When the euro emerged as a consolidated currency over a decade ago, hopes were high that its advent would present a challenge to the USD as the default world reserve currency. Times were different (and much simpler, with shadow banking complexity a tiny fraction of the current $1 quadrillion+ behemoth) and as BofA says, "perception that the euro is well placed to rival the USD as a reserve currency has underpinned the increased euro allocation to a level much greater than the sum of the roles played by its constituent parts. This has been justified on the grounds that the unified European financial markets would offer similar breadth, depth and liquidity to those of the US." Alas one concept largely ignored was that unlike the US, where there has been one consolidated bond market reflecting the underlying marginal credit and liquidity risks behind the US currency, in Europe "there remain 16 separate government securities markets with very different levels of credit risk and liquidity." The ongoing Greek crisis has only reminded pundits of this phenomenon all too well.
What were the primary reasons for the euro's steady climb over the past decade? The key factor has likely been emerging markets central banks' desire to diversify their FX holdings away from dollars and into euros. As can be seen on the chart below, EUR reserves have grown from 20% of total in 1999 to 30% by 2009.
Another euro-benefiting trend has been the the flow diversification, once again as a result of EM Central Banks, which "sell down a portion of USD-denominated inflows in order to keep the currency composition of portfolios stable." This forms a feedback loop whereby increasing perception of euro strength led to further accumulation of euros, and constant euro-favorable rebalancing of portfolios.
As pointed out above, Central Banks are now very likely to reevaluate their €-centric FX flows, in light of the just uncovered fissures in the eurozone. As BofA [fn]"FX Strategy, Greece issue to weigh on EUR-USD, 1/29/2009, Fixed Income Strategy"[/fn] suggests: "the euro’s weight in global FX reserves may now begin to slip back on a trend basis, with the JPY, gold, CAD and even the USD benefiting."
Ironically, in order for Europe to regain its prior lustre and for the Euro to come out a winner of sorts from the Greek debacle, would be to follow the Fed's approach to the 2008 financial collapse in the US. Which would mean a rapid and convincing bail-out of the country (contrary to what EU bureaucrats have been posturing, at least so far) instead of a slow, disorderly "muddle through" or, worst of all, an actual default, whether orderly or disorderly.
In quantifying the implications for the Euro as a function of the four different possible outcomes for Greece (for more information on the Greek bail-out flow chart, see our thoughts from yesterday), BofA provides the following useful matrix: unfortunately for the Federal Reserve, just one of the outcomes is €-friendly.
1) Muddling through
If Greece adjusts gradually, concerns about its fiscal situation would likely linger as a euro negative over the near-term – contributing to the weakness already built into our $1.28 year-end forecast – but an escalation that drives EUR-USD rapidly into materially undervalued territory would be avoided. Fair value estimates from G10 FX Strategy and the PARS group cluster in the $1.25 to $1.30 area.
2) Last minute bail-out
A failure of the Greek government to avert further fiscal deterioration that brings the country to the brink of default would likely see the euro under increasing pressure as speculation over an eventual break-up mounts. The euro is likely to stage a relief rally once an EU bail-out is agreed. Meaningful steps toward a full fiscal union would be euro positive.
3) Orderly default
Default by Greece on its debt – even if Greece remained within the Eurozone – would likely play as a material euro negative, in our view. In this scenario the investment universe for EM central bank FX reserve managers would narrow very sharply to the government bonds of those nations viewed as irrevocably part of a core DEM zone. The portfolio allocation to EUR would therefore fall sharply.
4) Disorderly default
The FX implications of a disorderly default scenario are similar to that of orderly default except that pressure on EUR-USD would likely be exacerbated by very material safe haven demand for the USD. Global financial markets are likely to react in a highly negative fashion to a disorderly default.
One has to keep in mind that the endogenous issues now plaguing the Greek economy find parallels in all of the PIIGS. In essence, what this means is that the eurozone is starved for a devaluation of the euro, and will do anything it can to achieve it, even, as we have claimed previously, throwing Greece to the wolves. The irony is that by inducing a rush out of euro-denominated FX reserves, the ECB would be doing the only thing in its power to facilitate the growing external imbalance problem now plaguing virtually the entire periphery of the eurozone. As BofA notes:
Beyond the immediate fiscal problem, the potentially more intractable issue is that, since 1999, Portugal, Ireland, Greece and Spain have all experienced a 25% increases in unit labor costs relative to Germany. This has led to the build up of sizeable external imbalances (Chart 17). Ordinarily currency depreciation would kick in help to boost exports relative to consumption and also ease the adjustment via revaluation effects on the national balance sheet. This cannot happen under EMU. Consequently Portugal, Ireland, Greece and Spain are consigned to a period of disinflation relative to the Germanic core of the Eurozone. The market is forcing this adjustment through by inflating funding costs in the periphery relative to the core (Chart 18). The political will to bear this adjustment likely will be tested should unemployment continue to rise. The alternatives are EMU exit or very large fiscal transfers from the core to periphery. Unless and until the situation is resolved we believe the euro’s viability as a reserve currency will continue to be questioned.
Whether all the highlighted factors will finally put an end to the dollar-funded carry trade is unknown, although as more and more traders realize that the USD has an ever-increasing likelihood of becoming the "flight to safety" currency once again, we would not be surprised to see the majority of unbooked carry trade losses be realized (January was a nightmare month for carry traders as we previously pointed out), spurring a major move in the USD-higher, and further punishing the Euro (and the Fed's debt-inflation strategy). From a geopolitical perspective, the only question is whether this is indeed a transition from the old (dollar weakness) regime to the new (euro weakness), and if so, whether this has occured with the tacit approval of Ben Bernanke. If the answer is no, then the kicking and screaming rush to the currency bottom, as the Fed takes the game to an all new level, will make any UFC championship final seem tame by comparison.