Odds of an eventual “Grexit” (i.e. Greece’s exit from the euro area) have risen sharply since June 30, 2015, when the embattled nation’s bailout extension expired and it missed a payment to the International Monetary Fund (IMF) totaling about EUR 1.5 billion. Shortly before the June 30 deadline, hopes were high for a last-minute resolution to the contentious debt discussions between Greece and its lenders that had dragged on for months. However, Greek Prime Minister Alexis Tsipras’ snap anti-austerity referendum announced on June 27 threw the proverbial spanner in the works.
On July 5, the referendum results showed that 61% of the Greek electorate had rejected demands from Greece’s creditors for economic austerity. But this was a Pyrrhic victory for Tsipras, as the odds of Greece leaving or being forced out from the euro area or “eurozone” have now risen to between 40% and 60%, according to a number of major brokerages. Standard & Poor’s assigns the probability of “Grexit” at 50%.
What would be the value of the euro if Greece does leave the euro area? While the answer to this question is no longer an academic exercise, in order to understand where the euro might trade, we first need to understand the genesis of the European Union and the trading history of the common currency.
Please bear in mind that this discussion is only presented for educational purposes, and you should consult your financial advisor before acting on any information contained herein.
Background of the EU
The European Union was formed through the Treaty of Rome in 1957, an historic undertaking that promised to usher in a new era of peace and prosperity for Europe after it had been the amphitheater for two World Wars in the first half of the 20th century. But although economic and monetary union was the ultimate goal for member states of the EU because of its undisputed benefits, it took more than three decades before the notion of a single currency became a reality.
In December 1991, European leaders approved the Treaty on European Union in the Dutch city of Maastricht and decided that Europe would have a strong and stable single currency by the end of the century. The Treaty set out the "Maastricht Convergence Criteria" that member states would have to meet to adopt the euro. These criteria included measures of price stability (based on the Consumer Price Index rate), sound public finances (government deficit should not exceed 3% of GDP), sustainable public finances (government debt not to exceed 60% of GDP), long-term interest rates and exchange rate stability.
On December 31, 1998, exchange conversion rates were irrevocably fixed between the euro and the currencies of the 11 participating member states – Austria, Belgium, Finland, France, Germany, Luxembourg, Ireland, Italy, the Netherlands, Portugal, and Spain. The euro was introduced on January 1, 1999, and for the first three years after its introduction, it was a virtual currency. On January 1, 2002, euro cash was introduced as legal tender in the greatest cash changeover in history, replacing existing notes and coins of national currencies like the French franc and Deutsche Mark.
The euro area was subsequently expanded with the addition of Greece (in 2001), Slovenia (2007) Cyprus and Malta (2008), Slovakia (2009), Estonia (2011), Latvia (2014), and Lithuania (2015). As of June 2015, 340 million people live in the euro area's 19 nations, forming one of the world's most powerful economic blocs. An additional seven nations that are member states of the EU have not yet qualified to adopt the euro, while two member states – the United Kingdom and Denmark – have opted out of adopting the euro but can join in the future if they desire to do so.
Euro's Trading History
Since its introduction, the euro has traded as low as 0.8230 to the U.S. dollar, a level it reached in October 2000, and as high as 1.6038, a peak reached in July 2008. It has not traded below parity (EUR 1 = USD 1) with the greenback since 2002.
The global credit crisis that erupted in 2008 led the euro to plunge 20% against the US dollar that year, as it became apparent that the biggest European banks owned colossal amounts of U.S. mortgage-backed securities that had lost most of their value. The bankruptcy of Lehman Brothers in September 2008 amplified concerns that other large banks were on the verge of going under, necessitating government-led bailouts of some European banks by a number of EU countries. The staggering cost of these bailouts led investors to turn their attention to the sovereign debt levels of heavily indebted nations like Portugal, Ireland, Italy, Greece, and Spain, collectively known as the "PIIGS."
Despite ongoing concerns about the European sovereign debt crisis, the euro traded in a range between approximately 1.20 and 1.50 to the U.S. dollar from 2009 to 2014. Fears that the eurozone would be forced to jettison its most indebted members, thereby jeopardizing the euro's existence, were assuaged by European Central Bank (ECB) President Mario Draghi's famous remark in July 2012 that the ECB would do "whatever it takes" to preserve the currency.
Decade-low Euro in 2015
In the first week of 2015, the euro slipped below the key support level of 1.20 to the greenback as traders grew convinced that the fragile European economy would lead the ECB to usher in some form of quantitative easing (QE) to stimulate it and ward off deflation. The ECB duly did so on January 22, 2015, as Draghi pledged that the bank would buy EUR 1.1 trillion of bonds at a monthly pace of EUR 60 billion through to September 2016.
