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Now for the hard part — euro faces its toughest test yet

30 Sep 2008

The credit crisis has proved that despite making great progress over the last 10 years, the euro capital market still has a lot of growing up to do before it can match the dollar market’s maturity, standards and depth. It also faces the damaging prospects of a protracted downturn during which calls for a dismantling of monetary union will surely intensify as discontent grows across the EU. Will the euro’s next 10 years be tougher than its first? Philip Moore reports.

The headline that appeared in Ireland’s Independent in mid-July 2008 was not quite what the architects of the Maastricht Treaty had in mind when they signed the accord in February 1992. "If all else fails, then maybe it’s time to ditch the euro," was the stark warning in this piece, which argued that the currency arrangement was likely to make an Irish recession longer than necessary. It also described the single European currency as "part of the problem, not part of the solution".

If the Irish article had been an isolated rant, it would scarcely be worthy of comment. BJut the opinions it expressed reflect the views of a growing number of voters within the EU. In Italy, sabre-rattling politicians have campaigned for a withdrawal from European monetary union, while in Germany there has been growing discontent at what some have dubbed the "Teuro", a portmanteau of "teuer" (expensive) and "euro". Outside the eurozone itself, 53% of Danes and 56% of Swedes said no to euro entry in the referenda of 2000 and 2003, while in the UK public opinion remains as strongly opposed to adopting the single currency as it was a decade ago.

At a broader level, meanwhile, Europeans remain lukewarm at best towards the union itself. According to the latest Eurobarometer survey on the subject, 52% of respondents within 27 European countries believe that membership of the union is or would be a positive thing. The majority of respondents in the Netherlands (75%), Spain (65%) and Germany (60%) are happy with EU membership. But in France only 48% regard membership as beneficial, while voters in Italy (39%), Austria (36%) and the UK (30%) appear to be thoroughly disenchanted with EU membership.

How much of a threat any of this is likely to pose to the single currency over the next 10 years is open to debate. Although very few economists and analysts believe that monetary union is likely to be jeopardised even by an extended slowdown across Europe, eventual possibility of a dismantling of the union is not dismissed entirely.

Cracks in the union

In its recent analysis of the Euro at Ten, the European Economics Group at Goldman Sachs presents two potential ways in which cracks could occur within the union. The first would be the by-product of a "peeling off" of one or more of the peripheral members of EMU as a means of attempting to regain lost competitiveness. That, says the Goldman analysis, would be "traumatic", not least for the banking system and capital market within the country in question. "It is difficult to see how a country could leave the EMU without also experiencing a collapse of its banking system," the reports warns.

Goldman Sachs believes, however, that monetary union would survive the departure of a peripheral economy, "even one as large as Italy". But the report says that the second way in which a schism could emerge, which would be a break-up at the core of the union, would represent a "death-knell for the euro". The Goldman report describes a split at the heart of the EMU as "inconceivable within the next 10 years" and "highly unlikely in the longer term as well". Its report nevertheless paints a scenario in which diverging competitiveness between Germany and other EU members increases popular pressure on policymakers in the weaker countries to push for an easing in monetary policy, leading to permanently higher inflation.

In those circumstances, who is to say that Germany does not decide that it is unable to live with inflation that is higher and more volatile than it was pre-EMU, and bows to pressure to re-introduce the Deutschmark? "From a practical perspective, it would be easier for a country to leave the euro on the ‘strong’ side, as the holders of debt would presumably be happy to have their holdings transferred to the stronger currency and there would not be a run on bank deposits," says the Goldman Sachs report.

That would in turn presumably prompt a huge divergence in spreads in the European government bond market unwinding the entire convergence process that has taken place over the last 15 years, and making the pre-EMU spread between Bunds and, say, Italian BTPs look razor thin.

For the time being, however, that apocalyptic scenario looks remote in the extreme. Instead, the Eurozone seems likely to expand rather than to shrink. The Czech Republic, Poland, Hungary and the Baltic States are all knocking on the eurozone’s door. Croatia will do the same soon after joining the EU, which it hopes to do in 2011, and Romania and Bulgaria also have eurozone membership on their longer term agendas.

