Why the euro won't weaken

When the eurozone sovereign credit crisis first emerged in 2010, the euro fell by about 10% trade-weighted and by 14% against the dollar. Recent developments in Greece and Italy strongly suggest the crisis is deeper and politically more intractable than was apparent in 2010 but the euro has proved remarkably resilient.

There are two principal reasons why the euro is holding up and why, in our view, it is more likely to rise than to fall in coming months. The euro has a strong external position and crisis resolution is in the interests of all concerned.

Developments in Greece and Italy strongly suggest that the public finance problem in some eurozone countries is much more serious than had originally been thought. While austerity measures will help reduce new borrowing requirements, they will do nothing to help service the existing very large outstanding stocks of debt.

These are manageable as long as yields remain low, but debt dynamics rapidly become unsustainable as yields rise. The more debt looks unsustainable, the fewer investors want to hold the bonds, and the higher the yields move. In addition, fiscal austerity measures are more likely to mean that the economy is unable to grow rapidly enough to service the debt.

Fears of debt unsustainability have driven bond yields to unprecedented levels. The deepening fiscal crisis has been met with what are widely regarded as, thus far, unconvincing policy responses from eurozone officials. Nevertheless, the euro as a currency has performed relatively well.

The fact that the euro still manages to trade above 'fair value'...is either saying something very negative about the dollar or that the position of the euro is not as dire...

It has been trading in a 'normal' way. Relative moves higher in euro rates have been associated with moves up in the euro. The strength of this relationship may reflect the dominance of the 'risk on-risk off' phenomenon. When the markets are 'risk on' they expect the European Central bank to continue to normalise rates and both swap rates and the euro move higher: when the markets are 'risk off' they fear a continued reversal of course by the ECB and both swap rates and the euro move lower.

And the euro is still trading in 'overvalued' territory, despite the crisis. The fact that the euro still manages to trade above 'fair value' compared with the OECD purchasing power parities is either saying something very negative about the dollar (which is possible) or that the position of the euro is not as dire as it is popularly assumed to be.

There are two main reasons for the euro's performance and they suggest the euro is more likely to rise than to fall in coming months. First, from an external point of view, the euro is indivisible. It is impossible to buy or sell a 'Greek euro' or a 'German euro'. For the currency market it is the position of the eurozone as a whole that matters, not its component parts. On this basis, the euro is in a strong position. The current account position of the euro is close to flat. While Germany has a current account surplus of over 5% of GDP, France, Italy and Spain have deficits of between 2% and 4%. The challenge for the eurozone policymakers is to manage these internal imbalances through transfers or changes in relative competitiveness.

But while the current account balance is close to flat, net portfolio flows into the eurozone are positive and have been trending higher in recent months. Some have argued that the strength of the euro merely reflects banks repatriating capital to shore up their balance sheets, and that it will fall once this is complete. While it is difficult to disentangle the portfolio flows, there is no clear sign that inflows only reflect bank capital repatriation. And even if the repatriation argument was holding the euro up, it is difficult to argue that it will end soon.

...while eurozone bonds and equities have been badly affected, the euro has proved remarkably resilient.

If current account flows are flat and longer-term capital flows (portfolio and direct investment) are positive, then short-term money flows must be negative. If the euro were being supported primarily by bank repatriation, then this should be seen in money inflows, but this is not the case.

The second main reason for the euro's performance is that politicians around the eurozone are well aware that a resolution must be found. It cannot simply be a choice between 'bailing out profligate governments without limit' (the Northern European fear) and 'killing the economy with austerity' (the Southern European fear). The costs involved in fixing the institutional weaknesses of the eurozone are far lower than the costs of failure. For this reason, we expect a lasting resolution to be found.

However, political decisions like this will almost certainly take far more time than the markets will be willing to wait, so an interim solution involving a reluctant ECB seems inevitable. The ECB has already been engaged in sterilised government bond buying, however it would be possible for it to do much more.

The worst case scenario of members choosing or being forced to leave the euro has been given more credence by German chancellor Angela Merkel's reaction to the prospect of a Greek referendum. While there is nothing in the EMU treaty about a country leaving, it is a theoretical possibility though we do not attach a very high probability to such a move.

Any euro exit would undoubtedly be surrounded by severe market uncertainties that would cause a 'risk off' retreat into the dollar in the short term, but the revised euro may then begin to rise. An exit by one or more 'peripheral' countries from the euro would ultimately put the currency under upward pressure as the remaining euro would behave a bit more like the Swiss franc.

The Eurozone fiscal crisis has deepened substantially during 2011, and politicians have been slow and faltering in their response. However, while eurozone bonds and equities have been badly affected, the euro has proved remarkably resilient. This reflects the strong external position of the euro, and expectations that a lasting resolution will have to be found. In our view, a gradual move towards a resolution is the most likely outcome, and as the news flow becomes less negative then the euro is more likely to rise than to fall in coming months.

This report must be read with the disclosures, analyst certifications and the disclaimer.