentive for the Eurozone to address its problems in a timely manner.

But while they last, the uncertainties may strengthen the ability of the dollar to recover against the euro. Euro-sterling may also be dragged lower. The UK’s budget problems rank among the worst in the developed world and the UK is one of the few major economies not to have found its way out of technical recession by the third quarter of 2009.

On the back of the UK’s budget issues, euro-sterling is likely to maintain a premium over its long-term average of 0.6842 during 2010 and perhaps beyond. But in spite of this, a move back towards the 0.8500 level may be seen during 2010 as the Eurozone grapples with its own issues.

ResearchEMEA@forex.com