In Denmark, meanwhile, improving sentiment towards the single European currency may embolden the government to have another crack at a referendum on eurozone entry. If that were to deliver a yes vote, it is probable that Sweden will do the same, although a reprise of the Swedish referendum on euro adoption is unlikely to take place before 2011.

Even if the eurozone welcomes in a steady progression of new members from the Nordic regions as well as from central and eastern European economies, it is unlikely to have a big impact either on supply or demand in the euro capital market. True, Danish adoption of the euro might persuade investors in the eurozone to re-explore the potential of Denmark’s huge mortgage bond market. But Nordic borrowers and investors have always been very well integrated with the global capital market. Indeed, a swathe of Nordic borrowers were at the forefront when issuance in the euro corporate bond market gathered momentum in 2000 and 2001.

The sterling question

Of incalculably more significance for the long term cartography of the euro denominated market would be the entry of sterling into the eurozone. Dominique Jooris, managing director, financial institutions at Goldman Sachs, says that there is still much that needs to be done in terms of harmonising standards in the European financial services industry. As an example, he points to the initiatives that are being explored by bodies such as the Committee of European Banking Supervisors (CEBS) aimed at creating more of a level field in the market for hybrid capital.

But as Jooris says, changes of that kind are likely to be evolutionary rather than revolutionary compared with the seismic impact that the entry of sterling into the euro would have.

Others agree that the complementary nature of the sterling investor base would play a very important role in breathing still more liquidity and diversification of maturities into the market for euro denominated issuance. "Clearly, the volume of funds managed in sterling are very significant and a substantial share of those funds are focused on the long end of the curve," says Terry Shanahan, head of securities syndicate at Société Générale in London. "That is why we see so much volume in the market for multi-tranche deals, with three, five and 10 year tranches in euros and anything longer in sterling. If the longer dated tranche of those deals were to switch to euros, it would open up a significant new avenue in terms of longer term funding, which would be very popular with issuers in sectors such as utilities."

Shanahan, however, echoes several observers when he says he does not expect to see sterling enter the euro in his professional lifetime. That prognosis seems to be shared by Goldman Sachs in its analysis of the Euro at Ten, which sees no prospect of a UK entry before 2020. "With the UK in the midst of a housing slowdown, the Bank of England facing criticism following the collapse of Northern Rock and the ECB being praised for its handling of the crisis, could public support for EMU in the UK have risen?" asked the Goldman Sachs report, providing its own rather unequivocal answer. "We asked ICM to conduct a poll on this issue in May and the results were as follows: 23% in favour and 73% against. The balance of 50% against is close to a record."

Broadening the depth and liquidity of the euro capital market — which the inclusion of sterling would do — would have important ramifications for its global competitiveness, because for all the talk of its credentials as a serious rival to the dollar market, the recent crisis in global financial markets has exposed many of its weaknesses.

Above all, it has demonstrated that execution risk in the euro market remains much more acute than in the US dollar universe, which has demonstrated its capacity to remain open — albeit at a price — in more or less any circumstances. "In August 2007 the new issue markets in Europe were completely frozen, while in the US, investment grade corporate issuance had a record month," says John Winter, head of European investment banking and debt capital markets at Barclays Capital in London. "It was a similar story in January 2008. US issuers and investors seem to adapt more rapidly and pragmatically to changing market conditions than their counterparts in Europe."

An inevitable by-product of emotion is volatility, which borrowers say remains a conspicuous characteristic of the euro market relative to its dollar counterpart. "The financial turbulence we’ve seen over the last year has shown that although we are coming closer to the standards and depth of the dollar market, the euro market remains more volatile," says Horst Seissinger, head of capital markets at KfW in Frankfurt. "But given that it is still only 10 years young, I would say that the euro has been an extremely successful market."

30 Sep 2008