Jonathan Marriott, Chief Investment Officer
The euro is one of the newest currencies globally, notwithstanding the issuance of numerous cryptocurrencies over the past decade. Even though financial markets have dealt with the euro since the start of 1999, it was not until January 2002 that notes and coins were brought into circulation. Initially, the currency bloc had 11 participating members, but it has since grown to include 19 members. The establishment of a new joint currency brought with it a need for greater co-operation between individual member state central banks, and the establishment of the European Central Bank (ECB).
Before its citizens held any banknotes, the euro initially depreciated on the financial markets versus the US dollar. The US dollar had, at that time, been widely accepted as the only credible reserve currency, given its global usage and ease of access to US dollar funding. The euro, which was the main currency used by 343 million citizens at the end of 2019, was potentially another viable contender. From 2002 to 2008, the euro appreciated versus the US dollar. The reduction in foreign exchange transaction costs, increased comparability between member states, and lower funding costs for the fiscally weaker members of the Eurozone, supported economic activity. However, soon after the global financial crisis (GFC), the shaky foundations of the currency became apparent.
Southern European countries saw an economic boom in the early days of the euro's introduction, given a single currency boosted holiday activity, and reduced borrowing costs for infrastructure to support this level of increased activity. This was caused, to a large degree, by its wealthier Northern neighbours. As households cut back expenditures globally following the financial crisis, Southern European states found themselves in a precarious situation. With a large drop in economic activity, unemployment soared and house prices collapsed. The way the euro has been constructed meant they were unable to benefit from a weaker currency to offset these effects, as Germany continued to export cars to fast growing China, thus supporting the strength of the euro. This resulted in years of austerity and eventually resulted in the Eurozone sovereign debt crisis, with Greece subject to rescue packages from the so-called "Troika" (the European Commission, European Central Bank and the International Monetary Fund). Talks of Greece leaving the euro raised further questions regarding the longer-term viability of the currency. The problem is that, whilst there was a monetary union, there was no centralised fiscal authority, and the ECB's policy was constrained between the needs of various member states. President Draghi, the ECB president in 2012, vowed then to do "whatever it takes" to protect the euro.
Whilst this notion was gallant, the ability to execute this policy was initially impaired. Unlike the US Federal Reserve and the Bank of England, the ECB did not buy sovereign debt at the height of the GFC and Eurozone debt crisis, as there was difficulty in determining what it could buy, and to what degree, given the lack of common Eurozone debt. Eventually, in 2015, the ECB figured out a way to buy sovereign bonds across the Eurozone, but the mechanism had to be tweaked to satisfy the more frugal nations. Sovereign bonds (that is, bonds issued by the government) would be repurchased by each nation's respective central bank, but financed by the ECB. The terms were such that the ECB would be subject to only limited losses, as any losses on the bonds repurchased would be shared with the respective nation's central bank. In addition, the proportion of bonds bought would reflect the amount of capital each member state provided to the ECB, also known as the "capital key". Whilst investors applauded this shift, resulting in much lower sovereign debt funding costs, the lack of real debt mutualisation still lingered. In addition, political populism in the likes of Italy, saw renewed threats of member states leaving the Eurozone altogether.
With this backdrop, it is not difficult to understand that whilst investors were keen on the euro as a reserve currency in the early days, the experience following the GFC has dented this view. So why is all this relevant today, especially given that the ECB has once again increased asset purchases to support the Eurozone through the pandemic?
Earlier this week, the European Union finally approved a €750bn package of grants and low interest rate loans. The debate was around the split between the two, with €390bn of grants (versus the initial €500bn proposition) and €360bn of loans eventually agreed. This package will be funded by bonds issued by the European Commission. The package will primarily benefit the Southern European states, the ones hit hardest by the pandemic. A qualified majority will oversee the disbursements, thus mitigating the problem of a lone dissenter scuppering its implementation. Even though this package came after much dither and delay, the fact that the EU is about to embark on a fiscal mutualisation of this scale, and seeks to counter balance the economic divergence between countries, marks a significant step forward for the European Union and for the euro. This change may cause investors to reassess their view on the viability of the Euro and economic prospects for the wider European Union.
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