Rumours of the euro’s demise are premature, according to Commerzbank, which toured Asia last week to give clients its views on the future of Europe’s currency union.
The bank’s message was mostly upbeat – in the end, Germany will not let the euro fail – but it also highlighted some fundamental challenges facing the eurozone project. The biggest of these is that its member economies are no longer moving in sync. The German economy is driving ahead at around 3%, while huge debts are holding back growth in Greece, Ireland, Portugal and Spain.
Indeed, Greece is still in outright recession and industrial production in both Spain and Portugal haven’t improved since the depths of the financial crisis in early 2009.
To stay in the euro, these countries will need to put their economies on an austerity footing for years to come, which inevitably means making deep cuts to public services at a time when voters are crying out for government support. It is hard to see them backing such policies for long, if at all.
That puts the European Central Bank (ECB) in a tricky spot, according to Ulrich Leuchtmann, Commerzbank’s global head of FX strategy. The ECB’s sole mandate is to keep inflation low, he said, but it also needs the indebted eurozone members to get their houses in order. That gives rise to a dilemma that strikes at the heart of Europe’s currency union. “Will the ECB stick to its inflation-fighting role or address the fiscal problems in individual member states?” asked Leuchtmann.
It cannot do both. Fighting eurozone inflation tends to mean setting interest rates that suit the region’s core economies, which is part of the reason why countries like Ireland got into trouble in the first place. For close to 10 years, between 1998 and 2007, it faced negative real interest rates. Today, with an even wider gap between the core economies and the struggling states, the central bank might eventually be forced to give up control of inflation.
If that were to happen, the ECB would blame the weaker member states – Greece in particular – for their failure to cut spending and restructure their economies. “The European governments have to fulfil their duties in full; monetary policy cannot substitute for government irresponsibility,” said Jean-Claude Trichet, Europe’s top central banker, recently. “Europe cannot afford to rest halfway. We need to be more ambitious.”
Trichet would like EU politicians to enforce tougher sanctions on countries that breach their borrowing limits, but the last effort to introduce new penalties failed to pass.
Ireland alone borrowed 30% of its gross domestic product in 2010 and the European Commission forecasts that its public debt will be equal to almost 155% of its GDP by 2012.
Even with the problems of staying in the euro, pulling out is hardly a better solution for countries such as Greece, according to the team at Commerzbank. “Countries have learned that devaluation doesn’t help the economy,” said Leuchtmann, who argued that the benefits of devaluation tend to be mitigated by higher inflation. “It’s better to default with the euro than create a new currency.”
Meanwhile, investors are paying attention to news in Portugal, where 10-year government bonds are trading at close to 7% – a level that its finance minister once said was untenable. The risk if Portugal needs bailing out is that rising borrowing costs could become contagious, spreading to Spain and, ultimately, testing the EU’s claims to solvency.
That means the buck stops in Frankfurt, Germany’s financial centre. Here, there is cause for optimism, according to the team from Commerzbank. Bernd Weidensteiner, the bank’s senior economist, said the euro’s senior member is pulling the rest along, both economically and politically, thanks to its disciplined handling of the crisis.
Germany has also benefited from a stronger-than-expected recovery in developing economies, which has restored demand for its exports and spurred the economy to grow faster than at any time in the past decade. Commerzbank forecasts it to grow at more than 3% for the next two years.
That should help ease concerns about Germany’s ability to bankroll its neighbours. Just as important, German voters and politicians still believe strongly in the euro, despite some grumbles about paying for the relaxed lifestyles of the southern Europeans. “Germany cannot be seen to be the country that brings about the euro’s failure,” said Weidensteiner, who argued that German political will was rock solid when it came to backing the euro.
In short, Commerzbank is confident the euro will ride out its current woes, but warns that the crisis raises many difficult questions – most of them political.
