There can be no happy ending for the euro

JUST as the mythical Cassandra predicted the destruction of Troy at the hands of the ancient Greeks, her modern-day counterparts are watching as Athens’ fiscal troubles wreak the very foundations of the European currency union – just as they predicted nine years ago when the Hellenic Republic was first admitted to the Eurozone. Questions about whether Greece’s budgetary irresponsibility would harm the euro were brushed aside; those problems have now come home to roost.

This is the first time that the credibility and the structure of the European Monetary Union (EMU) has really been tested since the launch of the single currency in 1999. But many people at the time warned that such a disparate currency union would have problems, since it does not have a central fiscal authority to address internal imbalances.
The recession has simply brought the issues to the fore as bond investors start to question the security not only of Greek government debt, but also that of Portugal, Spain, Ireland and Italy. The contagion of the Greek crisis has caused many to worry about bailouts, defaults and, in extremis, a break-up of the Eurozone.

This kind of speculation has led traders to amass $7.6bn of bets against the euro, the biggest ever short position in the single currency. But would decisive action – on the part of the European Central Bank, the European Commission, the International Monetary Fund or indeed of the Greeks – actually support the euro? Market reaction to news that ECB president Jean-Claude Trichet was cutting short his Australian trip to attend a meeting in Brussels would suggest yes. But in reality the euro will remain under pressure whatever decision is taken and by whichever institution.

The scale of Greece’s budget deficit is hardly unique and, as any British citizen will tell you, high budget deficits and floundering economies don’t just affect the Eurozone’s peripheral countries. The US, the UK and Japan have all been there before, and arguably are there now.

What puts the challenge confronting Greece on a whole new level is that the UK, US and Japan all had free floating currencies which could take the strain when required. All had control of their own monetary policy and were all able to dig themselves out of their respective fiscal holes at a time of strong global growth. None of these conditions are present in the Eurozone’s periphery.

This will make it difficult for the new Greek government, despite its best efforts, to maintain credibility in its budgetary austerity without outside help. So in the absence of a bailout, the country’s woes will continue to make waves across the currency bloc. The FX markets are uncomfortable with uncertainty and as long as there is no acceptable resolution, the euro will struggle.

But would such external help be forthcoming if the situation deteriorated further, and would it do anything to shore up the euro? While the IMF has indicated that it would extend funding to Greece in the event that it was requested, Simon Derrick at BNY Mellon says that there would be legal ramifications of the IMF imposing conditions on the ECB. “I can’t see that investors would respond well to that – it would hardly be euro positive,” he says.

The real question now is how willing (or otherwise) other Eurozone states will be when it comes to providing funds if required. But this has been a sticking point – the ECB has repeatedly stressed the no-bailout clause in the Maastricht Treaty. After yesterday’s events, it does seem increasingly likely that Greece will be bailed out. As Emma Lawson at Morgan Stanley points out, investors are being tested: “As this belief in the absorption of liabilities is tested, it is likely to lead to further euro weakness on either added negative news on Greek debt or in the event of further rating downgrades.”

A bailout of Greece would set a precedent for Portugal, Spain, Italy and Ireland as well. As funding would come primarily from Germany and France, this would radically change the way in which investors view German government debt and would be a huge negative for the euro as the very foundations on which the currency union was built are undermined.

The final, and now least probable scenario, is that what appears like ECB brinksmanship becomes reality and no bailout is proffered. It is unlikely that Greece would want to exit the Eurozone, simply because the cost of its debt would jump sharply and prompt a default regardless. It could be forced out, however. And whether Greece defaults or not, investors would still pull away from weaker Eurozone states, causing far higher borrowing costs and reduced growth. The euro would weaken in such a situation.

In truth, the only positive short-term euro outcome would be the covering of Greece’s debts by the Eurozone, says Lawson. “Either it would decrease the perceived risk of default and/or the removal of Greece from the euro area. In all likelihood this may not occur, or if it did, it would come as a last minute plan. At which point, the euro would have already been at risk of severe depreciation.”

Whatever happens to Greece, there will be little to make those short of the euro change their minds any time soon.