The Euro was the most watched currency in the World in the 2010 to 2012 period due to the sovereign debt crisis in the Eurozone. There were talks of the collapse of the Euro as a few member countries such as Greece, Ireland, Spain, Portugal and Italy were all running high levels of sovereign debt and markets were not willing to fund these governments at lower yields. Greece was on the verge of default with its two year bond yield quoting at levels of 70%. Eurozone member nations along with the ECB (European Central Bank) and IMF bailed out the indebted nations to prevent a collapse of the Euro.
The Euro had weakened by 20% from EUR 1.50 to the USD to EUR 1.20 to the USD on the back of worries of the Eurozone coming apart. However with the European Union (EU) Policy Markers and with the ECB (European Central Bank) collectively taking steps to prevent a Eurozone collapse, the Euro has bounced back to levels of EUR 1.35 to the USD as of February 2014.
EU countries of Germany and France with the assistance of the IMF lent funds to debt ridden countries to tide over the problems while the ECB bought bonds of the debt ridden countries and provided liquidity to banks to calm financial markets. This led to the markets becoming more confident on the Euro.
The Euro, introduced in 1999, is the single currency of a group of 17 nations belonging to the European Union. The nations using Euro have given up their own currencies in favour of the Euro. The countries using Euro have a common central bank, the ECB (European Central Bank), which manages and administers the currency.
The Euro is the second largest traded currency in the world, next to the US Dollar (USD). The Euro is also a reserve currency with almost 28% of world’s currency reserve held in Euro’s. In fact the position of Euro as a reserve currency has increased over the years, climbing from 17.9% of world’s currency reserve in 1999 to 28% of the world’s currency reserves in 2014. Given Euro’s status as a reserve currency, uneven movements in the Euro can cause huge disruptions globally.
The Eurozone runs a current account surplus of around USD 30 billion as of 2013. Hence the tendency of the Euro to strengthen against the USD is high given that the US runs a current account deficit.
The most powerful country in the Eurozone is Germany. Though the Euro is the single currency of the Eurozone, the debt of each Eurozone country, while denominated in Euros, carries the credit risk of the individual country issuing the debt. For example when Italy or Ireland issues debt denominated in Euros, markets will factor in the credit risk of Italy or Ireland in determining the price of the bonds. Germany, which is the strongest of the Eurozone nations, has the best credit rating according to the markets. German bunds (Germany’s sovereign bonds) are the benchmark against which all other sovereign bond yields of the Eurozone nations trade. For example at the peak of the Eiurozone crisis, when German ten year bond yields was trading at 1.97%, Italy’s ten year bond yield traded at 5.57% and Ireland ten year bond yield traded at 7.77%. . The spread between German and Italian bonds was 360bps while the spread between German and Ireland bond yields was 580bps (100bps=1%).
The spreads have now come off given that the Euro is stable. Ten year German Bunds are trading at levels of 1.7%, Italy and Irish bond yields are trading at levels of 3.8% and 3.5% with spreads at 201bps and 180bps respectively.
The future of the Euro
The Eurozone has its problems with sovereign debt and the problems are reflected in the common currency the Euro. The Euro has weakened against the USD in the 2007 to 2013 period reflecting the debt issues. However, the currency is still the second largest reserve currency in the world, and will continue to remain as the second largest reserve currency given the size of the Eurozone in the world economy, contributing to 19% of World GDP as of 2010, and given the free float nature of the currency.
The weakness of the Euro could extend if the Eurozone is unable to come out of its debt issues. The ECB, which has a mandate of price stability, is being coerced into buying bonds of debt ridden countries in order to clam markets. The ECB is also lending to weak European banks to stem a liquidity crisis due to the banks holding Eurozone countries sovereign debt. ECB has pledged to maintain policy rates at record lows of 0.25% until the Eurozone comes out of its problems. If the ECB continues on its deviation from price stability mandate, the Euro will weaken further. However, a weak Euro will benefit countries such as Germany and France as it will help in export and tourism revenues. In the longer term the Euro will find equilibrium against other currencies.
(Image: EURO/USD Chart)