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Euro devaluation this summer?

By Rodney Crisp - posted Wednesday, 29 June 2011


The new président of the European Central Bank (ECB), Mario Draghi, governor of the Bank of Italy, is not due to take up office until 1st November 2011. In the meantime, Jean-Claude Trichet, the outgoing president, has the unenviable task of guiding the euro nations through the worst financial crisis they have had to face since the adoption of the Euro as a common currency by eleven of the European Union (EU) member states on 1st January 1999.

Today, 17 of the 27 EU countries have adopted the euro. They constitute what is called the euro zone. A number of other countries, non-members of the EU, mainly micro-states such as the Vatican City, Monaco, San Marino and a few overseas territories such as Mayotte, Saint Barthélemy and Saint Martin, have also adopted it as their national currency. It is used daily by an estimated total of 330 million people, just under 5% of the world population.

Another 23 countries have pegged their national currencies directly to the euro, mainly on the African continent. The euro is the second most widely held reserve currency after the U.S. dollar. Itrepresents roughly 22% of currency reserves of the major economies and 33% of reserves ofdeveloping economies.

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The euro is now eleven years old and, by and large, has lived up to expectations. The coming months are going to be crucial as it braces itself to weather the storm of the worst sovereign debt crisis Europe has had to face since the Great Depression of the 1930s and the two World Wars. The current crisis was triggered when the sub-prime (poor quality loans) real estate bubble burst in the US in 2007. This had devastating effects not only in the US but also on all major European banks and financial institutions.

Governments came to the rescue of their banks by borrowing money on the international financial markets, creating a mountain of sovereign debt in the process. Some euro zone countries are now having difficulty honouring their debts.

While irresponsible house loans to people in the US, who had no means of paying them back, is what originally triggered the financial crisis, it was irresponsible management in Europe by successive governments of their country's national finances that made their economies unduly vulnerable.

None of the euro zone countries are free from criticism in this respect, apart from Germany, the only truly virtuous economy that underpins the euro. Ever since the disastrous economic conditions and galloping inflation that paved the way for the rise of Hitler and the third Reich prior to World War II, the Germans have developed a visceral attachment to strong currency. This is a principle that suffers little or no flexibility so far as they are concerned.

An increasing number of euro zone countries are nevertheless plunging deeper and deeper in debt due to high interest rates, low economic growth, high unemployment and aging populations. Debt is growing faster than the available fiscal income to repay it. Populations are already having difficulty making ends meet and their governments are imposing even tougher austerity measures on them.

There are already manifestations of social unrest in a number of countries. People reject the austerity measures that are unjustly being imposed on them, throwing the blame on their successive governments and opposing any recourse to international authorities such as the EU or the International Monetary Fund (IMF) for aid. They categorically refuse to accept the idea that they are no longer in sole charge of their country's financial affairs.

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All eyes are turned towards Greece at the moment. The EU and the IMF provided a life line of € 110 billion a year ago to avoid the country from becoming insolvent and have just promised an additional € 120 billion provided the government implements additional austerity measures. Throwing more money at the problem will gain time but few consider it will solve the problem. It is almost certain the additional austerity measures will act like oil on the raging blaze of social revolt.

It is not difficult to imagine that the flame of revolt may also spread to other euro zone countries experiencing similar difficulties to varying degrees. This includes countries like Italy, Spain, Portugal, Ireland and Belgium. Even France is carrying a heavy load of sovereign debt.

Greece has already had wage cuts, pension cuts, national budget cuts and tax increases. It is now obliged to embark on a massive privatisation campaign to sell off state held properties and public services. According to the new austerity measures the government will have to dispose of one large state-controlled company every ten days.

Tensions are growing not only on the street but also in parliament and could lead to a major political crisis bringing down the government and provoking new elections. This would result in the freezing of any further lending to Greece and plunge the country into default on its debt.

There has been some suggestion that the government should seek to restructure its debt with its creditors. In other words, try to negotiate a reduction of the debt of something between 20% and 50% and have the creditors write this off as pure loss, the alternative being that the country defaults and the creditors get nothing. The problem with this solution is that the international rating agencies would still consider it a default, making it impossible for any future Greek bonds to find takers on the market. Interest rates for other weak euro zone countries would also increase dramatically.

