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How Low Will the Euro Go?

Traders worry that Greece’s departure from the EU would be followed by other members, and that could become a self-fulfilling prophecy.

We are, at last, close to the moment that analysts, economists and investors have all been waiting for — but hoping against — ever since the euro zone debt crisis began almost a year ago: Within weeks, a country may finally embark on the process of exiting the currency union.

If Greece becomes the first country to leave Euroland — impelled, perhaps, by the victory in the June 17 general election of parties opposing the terms of the EU-IMF bailout — what will this do to the value of the common currency upon which the whole project was founded?

Most analysts think it will fall — mainly because of the implications a Greek departure holds for larger and more important economies. With Greece gone, eyes will turn to the countries that could be the next in line to leave — including the troubled peripheral economies of Spain and Italy. This could provoke a capital flight from these states, with much of the money rushing headlong out of the euro zone altogether. A mass outflow from euro-denominated assets would send the value plummeting.

There are signs that investors are fleeing the euro zone already — there was a net outflow of portfolio investments of €35 billion ($46 billion) in March according to Nomura, compared with a net inflow of €19 billion in February. The main reason behind this was the mass purchase by euro zone investors of foreign assets, including bonds and money-market instruments. At €60 billion, this was their biggest buying spree in more than a year.

Amundi, Europe’s second-biggest private fund manager, has recently reduced its holdings of euro-denominated assets in favor of dollar assets. The French company cites the market turmoil caused by fears of a euro zone breakup.

If the euro is set to fall in the event of a Greek exit, how much is it likely to fall by?

Although the currency has already slumped by 5 percent from $1.32 at the beginning of this month to $1.25 as European trading closed on Friday, it is still a tad above its fair value on a purchasing power parity basis. In other words, for a consumer brandishing $100 to be able to buy exactly the same amount of goods and services in the euro zone as in the U.S. at prevailing exchange rates, the euro would need to drop to about $1.20 to $1.22. According to this logic, the euro has further to fall — but not much further.

But eurodollar’s fair value is, to euro bears, merely the starting point. This gives an indication of where the euro should be, absent any special factors. The euro is, however, subject to the ultimate special factor: severe doubts over its very survival in some countries, which could prompt the capital outflows already discussed. After assessing the need for a “breakup premium” when valuing the euro, Capital Economics, an independent macroeconomic consultancy, thinks the currency could drop to $1.10 by the end of the year — “but it is not hard to envisage even steeper falls as the prospect of some form of breakup looms closer.”

Some analysts think it likely that Greece will be the only country to leave the euro zone. With the Hellenic Republic accounting for only a tiny and declining fraction of the euro zone economy, “breakup” might in this case be the wrong word, since it would not amount to much more than a small slab of stone falling off an otherwise robust and indestructible statue.

A recent survey of 6,600 clients by Société Générale suggests, however, that the investment and trading community — which is making the decision to buy or sell the euro and euro assets — thinks differently. Among those who responded, 75 percent thought Greece would leave the currency union. Of those who thought at least one country would quit, many believed more than one would do so within a year — with an average figure of 1.7 countries. A widespread belief that more than one country will leave could turn into a self-fulfilling prophesy, by plunging weaker member states into the sort of economic and fiscal crisis that has put Greece’s continuing membership in doubt.

Kit Juckes, global head of foreign exchange strategy at Société Générale in London, writes in a recent note that because of the potential chaos unleashed by a Greek departure – and the risk that EU leaders will not react sufficiently dramatically even to this spectacular event — he is reluctant to consider recommending a buy for euro-dollar until it falls to $1.10.

Potential euro bears should, however take note of a common counter-argument against a slide in the euro’s value — that, shed of its weaker members, the union’s currency will eventually rise. The currencies of strong, highly competitive countries tend to drift upwards until they reach an equilibrium where the countries are no longer more able to compete on price with anywhere else.

This may well happen — but the problem lies with the word “eventually”.

The dismantling of currency zones is a rare historical event. For this reason, a partial euro zone breakup would not be a smooth, orderly process whose outline could easily be predicted in advance by analysts. It would provoke many questions that would unsettle currency markets and prompt capital outflows for months if not years, not least the question of which countries were likely to leave.

Traders prefer, for eminently sensible reasons, to shoot first and ask questions later — and they would shoot the euro down before a new, stronger currency more firmly dominated by a robust German economy arose from the ashes of the old one.

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