Until recently, the notion of EUR/USD fracture was inconceivable to most market analysts who assumed that the breakup of the world's largest integrated economic bloc was simply too complex and too destructive to consider seriously. However, the events of 2011, which saw the sovereign debt crisis spread from the periphery to the very core of Europe, radically changed market perception as the idea of the euro break up suddenly became a very real possibility. Interbank FX dealing platforms even went so far as to run tests on the old regional currency units, such as the drachma and the lira, to be prepared just in case of such eventuality. Therefore, the upcoming year shapes up as a do-or-die year for the EUR/USD. The question on most traders' minds isn't whether the single currency pair will rise or fall, but whether it will actually survive the year intact. Market analysts are almost universal in their agreement that, in order for EUR/USD to remain a viable currency, the region will need to move towards much closer fiscal integration, but it remains to be seen whether EZ officials will be ready to make the necessary political adjustments to create a more unified European structure that can respond to the market challenges ahead.
Turmoil in the Credit Markets Engulfs All
In 2011, the Eurozone credit problems (which started with Greece the year prior) blew up into a full-scale crisis as one member after another came under the assault of bond market vigilantes. By the end of the year, it appeared that no country was safe as panic spread from the Southern periphery all the way to the Northern core. Although Greece was "patient zero" in this particular pandemic, in many ways, it was an outlier in the Eurozone. Unlike other European economies, Greece was clearly insolvent as its debt-to-GDP ratio rose above 150% while its revenue-raising ability was severely hampered by an inefficient and corrupt taxation system. The country needed immediate debt restructuring and capital infusion in order to revive the economy. Yet due to political considerations, theEurozone officials delayed any action and then imposed draconian terms on any bailout funds, insuring that the country devolved into a near economic depression. The net result is that Greece is now effectively a ward of the Eurozone, but worse, the delays and political wrangling that surrounded the whole bailout process destroyed investor confidence and emboldened the shorts to go after other weak European credits, exacerbating the crisis exponentially.
By the end of 2011, the credit crisis in Europe engulfed not only Greece, Portugal, Ireland, and Spain, but jumped directly to Italy - the region's third-largest economy and the world's fourth-biggest issuer of sovereign bonds. The turmoil in the Italian credit markets ended the career of Silvio Berlusconi whose anarchic-governing style dominated Italian politics for more than 19 years. In his stead, Mario Monti, a well-respected technocrat, became the prime minister. The markets welcomed the change, but the damage had been done. By the end of 2011, Italy was paying more than 7.5% on its 10-year bonds versus 4.5% just a year earlier.
Most analysts agree that this near doubling of debt costs is absolutely unsustainable. In 2012, Italy faces a roll of nearly 300 billion euros in its sovereign debt obligations. Most of these transactions are frontloaded to the first half of the year, making the financing even more challenging. Ironically enough, Italy is one of the few G-10 countries that runs a primary budget surplus, meaning that, absent interest payments, the country takes in more revenue than it spends. Yet, despite these impressive internals, Italy also carries a Herculean-debt burden of more than 120% of GDP, which is why the country is so vulnerable to a credit attack by the shorts. Italy simply cannot service debt at 7.5% with headline inflation at 3% or lower and GDP growth not expected to exceed 1%. The burden of carrying such high, real-interest rates is simply too onerous for the country to bear and many analysts fear that Italy will not be able to survive such harsh financing conditions if it's forced to deal with the problem unilaterally.
Half Measures But No Solutions
As the Eurozone credit crisis deepened, most market analysts have come to the conclusion that the region must implement a much more unified fiscal policy if the euro is to survive. Ultimately, that will mean some sort of a federal budget, a pan-European taxing authority, and a rationalization of pension benefits across the union. Such complete integration will require a massive cultural and political change from the region's 300 million plus citizens and is unlikely to occur quickly. In the meantime, the Eurozone will have to move towards issuing Eurobonds to address the concerns of the capital markets. Only by federalizing credit risk across all of its member nations will the Eurozone be able to lower the cost of financing for its peripheral economies to a sustainable level.