Default would be the worst solution. It would impact negatively on Greece's financial partners who would have to bear the loss. It would also have a catastrophic effect on Greece itself and its population already suffering considerable duress and struggling to survive. There would be a run on the euro as investors flee to safe havens and those weaker euro zone countries would feel the pinch as borrowing became more expensive. They would need further injections of fresh cash from the ECB and the IMF to prevent them from defaulting too.

In addition, the credibility of the ECB in maintaining a sound, stable euro would be seriously jeopardised. This could have negative repercussions on any future international investment in the euro zone.

Another suggestion that has been made is that Greece should take leave of the euro for whatever period is necessary for it to put its house in order. It could temporarily go back to the drachma at a one for one exchange rate, devaluate and come back to the euro when things get better. This would have the advantage of boosting exports and cutting labour costs but it would not solve the problem of the mountain of sovereign debt which could only get worse because of the devaluation. It would also generate heavy administrative costs.

There is no obvious, clear-cut solution the Greeks can implement to solve the problem. The best solution probably lies in a combination of several factors. They obviously have to put their house in order. A report by the Federation of Greek Industries last year estimated that the government could be losing more than € 20 billion a year on tax evasion. This must cease.

The austerity measures need to be revised in order to gauge their efficiency and make whatever adjustments may be necessary to alleviate the burden on low income families and individuals. Current plans for the massive sell-off of national assets and public services should be scaled down to a strict minimum and limited to non-strategic and non-cultural assets and services.

Greece spends 4.3% of its Gross Domestic Product (GDP) on national defence. This is the same as Russia. Compared to the USA's 4.7%, China's 2.2%, the UK's 2.7%, France's 2.5% and Australia's 1.9%, it is excessive. The defence budget should be reduced.

Finally, the ECB should bear its share of responsibility in the euro zone financial crisis for maintaining an over-inflated euro exchange rate of € 1.42 to the US dollar. Monetary specialists consider that its true economic value is closer to € 1.2 or € 1.15. When it was floated on 1st January 1999 it was quoted at € 1.14 to the US dollar. Since then the euro zone economy has not surpassed the economy of the USA by the 24.5% increase in the current exchange rate.

Significantly, the ECB operates from its head quarters in Frankfurt, Germany. Despite this geographic promiscuity with the euro zone's strongest national economy, the bank is totally independent and the sole authority for determining monetary policy. The euro is a floating currency subject to market fluctuations. It can only be regulated by the ECB. None of the individual member countries of the euro zone, including Germany, has the power or the right to manipulate it.

From the creation of the deutsche mark in 1948, until its replacement by the euro on 1st January 1999, the German currency was never devalued. In fact, it became so strong it was constantly revaluated during the period leading up to the creation of the euro. For over 60 years, the Germans have lived with a strong currency and it would be no easy task to persuade them that it is in every body's interest to devalue the euro.

Unfortunately, every solution entails inconveniences. The advantage of devaluing the euro is that it spreads the burden over the largest possible spectrum of stakeholders while leaving the door open for them to recuperate their losses as the currency appreciates over time.

If the ECB were to decide on a devaluation of the euro this should be accompanied by a series of operations on the Greek securities market by the ECB to force down the interest rates on Greek debt.

The timing of a major operation of this nature is important. Jean-Claude Trichet, the outgoing president of the ECB is French. He is fully aware of the pros and cons of devaluation. The French have acquired valuable experience devaluing the French franc. He is the right person to undertake such an operation and assume the responsibility, leaving a clean slate for Mario Draghi, the incoming Italian president.

Devaluations in France are traditionally conducted during the month of August when most people in Europe take their summer vacation and economic activity is at its lowest. The last one was in 1983 which came at the end of a series. It never particularly bothered anyone then. It should not now either.

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About the Author

Rodney Crisp is an international insurance and risk management consultant based in Paris. He was born in Cairns and grew up in Dalby on the Darling Downs where his family has been established for over a century and which he still considers as home. He continues to play an active role in daily life on the Darling Downs via internet. Rodney can be emailed at rod-christianne.crisp@orange.fr.

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