The Economy

Euro Faces Depreciation or Destruction: FX Bankers

Currency analysts think that in order to survive, the euro zone will have to break up or see the euro’s value weaken significantly.
Andrew SawersJuly 11, 2012

The heat may have come off the euro for the moment, but currency experts at Bank of America Merrill Lynch (BAML) think it’s too soon to declare the crisis over.

At a European Union summit in late June, an agreement was reached for the creation of a single pan-euro banking supervisor for the 17-member euro-zone nations as well as short-term support for Spain and Italy, including a restructuring of the Spanish bank-rescue deal. Markets took this well, initially, and the BAML analysts note that the cost of insuring against so-called euro-tail risk has fallen sharply in the past month.

Some concluded from the summit’s results that, “if pushed to the wall,” Germany will capitulate and agree to the sort of shared euro-bond debt funding that could end the crisis. “The EU Summit has persuaded many investors that the negative consequences of a euro breakup are so great that politicians will pay whatever price necessary to avoid it,” the BAML analysts, David Woo and Athanasios Vamvakidis, said in a client note issued Tuesday.

But Woo and Vamvakidis also say they “have reservations about the soundness of this logic.” In their view, euro-tail risk is being mispriced. They also believe that exposure to euro assets has been reduced to the extent that there is in fact less demand for insurance.

Indeed, there are political signs that the crisis is worsening, not improving: France and Germany are drifting further apart, German opposition parties are souring on the idea of euro bonds, and the rise of Italy’s Five Star party is upsetting that country’s reform agenda.

Moreover, the BAML experts think Italy may be a bigger problem than Greece. In absolute terms, of course it is: Italy is the third-biggest economy in the euro zone. In addition, though, it, along with Ireland, has the most incentive to leave the euro, according to Woo and Vamvakidis, who arrived at that assessment using game theory and a cost-benefit analysis. The analysis also revealed that Germany’s “incentive to pay other countries to stay is more limited than meets the eye.”

While the breakup of the currency union is still clearly a threat, Woo and Vamvakidis say there is another way the currency union could be saved, and that’s by a significant further weakening of the euro’s value, all the way down to $1.20. The currency is still 10% higher than it was in 2000 on a trade-weighted basis and 45% stronger against the U.S. dollar compared with its November 2000 low. “Our analysis makes it very clear that a much weaker euro may help save the euro in the end,” say Woo and Vamvakidis.

The euro’s drop would make Italy and other euro-zone countries more competitive globally, boosting economic activity with the United States, for example. While the euro’s fall would do nothing to rebalance the competitiveness between Germany and the peripheral countries, German export growth fostered by a weaker euro would put German businesses and consumers in a stronger position to buy goods from elsewhere in the euro zone.

“Our analysis suggests that the euro zone is now facing two paths — break up or accept a much weaker euro,” the BAML analysts conclude.

Andrew Sawers is editor of CFO European Briefing, a CFO online publication.