The fact that the ECB was embarking on QE just as the U.S. was unwinding its own QE programs led to an adverse interest-rate differential between most of the euro area (with the exception of Greece) and the U.S. Although this led to the euro tumbling more than 18% versus the greenback over the 12 months ended July 8, 2015, the reality is that the U.S. dollar reigned supreme in currency markets during this period, gaining against every major currency. More than the Greek debt crisis, it is this divergence in monetary policy between Europe and the U.S. that led the euro to trade at a 12-year low of 1.0458 in mid-March 2015, and threatens to push the currency towards parity versus the U.S. dollar over the next couple of years.
Greece's Debt Situation
Sovereign debt concerns have coalesced around Greece because its fiscal profligacy in prior decades resulted in a crushing debt load, estimated at about EUR 322 billion or 175% of GDP. This in turn has led to unsustainable deficits, a stagnant economy, and a jobless rate exceeding 25%. In contrast, most of the other PIIGS seem to be in recovery mode. For instance, Spain's economic growth projection for 2015 was raised from 2.8% to 3.1% by the Bank of Spain on June 24, 2015, while Ireland posted growth of 4.1% over the past year. (For more, see The origins of Greece's debt crisis.)
Losses from a restructuring of Greek debt are also expected to be quite limited for the European financial sector, given that Greece accounts for less than two percent of the eurozone economy. Previous bailouts and restructuring since 2010 have resulted in only about 17% of Greek debt being held by private-sector lenders, with the balance held by euro area governments, the IMF and ECB.
The ring fences and firebreaks erected by the ECB in recent years to prevent financial contagion spilling over to the other PIIGS (in the event of a Greek debt default or other adverse incident) seem to be working. For proof, consider that yields on Spanish and Italian 10-year government bonds were at record lows of 1.2% in mid-March 2015, although the uncertainty caused by Greece has resulted in them climbing to about 2.22% as of July 8, 2015, a tad above the 10-year U.S. Treasury yield of 2.19%.
So What Would Grexit Do To The Euro?
Let's ignore for the moment the fact that monetary policy divergence between Europe and the U.S. is what's really driving the euro lower in 2015. What would happen to the euro if Greece did leave the eurozone?
There are two schools of thought:
- The euro goes lower: No surprise that this seems to be the majority view. If Greece leaves the euro and goes back to the drachma, its currency may be severely devalued. While a steep currency devaluation could cause rampant inflation, it would also stimulate Greek exports and its biggest industries like tourism and shipping. On the negative side, liquidity may continue to be a severe problem, given the run on the banks (Greeks had withdrawn about EUR 24 billion from the banking system or 15% of the total deposit base in the first quarter of 2015) before the government capped daily withdrawals at EUR 60 per ATM card on June 29, 2015; the capital controls imposed by Greece on that day would also remain in place. A Greek exit from the eurozone would also signal that the euro is not impregnable, leading to significantly higher borrowing costs for other PIIGS nations amid speculation about which country may be next to exit. In this scenario, the euro could easily re-test its recent 12-year low of 1.0458, and head towards parity with the USD within the next couple of years.
- The euro goes higher – A contrarian view that is held by a sizeable minority is that if Greece exits the eurozone, the loss of its weakest member could actually strengthen the euro area and hence the currency. The key assumption here is that financial contagion, which would affect perceived higher-risk nations such as Italy and Spain, would not occur even if Greece were to exit, and the eurozone would remain unified. In this scenario, the euro would face interim resistance at around 1.15 to the U.S. dollar, and formidable, long-term resistance at the 1.20 level.
The euro traded in a range between 1.0916 and 1.1278 to the U.S. dollar in the period from June 26, 2015 to July 8, 2015. What do currency forecasters predict for the euro, given that it is trading just below 1.11 as of July 8, 2015? The median estimate of forecasters polled by Bloomberg is for the euro to trade down to 1.05 per U.S. dollar in the fourth quarter of 2015 and the first half of 2016, before firming up to 1.10 in the second half of 2016.
The Bottom Line
At the time of writing, European leaders have set July 12 as the deadline for Greece to strike a final deal or risk being forced out of the eurozone. In the event of Grexit, the euro could decline from its current level of 1.11 and re-test its 12-year low below 1.05, as additional downward momentum to the currency is imparted by the monetary policy divergence between Europe and the U.S. A contrarian view is that the currency could strengthen to 1.15 or 1.20 versus the USD if Greece exits the eurozone, with euro gains capped by the ECB's QE program.