June 9, 2005
By CRAIG KARMIN and MICHAEL R. SESIT
After the recent French and Dutch rejections of the new European Union constitution, a once-unspeakable question is now gingerly being raised: Could the European Economic and Monetary Union, which is at the heart of the euro, come apart?
No one expects that soon, despite comments from the Italian welfare minister last week that his country should return to the lira and a recent German magazine poll showing that 56% of respondents would like a return of the mark. But it is an issue long-term investors need to think about as Europe's national economies diverge and as the political tenor from London to Lisbon suggests Europeans want less integration rather than more. Regardless of whether the euro ultimately is scrapped, just the thought of it is making some of Europe's financial markets jittery.
Already the euro has been hit, falling nearly 6% against the dollar over the past month, and, despite a rebound earlier this week, many analysts now see the euro falling further by year end. Other markets also are reflecting the new tensions. The difference in yields between German and Dutch government bonds and those of lesser-rated economies -- such as Italy and Greece -- has widened as some wonder about how difficult it will be for the southern Europeans to stay in the monetary union that is the bedrock of the common currency.
"Recently, you have had random officials making noises that markets would normally not give a hoot about," says Alan Ruskin, director of research at economic consultants 4Cast Ltd. "But now you're seeing that the market is responsive to any hints that officials are having doubts about the longevity of the euro."
Europe's long stretch of poor economic growth and high unemployment rates have made the euro just one of many targets of populist frustration. Moreover, shooting down a referendum or voting out a politician will be an easier route for disgruntled Europeans than abandoning the common currency -- especially since there is no legal framework for existing members to exit from the euro. "This is all needless speculation," says Marc Chandler, a partner at New York-based consultants Terra K. Partners.
Not everyone is convinced. Some view the antieuro sentiment as part of a broader populist protest against free trade and economic reform.
"This is sort of uncharted territory," says Jim Sarni, managing principal at bond investors Payden & Rygel Investment Management in Los Angeles. He has positions in government and corporate bonds in major European countries.
One of the great successes of the euro has been to deepen Europe's capital markets, especially the bond market, which blossomed with the introduction of the common currency in 1999. European government bond yields also converged because of a shared central-bank policy and interest rates.
Yet in what some see as a sign that investors are again distinguishing between European economies and their governments' ability to implement structural change, bond yields have been diverging. Italy's 10-year bond, for instance, yielded just 0.09 percentage point more than Germany's 10-year bond earlier this year. That differential is up to 0.22 percentage point and some think it will widen because of Italy's economic woes and large pockets of growing resistance to overhaul.
Italy's economy is in recession and, saddled with a strong currency, its goods aren't as competitive on world markets as they were when the euro was much weaker. But no longer in control of its own currency or monetary policy, Italy can't make its exports less costly by devaluing the euro or try to enhance growth by cutting interest rates. And with a budget deficit that already exceeds the limits allowed by the EU's Stability and Growth Pact -- one of the treaties that underpin the euro -- Italy can't easily increase government spending and borrowing.
France and Germany face similar, if less acute, problems that could also weigh on their bonds. "Bond spreads will be volatile and some could widen further," says Mr. Sarni at Payden & Rygel. He also is bracing for more short-term weakness in the euro and has hedged his bond positions to protect against currency losses.
William Hummer, chief economist at Wayne Hummer Investments in Chicago, sees the euro at $1.15 by year end, compared with a prediction of $1.22 before France's referendum. "The economic implications of the French vote are more profound than popularly perceived," he says. The euro fetched $1.22 in late New York trading yesterday, down less than a penny.
Many central banks have indicated that they will gradually shift reserves to euros from dollars. But concern over the currency's staying power could cause some to pause. William Ryback, deputy chief executive of the Hong Kong Monetary Authority, recently said that "right now, I'm not sure, looking at the euro, that that's an attractive investment." Meanwhile, he said, "The U.S. dollar remains a significant game in town."
Joseph Quinlan, chief market strategist at Banc of America Capital Management, told clients last week that the euro's chances of replacing the dollar as the world's reserve currency were slim and that investors who had been contemplating diversifying out of dollar-denominated assets into euro assets should reassess that strategy.
The French and Dutch no votes "reinforce the view that Europe is a dithering dysfunctional family, unwilling and unable to make tough economic and political decisions," he said. "Europe is now more divided than united, weaker than stronger, and more inward than outward looking. Its stature as a global force in both diplomatic and economic senses is now in question."
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