Troubled Year Ahead for the Euro?

On January 16 the euro replaced the koruna as the official currency of Slovakia, bringing to sixteen the number of countries of the eurozone.  It was the first country in the former Soviet bloc to adopt the single currency – and just 20 years after the Fall of the Wall.  What a great way to mark the tenth anniversary of the launch of Europe’s new money!

But watch out! Maybe this milestone in the history of the euro will also usher in the most threatening period that the single currency has known. ECB president Trichet has warned of trouble ahead in 2009 and as member states struggle with the impact of the credit crisis some commentators are asking whether vulnerable eurozone countries will be forced to abandon the single currency – leading to a major crisis in Europe’s monetary union. It is a story which is widely discussed in the trading rooms of currency traders.

The rating agencies’ downgrading of the sovereign debt of Greece, together with the negative credit watch on Spain and Portugal are symptomatic of the doubts which the markets are having, although the agencies specifically acknowledge that membership of the eurozone is a positive factor for these economies and are mainly concentrating on the competitiveness of the countries concerned.

There is no denying that the markets are differentiating between eurozone members. Default protection insurance on German government debt runs at €54,000 per €10m whereas you must pay more than €250,000 to cover equivalent Irish debt and €260,000 for Greek debt. The yield on Greek euro bonds at 5.42 per cent is almost double the German benchmark yield of 2.93, with Ireland at nearly 2 points above Germany, Portugal at +1.24 points, Italy at +1.45 and Spain at +1.16.

These high premiums will be a serious burden for the weaker economies as they are compelled to issue bonds to cope with the credit crisis and forced to pay through the nose for the privilege. However, it’s worth considering the level of premium these countries would need to offer in order to sell their bonds if they ceased to be members of the eurozone – no doubt way above current levels because of the exchange risks which would be involved.

I suspect there is a degree of wishful thinking and a touch of schadenfreude as opponents of the eurozone cite these differentials as proof that the euro is beginning to crumble. It is also argued that the “one size fits all” nature of ECB interest rate determination and the inability of countries to devalue their individual currencies will lead to a big bust-up for the single currency.

That’s not how Danes, Swedes, Slovaks and Irish see it, to say nothing of the poor folk of Iceland. For them the eurozone is a zone of stability and security. If they are already members they bless the day they joined; if still outside they crave to be part of it. It’s no surprise that some voices in the UK are making the argument for replacing the pound with the euro,  just as the Conservative Party leadership affirms its eternal opposition to membership in the run-up to European elections.

When President Barroso said that some Brits were once again debating British membership he surely had in mind the newly published pamphlet Ten years of the Euro: New Perspectives for Britain, which makes the case for the UK to join.

One of the leading contributors to this pamphlet is Willem Buiter, former chief economist at the ECB and former member of the Bank of England Monetary Policy Committee. Buiter is a long-term advocate of British euro membership, but his comments on the current crisis are especially interesting. He gladly accepts the threat of defaults on sovereign debt among eurozone members. He believes it would bring back the disciplines lost when the stability and growth pact was emasculated but would not, in his view, lead the defaulting countries to leave the eurozone. “Any sovereign eurozone quitter would be clobbered by the markets”, he says, as he asks “who would want to be in the position of New Zealand, Iceland or the UK ?”.

As a final provocative touch Buiter states that it is “more likely in my view that Scotland will leave the sterling monetary union (and the United Kingdom) and adopt the euro as its currency than that the euro itself will founder”. I wonder what odds the bookies would give on that thesis?