Saturday, 26 May 2012

“Should I ask to be paid in pounds?”

A friend who had recently moved from the UK to a new job in Europe recently asked the question which is the title of this posting.  While the question may have been half in jest, it did reflect concerns about what will happen to the euro if Greece was to leave.  The reply was that there was not much to be worried about and here’s why.

For starters, Greece is very small in comparison with the rest of the Eurozone.  The GDP of Greece is only just over 2% of the GDP of the Eurozone.  A larger currency union means that people would have more reason to hold money in that currency and this would increase demand and the value of the currency.  But because Greece is so tiny and not central to business in Europe, the effects on the value of the euro from its exit would be minimal. 

Forgetting about other factors, the departure of Greece may even be a boost to the euro as it would end a saga that has brought a cloud over the euro.  However, it is the possible follow-on effects more than the actions of Greece itself that are the real concern.  If one country leaves the euro, it sets a precedent and makes it easier for others to follow.  Investors then begin to worry about this and move their money out of any struggling country which in turn makes it tougher for these countries and increases the likelihood that they also may have to leave the euro.  People in those countries would start withdrawing money from banks due to fears about losing out with the change to a new and weaker currency. 

The fears about other countries leaving the euro then become a self-fulfilling prophecy and one country after the next may become the target of this.  In this manner, first, the smaller countries of Portugal and Ireland, then probably Spain, followed by Italy, and even maybe France could fall like dominos.  If such a chain of events begins, it is difficult to know where it might end. 

What would be required to stop this would be the leaders in Europe drawing a metaphorical line in the sand to state that Europe stands behind a certain group of countries.  The leaders in Europe need to show conviction in standing behind the struggling countries and earn the trust of investors who will not bring their money back until they think it is safe.  As obvious as this sounds, it is not something that Europe has managed so far and still may be beyond their leaders.

Despite all the turmoil, the euro as a currency has held up surprising well.  Demand for the euro has stayed strong due to the size of the Eurozone which makes the euro a useful currency to have.  Even though there has been lots of selling of bonds issued by Greece and others, German bonds have been popular.  Big investors and others with lots of cash such as reserve banks in Asia like to spread their investments over many different regions and will always hold a large portion in euros.  Investors who want to make money from the troubles in Europe have done so by selling bonds of particular countries rather than selling euros.

So the euro has stayed around 1.30 vs the US dollar so far this year which is similar to where the euro was trading at the beginning of 2011.  A weak patch this week prompted the euro to drop to near 1.25 vs the US dollar and hit a two year low (or a three year low of 0.80 vs the UK pound).  It remains to be seen whether this is just a blip or whether investors have become fed-up with politicians and are moving money elsewhere.  Either way, my friend may lose a bit of money if he wants to convert it back to pounds but that all depends on the timing of the change as the euro is likely to recover at some stage.  However, it is not something to lose sleep over (yet).

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