Why Is The Euro Falling?

By Geoffrey Michael | October 09, 2011 AAA

When the euro was introduced as an accounting currency in January 1999, it was worth about US$1.179. It went into a downtrend that resulted in a low of 82.5 cents in October 2000. It bounced off that low and started a multiyear uptrend that lasted until July 2008 when it touched $1.60. By Oct. 18, 2011, the euro had slipped to $1.38.

TUTORIAL: Forex Currencies: Introduction

Placed into circulation in January 2002, the euro is administered by the European Central Bank (ECB) and the eurozone central banks. Together they comprise the European System of Central Banks headquartered in Frankfurt, Germany. The member banks are involved in printing and distributing the currency, but only the ECB establishes monetary policy.

PIIGS
The countries comprising the PIIGS are Portugal, Italy, Ireland, Greece and Spain. All five countries face structural economic problems and the possibility of defaulting on their debts, and all five use the euro. Greece is in the most imminent danger of default as a result of years of government spending that exceeded revenues. (For related reading, see 7 Things You Didn't Know About Sovereign Debt Defaults.)

Standard & Poor's slashed Greece's credit rating to the lowest in the world on June 13, 2011. S&P's view is that any restructuring of the debt would impose less favorable terms than the debt being refinanced, and would eventually result in a de facto default. The possibility of defaults by Greece and other PIIGS nations has put downward pressure on the euro.

Adding fuel to the fire, on Oct. 7, 2011, Fitch cut the sovereign credit ratings on Spain and Italy by two notches and one notch, respectively. It also maintained its negative outlook on both countries which means that more downgrades could be forthcoming absent substantive changes in fiscal policy.

Both countries rely on bond purchases by the ECB to keep yields from increasing to unsustainable rates. The situation in Italy has been exacerbated by a sex scandal that has weakened and distracted the government headed by billionaire Prime Minister Silvio Berlusconi. Italy's rating is now equivalent to that of Slovakia and Malta. (For related reading, see Why Bad Bonds Get Good Ratings.)

National Debt
The economic and fiscal problems in the PIIGS nations have been the primary cause of weakness in the euro relative to the dollar. In this case, the dollar may be the lesser of two evils since the U.S. has its own share of financial issues and economic weakness. In addition, S&P downgraded U.S. Treasury long-term debt to AA+ for the first time on Aug. 5, 2011, putting it behind a dozen other countries. It also shifted its long-term outlook to negative, which means it doesn't believe that current government fiscal and monetary policies are likely to restore the AAA rating anytime soon.

In spite of the downgrade, U.S. Treasuries have remained a desirable safe haven when compared to other regions, especially Europe. As Treasury prices have risen, long-term interest rates in the U.S. have steadily declined, with the 30-year fixed mortgage now below 4% for the first time on record. This is typical when the perceived risk of deflation outweighs inflationary fears, and Treasury yields move inversely to prices.

Business Impact
The euro's weakness is a double-edged sword for American consumers and businesses. For Americans traveling to Europe, the stronger dollar is a benefit because they will get more bang for their buck. More favorable exchange rates will allow them to stretch their dollars when purchasing goods and services in Europe. It's also a benefit to American companies with a European presence since they pay salaries with the euro.

For American businesses that export to Europe, the stronger dollar means that the cost of their goods will appear higher to European importers. Higher costs could be passed on to European consumers in the form of higher prices, which would have a depressing effect on demand. This means lower sales volume for American exporters which have already been hurt by a lingering recession.

American businesses that import products from Europe see the opposite effect, as their purchasing power is increased by a weak euro. Their savings can be passed on to American consumers in the form of lower prices, or they can hold their prices and increase margins.

Economic Impact
A weaker euro acts as a short-term currency devaluation that could stimulate job growth and economic recovery in Europe. It would likely improve the trade balance with the U.S. as a lower exchange rate would increase European exports. Over a one-year period, the Organization for Economic Cooperation and Development estimates that 1% growth is achieved for each 10% drop in the euro relative to the dollar.

The fear is that a financial collapse in Greece could have a domino effect across Europe. The relative strength of the entire banking system is in question, and the spillover effect could be catastrophic. With the exception of Germany, high unemployment and declining industrial production continue to plague most of the region.

The Bottom line
The recent news coming out of Greece and the other PIIGS nations has been filled with talk of austerity programs, bailouts, debt downgrades, debt restructurings and default. This turmoil has kept U.S. interest rates in check as demand for U.S. Treasuries has not waned. It has also allowed the U.S. to finance its deficits with cheap money, a situation that won't continue indefinitely.

This is a dynamic situation that will continue to unfold. On Oct. 10, 2011, French President Nicolas Sarkozy and German chancellor Angela Merkel announced a plan to recapitalize European banks and a long-term package to deal with the debt crisis. The details are not yet public, so the impact on the euro remains to be seen. (For related reading on the euro, see The Euro: What Every Forex Trader Needs To Know.)

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