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The Euro – Anticipating the End Game

by Patrick Butler, Board Member,  Raiffeisen Bank International 

In the 1990s treasurers made a fortune from the ‘convergence trade’. Back then, future member countries were preparing for the introduction of the euro, diligently working towards fulfilment of the Maastricht criteria. These required a total government deficit to GDP of no more than 60%, an annual deficit no higher than 3%, and long-term interest rates no higher than 2% above the three lowest inflation member states. (Halcyon days!) Against this background, the assumption was that interest rates in those countries where inflation had traditionally been much higher than Germany’s would move down to match DM levels. That assumption proved justified and funding Italian government bonds, for instance, in DM, generated substantial carry profits, a capital gain and no counterbalancing currency loss.

During the past year, conversely, the smart money has been on the divergence trade, betting, essentially, on an increase in yields in the peripheral euro-countries relative to the hard core, in particular Germany. And that divergence has been dramatic. Greek Government five-year credit default swaps (CDS), for instance, started 2010 around 2.55% above Germany’s, and are ending it around 9% over. Despite, however, all the political noise and blame directed at speculators and wicked bankers, this phenomenon is caused not primarily by market participants actively shorting risk, but by a simple excess of supply over demand: a glut of debt-issuance by high deficit governments and an absence of investors. So extreme has this disconnect become that two member countries have already had to turn to the IMF and EU for financial support – a bail-out – and they may not be the last. Every day, politicians, media and market pundits prognosticate on developments, propose solutions and predict the next twist. The treasurer, though, needs to understand the drivers and dynamics so that he can prepare and, where possible, position for potential outcomes. Although the future could take one of a number of paths, that number is, in reality, very limited, as a brief analysis of how we got here demonstrates. 

In the run-up to monetary union much attention – correctly – was paid to ensuring that countries joined at the ‘right rates’; that their relative exchange-rate related competitiveness at the time was, as near as possible, equivalent. This was necessary to avoid the shock, and adverse consequences, not just on the affected country, but on the rest of the bloc, of an effective revaluation or devaluation on the part of any one state. Similarly, economic and monetary convergence were emphasised. As Wim Duisenberg put it in 1997: “… exchange rate stability can be achieved only in the presence of continued convergence of economic fundamentals – in particular price stability – and sound fiscal and structural policies”. Indeed, this was the raison d’etre for the Maastricht criteria, and a laudable, essential prerequisite for the common currency. 

Heady times

A two-tier, or rather, multi-tier Eurozone has developed, light-years away from the economic convergence envisaged and required.