For euro, strains are just beginning

Even without a spectacular flameout in Greece, Italy, Spain or Ireland, the euro faces sustained systemic pressure as its member states grapple with unresolved built-in pressures.

While the focus, for Greece particularly, is on how the country will dig its way out of its fiscal hole, the fact is any solution will involve deep pain and difficult politics. That is likely to present any number of pitfalls for euro holders, not least that even if the euro zone can hold together, the European Central Bank may keep rates lower for longer as part of an effort to salve the pain of the peripheral countries.

The European Commission is examining a Greek proposal to cut its deficit to 2.8 per cent of gross domestic product in 2012 from a gargantuan 12.7 per cent in 2009. Those figures are of course open to debate, especially considering that a European Commission report showed Greece had for years deliberately misreported budget deficit data under a system in which statistics were open to political manipulation. Rather than a five per cent budget deficit, Greece instead had one of 7.7 per cent, prompting debt downgrades and speculation it will require a bailout or could even exit the union or default.

While less stark, and in Ireland's case more aggressively addressed, other small euro zone countries are suffering from similar difficulties. All of the euro zone must live with one monetary policy and limited labor mobility, despite huge variations in competitiveness across the zone.

"The sharpening internal strains illustrate that the euro zone is far from being an optimal currency union," Citigroup currency strategist Michael Hart wrote in a note to clients. "And this will ultimately make itself felt in the value of the euro."

First, the easy part: Greece almost certainly will not default and is even less likely to leave the euro project. Neither, at least for the foreseeable future, will anyone else. Besides the fact that there is no clear structural framework for euro exit, a country foolish enough to do it would face crippling financing costs. Default is only slightly more possible, but still vanishingly so; a country within the euro tent will be helped to some sort of a plan that can service debt. The likelihood that the group marriage that is the euro will survive, however, is not an assurance that the currency will hold up well against its major trading partners.

Ironically, one of the best things the euro has going for it as an investment is that it is up against such a weak field. Britain faces its own debt difficulties and must cope with the contraction of an out-sized financial sector. Japan is an aging country with a huge debt burden. It currently enjoys very low financing costs but it is a bit like a 60-year-old in Florida due to retire in two years but with a 30-year mortgage on a teaser rate. And finally the dollar, though still the world's reserve currency, is subject to huge risks too.

Greece, for example, suffers from an enormous competitiveness gap with Germany, a manifestation of which is that Germany has a large current account surplus and Greece a deficit. But unlike in the United States, Greek citizens are unlikely to move to Duesseldorf, staying instead in a country with no currency it can devalue to regain market share.

Leaving the currency union might allow Greek exporters to prosper, but the country would face a huge increase in its interest bill as creditors demand more from a weak stand-alone. Depositors in Greek banks might also take fright and exit for rivals within the currency zone, making a banking crisis as part of leaving a very real threat.

So what does Greece staying within the euro look like? What too may be in store for other peripheral countries with weak positions? An extended recession, as wages are pushed down and export prices fall to competitive rates. This will not be easy, nor will it be popular.

And because it is a process rather than an event, it means the euro faces literally years of internal pressures, pressures that will be closely watched by the debt and foreign exchange markets. Imagine, for example, that Greece arrives at an agreement with the European Commission over a budget plan. Well and good, and perhaps that will remove the current pressure on the euro. That event is only a small part of what needs to happen, only an opening chapter.

Greece must then live with its bargain, and investors must face up to the risks of it, and of similar discussions and strains to come in Italy and Spain. 


- The writer is a Reuters columnist. The opinions expressed are his own