Focus on currencies – Euro, a tale of two sides

The euro is a peculiar currency.
It is used in 17 countries with very different economic models and fundamentals, which share a monetary policy but not a fiscal one.

And it has been quite a complex one in terms of forecasting over the last year or so, since the Greek sovereign debt crisis has become a global one.

Since August 2, the day on which ECB President Mario Draghi (pictured) committed to significant and costly policy actions to save the common note, the euro has been gaining steadily ground against the dollar, reaching a fresh high of 1.353 on August 23, on the back of possible further quantitative easing to be announced by the US Federal Reserve.

According to Adrey Dirgin, head of research at Forex Club, the single currency could reach 1.27 against the dollar by the end of September.
A forecast which would have been considered extreme only a few weeks ago, when EUR/USD was flirting with the 1.20 mark.

Yet, the future of the European currency is all but certain, even when it comes to its very own survival.

Banks, asset managers and corporates have been planning for the odds of a Grexit scenario for a number of months, and despite the political commitment to keep the monetary union together is getting stronger, Citigroup assigns a 90% to a break-up within the next two months.

Even sovereign states, as in the case of Finland, are stress testing their systems against this scenario.

“We have to face openly the possibility of a euro-break up,” said Erkki Tuomioja, the country’s veteran foreign minister. “Our officials like everybody else and like every general staff, have some sort of operational plan for any eventuality.”

As the eurozone becomes ever more entangled in the debt crisis, the likelihood of an accident increases, according to Nomura.

“The need for serious contingency planning forces us to examine the small print to determine likely outcomes for euro linkers and inflation swaps. The most challenging case would be if Eurostat and the eurozone HICP index ceased to exist. But we also need to address what would happen if a particular country unilaterally left the eurozone,” said David Mendez-Vives and Nick Firoozye, fixed income researchers at the Japanese bank.

According to the analysts, as European fixed income markets remain under heavy stress from the current sovereign credit turmoil, one of the biggest challenges of an exit would be the redenomination of bonds.

“Most bond markets in Europe are governed by local law. In fact, neither France nor Germany issues any foreign law sovereign debt and the presumption is that local law contracts and assets will be redenominated into local currency if any new currency law is adopted,” Nomura said.

This assumes that the currency law is simple and the legislature adopts a legal tender law, where all obligations to be settled can be paid in the new local currency.

This would then ensure that all German, French or Italian law bonds, whether corporate or sovereign are likely to be redenominated, together with the corresponding German, French or Italian law deposits and loans.

Meanwhile, the treatment of euro derivatives would be subject to a higher degree of legal uncertainty.

“It is clear that they will continue to pay euro if the euro exists, or a legislatively mandated replacement if that is determined. But failing that, redenomination into hard currencies has many, possibly unintended, consequences,” they said.


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