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Asia needs to notice euro crisis
The euro crisis has caused considerable volatility in financial markets
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he euro crisis has caused considerable volatility in financial markets. Euro area equity markets have underperformed Asian, American and non-euro European markets (like the UK and Switzerland). Euro bond markets have had a terrifying ride, with yields swinging wildly. The euro itself has lost value against most major currencies.
What is the cause of all of this? Superficially it seems to be Greek government debt. This reached levels that have caused investors to shun Greek bonds. Portugal and Spain have become a cause for concern too. euro area economies have had to offer large sums of financial assistance to Greece specifically, and create a slush fund of assistance for any other euro area country that needs it. Even with this, Greece is still likely to have to restructure its debt at some point in the coming years.
However, the fiscal problems of Greece and others are actually symptoms of a bigger problem.
The Euro does not work.
The Euro is not what economists call an optimal currency area. The whole point about a monetary union is that the economy is supposed to be sufficiently integrated that a common interest rate and exchange rate will be equally suitable for all. If one country has growth of +3 percent and one country has growth of -3 percent, it is going to be pretty hard for the central bank to come up with a single interest rate that is equally suitable. Inevitably, monetary policy in that scenario will fail one or other of the monetary union members.
So, does the fact that the euro does not work mean that it is doomed to break up? No. Many monetary unions do not work. In a perfect world (where economists run everything) the United States would have not one, but three currencies. However, in spite of the fact that the US monetary union does not work, it holds together. It holds together because policy makers compensate for the fact that it does not work. There is a fiscal union along side the monetary union.
If a part of the monetary union is suffering weak growth (-3 percent, for instance) and monetary policy is unsuitable (interest rates are too high), then the negative economic effects can be compensated via fiscal transfers. The stronger growth area (the +3 percent economy) can pay taxes that go to fund spending in the weaker part of the monetary union.
Today, tax dollars from New York pay for unemployment benefits for out of work Californians. Both parts of the US can thus share a common monetary policy without too many ill effects. It should be noted, the government of California does not get any of the cash. The cash goes straight to the people of California. The government can sink or swim on its own.
Why does this matter? It matters because, if the euro is a dysfunctional monetary union, the solution to this problem is not going to happen overnight. As the euro area gropes towards a solution, it will continue to experience volatility and crises. The euro area probably will achieve a fiscal union, but not overnight (it took the US around 150 years to get it right).
While we are waiting for the euro to sort itself out, there are several consequences. The euro as a currency is likely to remain weak. There is likely to be a flight to quality within the euro area. Risk premia are likely to rise. Finally, pressure for fiscal tightening is unlikely to abate.
This results in a double divergence. Strong economies benefit. The German economy is export-led, and gains from the weak euro. The flight to quality keeps bond yields low, lowering the funding cost for the German government. Weak economies, meanwhile suffer. Risk premiums raise funding costs. Economies that are uncompetitive have smaller export sectors, and benefit less from the lower euro. The need to tighten fiscal policy is more acute.
As well as the strong versus weak divergence (which roughly corresponds to north versus south), there is the domestic versus export divergence. Domestic economies (wherever they are in the euro area) are likely to suffer more as a consequence of this crisis. Fiscal tightening means less domestic demand. exports benefit from the weaker euro, however.
The tendency for the euro area’s economy to diverge means Asia can not ignore the euro crisis. The euro area consumes Asian exports. In some fields, euro economies compete with Asian economies for market share. euro domestic demand is likely to be slower in the coming years. The weaker euro makes Euro area exports relatively cheaper. Asia is going to have to struggle harder to sell to the euro area, and to sell in other markets where it competes against euro area companies.
This is not a remote crisis, but a challenge for Asia to meet. It is also a challenge that Asia will have to endure for some time.
The writer is deputy head, Global Economics, UBS Investment Bank.
