Europe's single currency has been hitting the main financial headlines in recent weeks as it declined sharply against the US dollar in response to the sovereign debt crisis in the eurozone and fears of contagion from Greece to other European countries (most notably Portugal and Spain, but also Ireland and Italy). This put substantial pressure on the value of the euro which fell to a four-year low against the dollar. The euro has shed 17 per cent from its January peak to its recent low of $1.2143 last week.
The €110 billion bailout package for Greece on May 2 was not enough to quell market concern and the euro suffered further as the spread (or yield differential) between risky Greek bonds and safer German bonds widened. The yield on the 10-year Greek government bond had briefly surpassed the 11 per cent level in recent weeks while the comparable yield on the German bund declined to its lowest level since 1990. The decline in German yields also helped prices of Malta government stocks rise towards their record levels.
To enable the Greek government to secure funding and avoid defaulting, the bailout package imposed a number of new austerity measures. Greece has been required to slash public-sector wages, raise taxes (including a hike in VAT rates), impose a new levy on businesses, cut pension payments and raise retirement age for some public-sector workers. Fears that similar austerity measures are necessary in other eurozone countries (such as Spain and Portugal) to come in line with more stringent requests by the EU and the International Monetary Fund has raised fears that the eurozone region could move back into recession. This placed further downward pressure on the euro.
The Greek bailout was followed by a €750 billion support package announced in the early hours of May 10 to prevent the crisis from spreading to other countries. While this initially seemed to have restored faith in the single currency as the euro had briefly managed to recover some lost ground against the dollar and global equities rallied on the day, markets remained very sceptical about the common currency.
On May 10, the European Central Bank also announced it would intervene in secondary markets to buy sovereign debt which, by supporting demand, would help euro member states to issue bonds and hold down their funding costs.
This announcement came in response to the increased yields demanded by the market for those countries mainly seen to be part of the crisis. The Spanish government immediately benefitted from the ECB intervention as it successfully tapped the bond markets last week.
As the euro suffered from these developments unfolding on a daily basis investors generally became increasingly concerned on the future value of the euro against major currencies.
Currencies always tend to overshoot and it had been widely argued for some time that the euro had been overvalued in recent years. Some analysts suggest that the euro is set to slide further and could be heading for parity against the dollar replicating the weakness of the single currency in the early years of its formation as shown in the movements of the euro against the dollar since January 1999. The euro was launched in 1999 at $1.1789, hit an all-time low of $0.8252 in October 2000 and since then appreciated gradually and peaked at $1.599 in July 2008.
BNP Paribas, one of the main proponents of euro/dollar parity, recently suggested that this level could be reached by Q1 2011, while other banks suggest that following the sudden decline in the value of the euro, this is likely to stabilise at around current levels until the end of 2010. However, a number of analysts are increasingly concerned that further adverse conditions could arise in the short-term bringing added downward pressure on the euro.
A very common measure of the relative value of a currency is to use the purchasing power parity. This currently indicates that the euro remains overvalued against the dollar. Some economists predict that the long-term "fair value" is between $1.10 and $1.20. However, the consensus is that the euro will trade at between $1.15 and $1.26 during the remainder of 2010.
The euro may remain under pressure also because the ECB is widely expected to maintain a loose monetary policy.
Before the outburst of the eurozone sovereign debt crisis, analysts were predicting the first euro rate hike to take place during the last quarter of 2010 or early 2011. However, following recent developments most commentators agree that the first rate hike in Europe will not happen before Q2 2011 at the very earliest. On the other hand, the US Federal Reserve is increasingly likely to start edging up interest rates towards the end of 2010 giving a further boost to the US dollar.
While the euro has lost significantly against the US dollar, it has suffered less against the British pound. The Bank of England recently warned that weakness in the eurozone was one of the main risks to Britain's export-led economic recovery and could be the main reason why sterling has failed to recover much of the lost ground against the euro. The recent political uncertainty in Britain also played its role in the movements of sterling in recent weeks. However, despite the significant UK budget deficit and the inherent risks of a coalition government, sterling is expected to appreciate against the euro in the coming months.
A decline in the value of the euro is not necessarily an all-round evil as many seem to have suggested in recent weeks. A cheaper euro will increase the attractiveness for tourists to visit the eurozone and this could alleviate the recent pressure felt by Malta's tourism industry when sterling weakened markedly since the start of the financial crisis at the end of 2008. Moreover, European exporters are set to benefit from this environment with the German multi-nationals such as BMW and Siemens expected to be among the main beneficiaries given the higher amount of sales to the US. Some suggest that this may actually save the eurozone from dipping back into recession as exports account for almost half of the German economy. Locally, ST Microelectronics should be a beneficiary of a weaker euro.
The sovereign debt crisis and the weakness of the euro could also have wide-ranging implications on local investor behaviour. Investors may feel more comfortable increasing their exposure to Malta's sovereign paper as evidenced by last week's hugely successful Malta Government Stock offerings which attracted considerable demand especially in the new 20-year paper.
Local investors may also seek a higher non-euro exposure in their investment portfolios as a hedge against the possibility of further euro weakness ahead. Currently, there are few non-euro securities listed on the Malta Stock Exchange and in view of the probability of increased demand for "foreign currency" securities by local investors, prospective bond issuers are likely to be more willing to offer bonds denominated in currencies other than the euro to satisfy increased investor appetite for such instruments.
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Mr Rizzo is director of Rizzo, Farrugia & Co. (Stockbrokers) Ltd.