Friday, 26 November 2010

To survive, the euro must fall

Whatever the immediate prescriptions being devised to solve the eurozone crisis, ultimately to get out of the mess, Ireland, Greece, Portugal, Spain, Italy (with probably more to follow) have three simple options, 1. stimulate their domestic economy 2. Export their way out 3. Sell some of their assets to international buyers.

In the medium term, an austerity package mostly rules out one, and in the longer term an over-valued euro rules out all three.

Both to rescue the weaker economies and to avoid a breakup the euro must be at a level which is consistent with a clearing value for weakest and most troubled economies. The single currency does not appear to be overvalued for Germany, the biggest eurozone nation. Intuition might suggest that the economic health of Germany, which has the largest slice of eurozone GDP, should have the greatest influence on the euro exchange rate, but this is wrong. The international value of a common currency binding many different nations together must eventually converge to a price which clears the marginal cost of goods, services and assets of the least competitive and weakest economies. The reason is simply, if it does not, monetary union will become untenable which will result from one of the following two paths:

1. The political and economic fallout will spread progressively from the weaker economies to the stronger ones, as the stronger economies are asked to foot increasingly larger bills to bail out the weaker ones deepening the required pit of rescue money. This will cause the burden on the richer economies to escalate, at the ire of the electorate. The political will to remain in the euro will diminish and raise the risk premium on the euro, which will cause it to fall.

2. The weaker economies will weaken further, ultimately making monetary union untenable and cause the ultimate breakup of the eurozone. This will also raise the euro risk premium and its value must therefore fall.

QED

Since the euro was originally devised primarily for political considerations, the first route to the fall of the euro is more likely. But fall it must.

1 comment:

  1. The point you miss imho is that after a split there are basically 2 Euro's (at least currencies) and the process to it will very likely go extremely fast.
    Your scenario 2 is by far the most likely although also likely a lot of money will still basically useless be thrown at the problem.
    Scenario 1 even now looks to have come to an end.

    There will be a split and likely country per country, not the whole group in one time as it will most likely be caused by local voter pressure and that won't be built up in all countries at the same time. Furthermore the surrounding conditions, like: primary surpluss and elections etc will very unlikely happen at the same time. There might however be a sort of Arab Spring effect, contagion of Euro uprising.

    For simplicity sake start with just a simple split North-South. South leaving the Euro (as it likely will happen one PIIGS-country at the time)as the by far most realistic option. The PIIGS are no natural partners: Ireland doesnot fit the normal characteristics, nobody want to be in the same group as Greece.

    Anyway people end up with a South Euro OR a North Euro. The first likely to go down the second go up. So as an investor, if there is any doubt of some break up, take care you got the money in the North.

    The exit is likely done in a very short period of time to avoid eg bankruns in the South.
    So the time for the Euro to fall will be very limited after that you get a totally new situation.

    Leaving one at the time will have its own dynamics. Markets will start to judge the possibility of a subsequent PIIGS-exit even more. Likely also leading to basically a short Southern Euro long Northern Euro bet. Pulling more and more money out the remaining PIIGS and making an exit even more likely. The funds to do some rescuing have dried up by then.

    My idea is that Greece is the first candidate. There might not be much exit contagion as everybody sees Greece as something (negatively) special. But after the second likely Portugal the train will start moving. And if the second one would be Italy it likely is a high speed train.

    All ado wont be good for the Euro. But it is either a few day event (if only one or two splits take place or the total South goes)or max a process of 1 or 2 years . Fatigue usually hits in 2 years after austerity. The countries involved donot seem very patient. And after an exit more pressure will build up on the remaining ones. So it is also not a very structural thing.
    It likely will leave a more Northern Euro and with the remaining problems relatively clear the post exit-Euro looks stronger than the pre-exit one. At least structurally.
    Allthough both will likely be long enough to make a bet on.

    Assuming a non-crisis Euro. It could have been around 1,70-1,80 to the USD at this moment. So we have a 0.30-0.50 Cent mess and uncertainty deduction. Likely that deduction will go up if the mess and/or uncertainty goes up. However it can also go done if a permanent stable solution would be found. So for the North you will have the present deduction possibly an increase because of the bigger mess because of the split but a decrease because of the split effect (leaving a more competitive unit). Likely as problems get solved and things become more clear deductions will get smaller.
    For the South basically a mirror image scenario.

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