Treasury Today Country Profiles in association with Citi

Euro defies gravity

Something is amiss… the value of Europe’ single currency remains stubbornly high despite the financial chaos engulfing the Eurozone. How is the euro standing strong while Rome burns?

In the past year the euro has risen 3% against the US dollar and remains on par with its value against the pound sterling last November. This is remarkable given that all five governments of the Eurozone periphery have fallen due to the economic troubles stemming from the crisis. Investors are perplexed. Shouldn’t the value of the euro be collapsing with confidence in the Eurozone at an unprecedented low?

The answer, it seems, is no. A curious disconnection exists between developments on the bond markets, on the one hand, and the foreign exchange market, on the other. The euro simply refuses to go into free-fall. In recent weeks, investors, prominent among them hedge funds, have lost a lot of money amid frustrated attempts to short Europe’s single currency. Indeed, as the Financial Times reported earlier this week, many have even started to throw in the towel and look for FX opportunities elsewhere.

“I must admit I am a bit surprised by the developments in the FX market,” says Robert Bergqvist, Chief Economist at SEB, a financial institution based in Stockholm. “I have been quite concerned about the Eurozone for some time and have been surprised by investors still showing some confidence in the euro.” Nevertheless, the euro’s strength is relative. Keep in mind that both the US dollar and pound sterling have depreciated in the last twelve months.

Too big to fail?

One possible reason for the euro’s surprising resilience could be its status as a global currency, argues Bergqvist. “The problem for very big investors is that you don’t have many alternatives. I think the answer to some extent is the lack of reserve currencies to invest in. As a big investor you simply have to invest your money in euro and US dollars,” he says. The Chinese government is one example. As it reduces its exposure to US dollars, it has looked elsewhere – particularly to the other side of the Atlantic divide.

Furthermore, often overlooked is the important role played by the European Central Bank earlier this year. Under Jean Claude Trichet, the former ECB president, the central bank has pursued a more hawkish monetary policy compared to the American Federal Reserve and the Bank of England. In July, its Governing Council raised interest rates by 25 basis points for the second time in the space of a few months. Investors, who were then still on the lookout for higher yields, saw the euro as an attractive investment despite its troubles.

“I would say in the first four or five months of this year that higher yields in the Eurozone were instrumental for a stronger euro against the dollar,” says Niels Christensen, Chief FX Analyst for Nordea, the leading financial institution in Northern Europe. “Believe it or not, it seems that the interest rate differential is a much stronger driver for the euro/dollar than the debt crisis on both sides of the Atlantic.”

Scandinavian side effects

One spill-over effect of the euro’s strength, however, has been the unwelcome attention received by Nordic and Baltic economies. With investors seeking value elsewhere, many are now looking at FX opportunities in Scandinavia and along the Eurozone’s eastern periphery.

“We have seen quite a strong appetite [for Nordic currencies] from foreign investors, who would have originally liked to make investments in euro, but who have now made these investments outside the Eurozone,” says Bergqvist. These large capital flows are creating problems of their own. Given the relatively small size of the Swedish, Estonian and Latvian markets, large investments could be creating liquidity problems down the line.

Meanwhile the euro marches onwards, coping surprisingly well with the Eurozone crisis. But the pressing question remains: how long will the euro survive if the Greek and Italian economies keep burning?