A decade ago you could not avoid the euro. Every conference organizer and bank was jumping on the events bandwagon in the run-up to the launch of the single currency on January 1 1999. However, as the single currency approaches its 10th year it is hard not to think that this fanfare was fully deserved. The single currency has not only survived, it has prospered. With the euro climbing to new records against the US dollar on an almost daily basis there are doubtless plenty of smug central bankers in Frankfurt.
However, in spite of its apparent success, the euro looks more vulnerable now than at any time since its creation. The reason is the diverging fortunes of the Europe’s economies. Germany runs the world’s largest current account surplus in absolute terms, at $286 billion, or more than 5% of its GDP. Spain runs the world’s second-biggest current account deficit, $161 billion, or 9% of GDP. Global imbalances have been debated ad nauseam in recent years. European imbalances could soon rise up the agenda.
This diverging economic performance of the eurozone’s biggest and fourth-ranked economies is the clearest symptom of the problem. Forward indicators in Germany, such as the Ifo business confidence index, have remained remarkably resilient. The index rose in March for the third month running, confounding economists. If Europe’s heartland is on the brink of an economic crisis, it seems that the businessmen polled by Ifo have not noticed.
In Spain
The picture in Spain could not be more different. The Spanish services sector purchasing managers’ index (PMI) recorded its sharpest ever fall in March, from 46.1 to 40.9. Spain’s housing bubble is also deflating. Having risen by 270% since 1995, house prices are now declining in real terms, with the year-on-year gain in March just 4%. The Asprima real estate association expects prices to decline by 8% this year.
That matters in an economy where construction accounts for 18% of GDP, 13% of employment and one-third of new jobs created since 2005. The prospects for these workers look grim. Some smaller property companies have already filed for insolvency. As in the US, there is a supply overhang. Spain has been building 800,000 new homes a year – more than France, Germany and Italy combined. According to Goldman Sachs there are now 650,000 empty homes.
The re-elected government of José Luis Zapatero has announced a €10 billion fiscal stimulus package to try to prevent an economic hard landing. It might work but being in the eurozone limits other policy actions. If the Spanish still had their own currency, the government would have devalued it by now, or the markets would have done it for them. Instead, bond yields tell the story. Just two years ago the Spanish 10-year bonos yielded less than the equivalent Bund. Recently, the spread of bonos over Bunds breached 40 basis points for the first time since the launch of the euro.
It is abundantly clear that the policy prescription offered by the European Central Bank is no longer appropriate for Spain. Nor is Spain alone. The spread of the 10-year Italian BTP over the equivalent Bund has also hit a record in recent weeks. Italy is teetering on the brink of recession. In the past 20 years the industrial production performance of the four biggest eurozone economies – Germany, France, Italy and Spain – has only once been as divergent as it is now.
No wonder France’s president Nicolas Sarkozy has been complaining that the European Central Bank should pursue a twin strategy of targeting inflation and growth, like the US Federal Reserve. Italy’s newly elected prime minister Silvio Berlusconi will be a vocal ally.
Those who believe that the euro will break apart because of these internal stresses will probably be proved wrong. Spain is often cited as the favourite to pull out of the euro. That can be justified in economic terms but does not marry with the political realities. Being part of the wider political and monetary union has helped assuage Basque and Catalan nationalists. If Spain toppled out of the eurozone the country could unravel.
However, the Gold Standard fell apart during economic hardship following World War I and the Great Depression. The single currency will be tested as never before if the tough monetary policy stance of the ECB precipitates a broad recession. Those crowing at the success and strength of the euro should pause. Nemesis follows hubris.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own