Greece Update

Currency in Crisis

The euro is bouncing back as the from its stop-loss triggered move to $1.3463. Perhaps it has been helped by a more resilient than expected US equity market. The euro's low of $1.3436 seen earlier this month appears safe at the moment, though the market does not appear finished for anything for the nearest of tenors. A move above $1.3520 would help stabilize the tone and may prevent another try lower after the European markets close for the day.

There seems to be two main forces on the euro at the moment. First, reports suggest Japanese asset managers have been featured euro sellers today and some are linking this to repatriation ahead of the fiscal year end.

Second and more important, the brinkmanship game in Europe is reaching a fevered pitch ahead of the EU Summit later this week.

The Deputy PM of Greece was on the wires and sounding fairly bellicose--suggesting that Germany is allowing its banks to speculate against Greece and that Germany is putting it own interests first and is embracing the weaker euro as a boost for exports. He also suggests that if no EU support mechanism is provided for soon, there will be no reason to have monetary union.

While sympathetic to the challenges it faces, the Deputy PM is probably exaggerating the case. First, German banks, like other European banks have extensive Greek exposure. Buying insurance may not be speculating. In fact, we hear that hedge funds, which had bought CDS on Greece on speculation that its debt and deficits were not sustainable, are not happy to sell to the banks who want more protection.

Second, Greece was not a founding member of EMU. The purpose of EMU was not to support the weaker credits in the region. Nor was it seen by most of its advocates as necessarily an optimal currency zone. Arguably political considerations were paramount. On what conditions could Germany be reunified?

Third, more cynically, the kernel of truth in the Greek claims may be that Germany might be happy for Greece to drop out. That is what the opinion polls seem to suggest. Merkel faces her first electoral test since the Greece issue has blown up on May 9th when NRW goes to the polls. There is not mechanism to evict Greece and there is no mechanism that allows Greece to leave EMU.

A cold cost-benefit analysis, would still suggest Greece is better off in EMU than outside. If it were to leave, its interest rates would likely skyrocket, forcing an even deeper contraction. There would likely be a huge Greek banking crisis. It would get a much weaker currency, but this may not be sufficient. The competitive gains would likely quickly erode by inflation. This is to say that currency depreciation is a poor substitute for structural reforms that boost Greece's competitiveness.