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Crisis could be coming to the eurozone – so be prepared

Some of the most dramatic fallout from the recession may still be to come. And the eurozone could be right at the centre of it. Riccardo Marzi explains what it means for investors.

Much of the focus in the current recession has been on troubles in Britain and America. However, some of the most dramatic fallout may still be to come. And the eurozone could be right at the centre of it.

Let me explain. A flexible exchange rate acts as a safety valve that can relieve imbalances building between two or more economies. Last year we saw this safety valve in action here in Britain, when the pound plunged against other major currencies. The weak pound was grim for anyone going abroad, but it's helped Britain avoid deflation so far and also made our exports more competitive, which, in the longer run, could help the country out of recession.

But when this safety valve is closed off by fixing the value of a currency, these strains tend to build slowly, making an economy more and more vulnerable, until all of a sudden they explode, leading to forced devaluation, recession and financial crisis. You don't have to look far to see this in action. Remember 1992, when the pound was forced out of the European Exchange Rate Mechanism? Or Argentina's problems in 2002, when it was forced to abandon its dollar peg?

Why does this happen?

Variations in productivity growth between two economies are usually reflected in the exchange rate. The lower your productivity growth, the weaker you can expect your currency to be. You also have to consider the current account and fiscal deficits, which add to the supply of a currency in the market, and so also weaken a currency.

When a currency is fixed, these pressures can't be reflected in the exchange rate, so one of two things can happen. Either the system breaks under the strain and you have a sudden collapse, or there is a gradual and painful readjustment through falling wages (to restore competitiveness) and falling living standards. This is happening in Latvia right now, as the country tries to maintain its currency peg to the euro.

What could this mean for the euro?

The euro has been in use for ten years without a major hitch. But now that we have a major slump we could be in for some nasty surprises as economies become more vulnerable. For example, as we've already seen, recessions lead to rising government debt, as the tax take falls and public spending rises. There are three ways for a governments to lower its debt pile, other than by repaying the debt. It can gradually inflate its way out; it can devalue its currency (similar, but quicker and more painful); or it can default. The trouble is, if you're in the eurozone, the first two options aren't open to you. So while it might seem far-fetched at the moment, the only option for a eurozone economy pushed to the limit would be to default on its debt.

Several eurozone economies are suffering just now, but the most extreme event would be if Italy defaulted. Italy is the third-largest economy in the eurozone and could prove too expensive to save. What worries me is the interest-rate gap between Italian bonds and the German bund, which currently stands at 85 basis points (0.85%). Italy has benefited hugely from low interest rates that have enabled it to finance its debt cheaply, which already stands at 115% or so of GDP. A back-of-the-envelope calculation suggests that if interest rates were to rise by 1% (not a lot, in other words), then Italy's deficit (revenue minus expenses) would rise by 1%. To cover this increase, tax revenue (which accounts for around 40% of GDP) would have to rise by 2.5% a tall order in a country with some of the highest tax rates in Europe. This could result in the economy slowing further because of high taxes and the growing deficit. It might take a few more years to get to that point, but it's worth keeping in mind: you want to be prepared for these events, so you can take advantage of them.

Plenty of other less dramatic scenarios could occur, ranging from the failure of a large German bank, to riots in the harder-hit and more politically volatile countries, such as Greece. Early signs of a crisis should be easy to spot, such as rising interest rates on a country's debt, or regular failed auctions in government bonds.

What should investors do?

If you have a crisis in one eurozone country, the euro will almost certainly tank against all other currencies. We've already seen that when investors panic they sell everything the good, the bad, and the ugly. So it's quite likely that euro-denominated assets will also sell off, as foreign investors dump their holdings. That means that a crisis in the likes of Spain, Italy, Greece or Ireland could also result in higher-quality German and French assets being dumped.

For now, the chance of a severe crisis is low. But if the economy remains sluggish and fails to recover strongly, the chances of something more serious happening become increasingly likely. So be prepared to sell euros against other currencies, and then be prepared to buy assets at knock-down prices once the oversold phase is over.

Riccardo Marzi has just launched a new trading newsletter called Events Trader. Find out more about Events Traderhere.

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