Investors in the currency market have in general been fairly forgiving of the euro for most this year. Peripheral concerns might have been raging around it, but the euro was boosted by the success of its biggest economy Germany, a fast-growing, financially secure behemoth.
But now the worst has happened. Italy has been uncovered as a slow-growing, high debt, inflexible economy with a demographics crisis. It is the third largest economy in the Eurozone. Whereas in the past a blind eye was turned as the bigger economies clocked up eye-watering rates of debt this is not the case now.
The EU officials and various branches of authority have made a mess out of solving the Greek crisis, so investors can't have much faith that they will have the answer if a larger economy falls. For example, a few days ago an EU official admitted that there is no plan to bailout a "core" European economy.
The euro is coming under some intense pressure and without a quick resolution it may go into free-fall. Right now hedge funds, retail traders and even trading models have been liquidating their long euro positions. Real money, trader talk for sovereign wealth funds, has mostly stayed on the side lines according to latest reports.
Sovereign wealth funds or SWF's tend to be long-term investors, so the question is will they start to get cold feet about holding the single currency, especially if they think it won't survive in the long-term?
Italy has seen its bond yields surge by over 2 per cent to 5.5 per cent since November 2010, although they remain below the 17 per cent investors charge to hold 10-year Greek debt. Even so, if you have EUR2 trillion of debt on your books, plus nearly EUR300 billion of debt to issue this year every basis point counts and Italy has seen the cost of financing its debts soar in recent weeks.
The problem with the Eurozone is that too many economies are high debt/ slow growth. Germany is an anomaly since its debt levels are manageable and its economy is competitive. But that is not the case for France, which has a EUR1.8 trillion debt burden and Spain, which has EUR980 billion.
Growth rates are also too slow to reduce these debt burdens, especially in the core economies. Since 1996 the average growth rate in France has been 1.7 per cent and 0.8 per cent in Italy. In Germany growth may be accelerating at nearly 5 per cent annual rate, but since 1996 the average rate was only 1.3 per cent, so recent years look like an anomaly more than the norm.
Spain's economy has grown on average by 4.9 per cent in the last two decades, but fast growth has masked rising wages and falling competitiveness that is now marring its recovery and return to fiscal sustainability.
When you look at the hard facts you have to wonder why the Eurozone was ever formed. With such broad-based structural problems it seems like a disaster waiting to happen.
So what will it take to ensure the survival of the currency bloc and thus the euro? Firstly, debt loads are too big. For smaller nations like Greece plans are already in motion to remove some of the debt burden through default. If it happens in Greece then there is nothing to suggest it won't happen in Italy. While this is going to be painful for investors in the short-term, in the long-term it will help market to functionality.
For too long investors were mis-pricing risk and treating sovereigns including France, Italy and even Greece like they were essentially "risk-free' entities that could not default. But this crisis has been a wake-up call to us all. Sovereigns are risky and they can default. Now investors realise this they can start to price it in. Once you can price the risk of an asset with relative accuracy people will start to buy it.
Sometimes the most painful decisions are the best medicine. Europe needs to cut its debts, even if it means default. It then needs to learn to live more within its means - that means cutting overly generous welfare states and being realistic about what level of public expenditure it can afford. Next it needs to come closer together: Eurozone countries need to have standard fiscal policies, tax collecting policies and spending targets.
The end result may differ dramatically from what the founding fathers dreamt of for their currency union, but it could ensure the survival of the euro and the faith of long-term investors.
© Forex.com 2011
