Why is the Euro Going Down

When Western nations such as Australia and the US see their economies recovering and their job cuts slowing, it is easy for forget that many countries are still struggling with the effects of the Global Financial Crisis, several years on. For example, the Euro has seen some significant losses against the US dollar and this is due only in part to the Greek crisis.

Rather, this could be just the beginning of the collapse of the Euro all together if precise action is not taken, since a number of other member countries such as Spain are also struggling with high debt levels. As the Euro struggles to recover, that recovery is made even more difficult due to the lack of investor confidence – while the US Federal Reserve has been long established, the Euro is relatively new to the market and doesn’t offer the predictability or instill the trust of the Fed.

Plus, the Euro is going down in relation to the US dollar which is seeing increased demand thanks to European companies investing in the US dollar to get better value from their investments. US companies are also pulling out of foreign investments to secure their capital base at home and this shows a rise in the dollar value, when compared to the Euro.

The Euro in 2010

The European currency is constructed with a common central bank, but no common treasury and with a fixed exchange rate, a country is not able to depreciate their currency. Also, in the US, American states can benefit from transfer payments if they are worse off than other states, but that practice is not seen in Europe. As a result, the Euro has been severely tested and the Greek crisis has put the currency on its longest losing streak against the dollar since November 2008.

Even though it is predicted that Greece will survive its fiscal crisis, there are concerning budget deficits in other Euro-region countries such as Spain. Other countries facing similar difficulties to Greece could force the Euro to fail if institutional measures are not taken. The European finance ministers pledge to safeguard the financial stability of the Euro as a whole, but the currency may still disintegrate if the next step towards political union is not taken.

Options for EU Countries

EU countries are especially weak thanks to a single monetary policy, yet maintaining different fiscal policies. Despite this, the EU leaders have promised action to help Greece control its budget deficit, which could involve other EU countries selling their Eurobonds. This would allow Greece to refinance around 75% of its maturing debt and meet its targets, and the rest of the country’s needs can be met internally. Higher value added taxes are also being considered on luxury goods and energy products, and if enough progress isn’t seen from these measures, Greece will have to cut its capital spending.

Euro-area officials are also considering a plan to grant Greece approximately 25 billion Euros if required, and the funds may be coming from state-owned lenders such as Germany’s KfW Group. A tax on financial transactions may also be imposed to deter speculation on currency trading.

Why is the Euro Down?

Investors the world over know that Greece is in financial trouble and many are pulling their money from Greek markets, while European Union officials aim to instil confidence in investors. It is the investors who are pulling out who are creating the financial instability which has caused them to pull out in the first place.

While this vicious cycle is part of the reason the value of the Euro is down, investors are also selling up because they believe Greece is broke. As a result, it is a natural instinct to withdraw funds from a government which is in debt, and can’t handle its own finances, let alone your investments. It was in fact the Greek government’s irresponsible spending which lead to their current situation, where they continued to spend more than they made, and saw their debt levels reach approximately 94% of their GDP. It was at this point that investors wanted their money back.

At the same time, the fiscal policy of the US has raised their debt to 87% of their GDP and if current trends continue that rate is expected to be 95% by the end of 2010 and 105% by the beginning of 2011.

Solutions to the Falling Euro

In December 2010 the proposals to increase the bailout fund found a voice when the Belgian finance minster Didier Reynders backed the move as a chair on the EU’s economic affairs council. However, the German chancellor Angela Merkel does not see any need to increase the rescue fund which is already at 440 billion Euro. Merkel has also dismissed the creation of a Europe-wide bond on the basis that the bloc treaties do not allow for the creation of such a bond.

However, the rules which govern the operation of the rescue fund mean that the Eurozone is unable to lend the entire 440 billion Euro amount and if Spain and Portugal needed rescue funds, greater lending capacity would be required. At the same time, a Europe wide bond was rejected as a the solution to the Greek crisis in May 2010 on economic and legal grounds.

Instead, a more comprehensive solution is needed to effectively stabilize Spain and Portugal, and in turn strengthen the Euro. Where one European country after another is treated in the crisis does not offer a viable solution.

Currently, mass purchases of bonds by the European Central Bank have decreased borrowing costs for Spain and Portugal, who cannot expect the same bailout assistance offered to Greece and Ireland. Instead, a proposed Italy-Luxembourg plan was put forth to create a European bond which would allow the struggling countries to borrow at lower rates. However, the German finance minister is opposed to this plan, saying that as the interest rate risk is distributed to all Eurozone countries, it would not meet the EU budgeting rules.

The Irish government is working to regain control of its economy and presented its austerity budget plan to parliament which aims to cut 6 billion Euros of spending in 2011 and 15 billion Euro in the following four years. Ireland also maintained low corporate rates, despite opposition from France and Germany during the bailout.

The Future of the Euro

Despite plans, talks and proposals, the fate of the Euro still looks to be in doubt, with nearly $8 billion from traders and hedge funds being bet against the Euro, which is the biggest short position in the single currency since its launch. The build up of the net short positions is made up of more than 40,000 contracts traded against the Euro and shows investors are not confident that other European countries can manage their fiscal problems after the Greek crisis.

As a result, foreign business is likely to be much more wary about investing in the Eurozone and will require significant hedging of the currency. However, as the hedges are harder to get, foreign investments could cease all together, adding to the Euro’s problems.

The future of the Euro will be determined by the likelihood of a wave of sovereign defaults and what the Eurozone is willing to do to prevent these. For the Euro to survive a sovereign debt restructuring, a significant restructuring of the public and private debt in the struggling countries is needed. It is quite likely that there will be a wave of sovereign defaults because there is always an inherent danger in lending to sovereigns as they lack collateral. As a result, the security of their creditors is dependent on them being able to sell their debt to others for a good return.

The confidence of the creditors comes from the sustainability of the economy in relation to the prospective growth, and the interest rate. if growth is low, and interest rates are high, a larger surplus is required and the greater these costs are, the less confident investors will be. With rising ratios of debt to GDP, high interest rates and poor growth outlooks, options are not attractive to investors.

Since the funds on offer at the moment are not enough to finance all of the weak countries, the Eurozone will need to make changes to prevent future defaults. As a result, the restructuring of sovereign debts could trigger a wave of debt restructuring and see another tangent of the Global Financial Crisis. What is needed are transfers from the credit worthy to stabilize the un-creditworthy and the more swiftly that happens, the more likely it is that the Euro will return to normal sooner.

Alban is a personal finance writer at Home Loan Finder, a home loan comparison website.