A recent European Commission study on the subject of Eurobonds offered three possible scenarios on how Europe could issue debt. The first and the most radical option would be to replace all of the national credit issuance by bonds backed by the whole EU. This course of action would create a huge capital market that could compete on equal terms with U.S. Treasuries, but it would also mandate extensive changes in the EU treaty and would require Europeans to give up much of their national sovereignty. A more moderate approach would be for euro area countries to issue "stability bonds," which would only be partially guaranteed and would be subject to caps on volume. Such a solution could provide some relief to beleaguered Club Med economies, but it may not be enough to stabilize the markets. Finally, a third way would allow EU countries to issue a limited amount of "blue bonds," which would enjoy the collective backing of all of the members, and thereafter issue "red bonds," which would be backed solely by the issuing sovereign.
For the time being, European fiscal officials have been highly reluctant to adopt any of these proposals as Germans are loathe to dilute their balance sheet while periphery members are reluctant to cede authority over budget matters to some supra-national entity. The only policy response has come from monetary authorities and it has been limited at best. Because the ECB is legally prevented from buying member bonds on the primary markets, the central bank has been woefully ineffective at controlling the interest spikes suffered by Spain, Italy, Portugal, and other member nations. Instead, the ECB has tried to support the secondary market, but even there, its participation has been limited at best. The ECB has contained its purchases to no more than 20 billion euros per week, sterilizing the trades for minimum impact. Little wonder then that its activities have been woefully ineffective.
In a perfect world, the Eurozone would quickly move to a Eurobond solution, allowing member nations to mutualize the credit risk across the whole region. Such a structure would put an end to the endless game of hunting the next weakest credit, but it is unlikely to become policy anytime soon due to fierce resistance from Northern Europe. Instead, policymakers are trying to use a multifaceted approach that includes more aggressive intervention from the ECB, a mild leveraging of the EFSF, and the prospect of using the Fed along with 17 central banks from Europe. Together, they would create a lending consortium that would provide a "triple-digit billion" loan to the IMF. This would be used to create a special fund that would help finance troubled credits in the Eurozone region.
It appears that authorities on both sides of the Atlantic are coming to the conclusion that the central-banks-to-IMF scheme is the most expeditious policy response to the sovereign debt problem. It neatly sidesteps many political barriers by providing much needed capital without obtaining legislative approval. Yet, the jury is still out on whether this course of action will actually pacify the credit markets and create a viable firewall around the biggest EU sovereigns.
Teetering on the Verge of Recession
Meanwhile, as Eurozone officials struggle with the burgeoning debt crisis, the turmoil in the markets is clearly expanding into the real economy. The region's basic measurements of economic activity have all turned sharply lower. Both PMI Services and Manufacturing surveys have dipped below the 50 boom/busts line for the past three months in a row, indicating that the region as whole will likely contract in Q4 of this year. The ECB has acknowledged the rapid deceleration in activity and the new ECB president, Mario Draghi, surprised many market observers with a rate cut of 25bp at the October meeting and added another 25bp cut in December. The drop in the benchmark rates has had no meaningful impact on stimulating lending and instead, it simply served to partially offset the major contraction of credit conditions caused by the volatility in the sovereign debt markets.
Going forward, it is almost certain that the ECB will need to cut rates further as it tries to counterbalance the draconian austerity measures demanded by the market. The irony of the situation is that, even if the Eurozone officials are able to weather the storm in the capital markets, the massive budget cuts required to bring the balance sheets to order will likely result in a severe recession in the Eurozone as government demand is removed from the economy.
2012 may well be the moment of truth for the Eurozone as the region struggles to resolve the issues of sovereignty and currency. There is little doubt that the single currency project has been a massive economic success for the region, eliminating many former barriers to trade while making commerce much more efficient and friction free. The euro has made the Eurozone not only an economic powerhouse, but a political force to be reckoned with as Europeans compete on an equal footing with Asians and North Americans on the global economic stage. The testament to the strength of the idea lies in the price of the euro itself. Despite all of the problems, the euro trades at 130% of the greenback as the Eurozone remains the largest economy in the world. The key to maintaining that status will mean that member nations will have to sacrifice political sovereignty in return for economic prosperity. If they are finally willing to make that adjustment, the euro will survive and may once again prosper. If not, 2012 may well become the year that the single currency experiment in Europe comes to a chaotic end.