The euro has been on a roll recently. Since early July it has risen by nearly 10% against the dollar, hitting highs not seen since 2011.
Why? Well, while the Federal Reserve is still printing money, and dithering over whether to ‘taper’ or not, the European Central Bank has got away with vague promises to “do whatever it takes”.
With the worst of the crisis apparently over, that’s been enough – for now.
But bubbling under the headlines about recovery from recession, several of the high-debt countries still face big problems. They may not be enough to force anyone to leave the single currency, but it could certainly be enough to force Brussels to turn on the printing presses next year.
Here’s why the euro may be plumbing its low again before too long.
Interest payments are wiping out GDP gains
There’s no doubt that things have improved in the eurozone. Some countries have made huge strides in cutting the gap between revenue and spending. If you take away interest payments, many countries – including Greece – would actually be raising more money in taxes than they are spending.
Trouble is, you can’t forget about interest payments. Because absolute levels of debt are so high, these are still a big drain. Worse still, they’re growing.
How long before the debt overwhelms these countries? Alexandre Tavazzi of Pictet Wealth Management thinks that one way to judge whether this burden is sustainable or not, is to compare interest rates with nominal growth. If the interest rate on the debt is growing faster than the economy (which is what generates tax after all), then there’s a problem.
Other than Germany, every eurozone country is growing more slowly than the yield on its ten-year government bonds. This is a particular problem for the troubled ‘peripheral’ countries. In the case of Greece, for example, the gap is a whopping 15%.
And as Salman Ahmed of Lombard Odier points out, despite its progress, Greece’s debt-to-GDP ratio is nearly as high as it was before bondholders were forced to take haircuts last year.
Interest payments will only get higher still when these countries have to refinance government debt in the coming years. Spain needs to raise €200bn and Italy around €350bn in 2014. Even if markets will lend them this money, they’ll be replacing low pre-crisis interest rates with higher ones. That’ll make it even harder to balance their budgets.
The banking system is still in crisis
More worrying still is the state of the banking system. In 2011, the ECB carried out a series of stress tests, which supposedly ‘proved’ that banks across Europe were solvent even if the economy deteriorated further.
But the long drawn-out recession has punished banks’ balance sheets. Bad debt (non-performing loans, in the jargon) continues to rise. In Italy, almost 9% of all loans have gone bad, from 3% in 2008. In Spain, it’s even worse, at 13%.
The original plan to deal with all this was to create a eurozone-wide ‘banking union’, with a common regulator. The costs of bail-outs would be covered centrally, spreading the burden. And in the long run, there’d be new rules to ensure taxpayers didn’t bear the costs of future bail-outs.
But German opposition has scuppered this idea. And the tougher rules on bail-outs won’t come into effect for years, which leaves taxpayers in Spain and Italy holding the bag for bailing out their own banks. That in turn pushes their national debt levels even higher.
Another worrying factor is that these banks hold ever-increasing amounts of their country’s debt (70% of Italy’s debt is now held domestically) – after all, no one else wants it. So any banking crisis could lead to a sovereign debt crisis, and vice versa.
The ECB needs to talk down the euro – at the very least
The most politically palatable way to deal with all this is to somehow get growth and inflation higher in the eurozone. But the pressure on banks’ balance sheets also makes them even more averse to lending money to individuals and businesses. That in turn, hits growth.
There are also growing complaints from firms that the strong euro is hurting exports – both the French insurer AXA and car-maker Renault have recently blamed the currency’s appreciation for hitting their earnings.
In short, in the absence of banking union or deeper integration, what the eurozone really needs is a weaker euro. That suggests the ECB will be forced to take steps to cap the euro – whether that involves printing money, or cutting interest rates – to boost growth and make exports more affordable.
The most obvious way to benefit from this is to bet on the dollar going up against the euro. As my colleague Ed Bowsher has pointed out, the shale gas boom is already slashing America’s trade deficit through reduced energy imports and a manufacturing revival.
You can spread bet (remember it’s highly risky), and there are exchange-traded funds (ETFs) you can buy. But bear in mind that any direct currency bet is a short-term trade, and if you do buy an ETF, keep a close eye on its performance.
A more indirect, but potentially more profitable, trade is to buy into those countries which will gain the most from a weaker euro and any hint of money-printing. These include Greece, via the Lxyor ETF FTSE Athex 20 (PARIS: GRE), and Italy, through the iShares FTSE MIB (LSE: IMIB).
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