The OTHER biggest loser aside from the dollar: the euro
Your correspondent took a brief sabbatical but is now back in the saddle, and apologizes for the lengthy departure. Picking up where we left off…
The U.S. dollar’s travails amid the global financial crisis have been extensively chronicled in the financial media, as well as on this site. In our last episode, the greenback’s precipitous decline has prompted certain major economic powers to engage in a very public campaign to reduce the global economy’s reliance on the greenback, including the very dramatic step of creating an entirely new global unit of exchange.
Creating a global currency raises several technical and logistical issues, yet one important strategic question in particular: why wouldn’t global economies just shift to broader use of the euro?
A global shift out of dollars and into euros would be eminently logical. Upon its introduction ten years ago, Europe’s common currency was initially touted as a challenger to the dollar’s status as a premier reserve currency. The euro has grown in international acceptance and has appreciated strongly since plunging to record lows beneath 85 cents in the immediate wake of its launch. European capital markets are comparable to the U.S. in their depth and liquidity, and the combined economies of the 16 countries that use the single currency make up the 2nd largest economy in the world. And several years ago, members of the Organization of Petroleum Exporting Countries (OPEC) mooted a proposal that would price oil in euros instead of dollars.
So why wouldn’t international monetary authorities look to the euro as a unit of trade and foreign exchange reserves? Part of the answer can be found in an excellent special report The Economist ran earlier a few weeks ago that coincided with the single currency’s ten-year anniversary. The entire report is worth a read, but among the major takeaways are that the euro zone’s lack of political union and economic convergence within its constituent economies have hampered the currency’s ability to displace the dollar:
By early 2009 the yield on a ten-year Greek government bond was almost twice that on a comparable German Bund. The spread over Bunds for Italian, Spanish and Irish bonds also widened dramatically before narrowing again more recently. One explanation was that in skittish markets Bunds were prized for their extra liquidity. Another was that the bond-trading arms of bombed-out banks were less willing to make markets in the issues of small countries, such as Greece and Ireland, which left their prices unmoored.
But at least part of the rise in spreads reflected concern that countries might find it hard to pay back their borrowings. The government bonds of Greece, Ireland, Portugal and Spain were all downgraded a notch by credit-rating agencies. For some, bond spreads are a crude gauge of the risk that the euro will break up. If a euro-zone member were shut out of capital markets and had to default on its debt, it might be tempted to use the opportunity to recreate its own currency and devalue. In that event, creditors could be forced to convert their bonds into claims in a new currency at a discount linked to a new exchange rate against the euro. Default would be one way for countries to free themselves from the euro’s shackles—or, to look at it from the opposite point of view, for the euro zone to rid itself of troublesome members.
So while the euro may have the backing of a young but serious monetary policy authority in the European Central Bank, investors are still unsettled by an ethereal fear that smaller, more troubled economies could default on their debt (or at least encounter difficulty in servicing it). Hardly a ringing endorsement in the world’s second-largest economy or the currency it underpins.
Another factor is that unlike the United States, euro zone economies are to a large extent export-reliant (see Italy and Germany, the euro zone’s largest economy and the world’s largest exporter), which means they often embrace a weaker euro. As a result, European policymakers tend to get very nervous when the single currency appreciates too quickly, as it can undermine the chances of an economic rebound.
China is clearly wincing at the weakness of the U.S. dollar, and other countries are eager to reduce the brewing currency risk imputed in the greenback. Clear-eyed observers, however, expect Chinese authorities to continue to support the greenback – if for no reason other than they may have no credible alternative at this point. As an article in the Weekly Standard recently noted:
…the Chinese economy, for all the talk of "delinkage," is still tightly bound to America. China has an export-dominated economy--perhaps as much as 38 percent of its gross domestic product is attributable to the sale of goods to foreign markets. The country exports to many nations, but there is one market on which it is particularly dependent. In 2007, 97.7 percent of China's overall trade surplus related to sales to the United States, and in 2008 the figure was 90 percent. In short, China runs a trade deficit with the rest of the world, buying raw materials and components, and a surplus against the United States, selling finished goods. Beijing, therefore, is locked into buying Treasuries and will remain so until Chinese manufacturers either find new foreign markets--something they are only having moderate success in doing--or they can sell to Chinese consumers. And consumption growth, despite rosy government statistics, appears to be anemic.
This extraordinary reliance on the American market means that China had--and still has--no real choice but to continue to purchase dollar-denominated obligations with its export earnings. It is, of course, theoretically possible for Chinese technocrats to convert dollar earnings into pounds, euros, or yen, but the markets for those currencies are not big enough to handle the country's outsized purchases.
In short, while global monetary authorities are likely to intensify their calls to diversify away from the dollar, don’t expect the euro to be the beneficiary.
Facebook: Javier E. David
Twitter: hankrearden73
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The OTHER biggest loser aside from the dollar: the euro
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