Just last spring, the debt crisis in Greece, Ireland and other troubled European states threatened the destruction of the Euro itself. Talk of the breakup of the Euro zone was rampant among investors, economists and even some policy makers.
This time around, the 12-year-old common currency appears much more resilient in the face of ongoing sovereign fiscal troubles. The price of the Euro slipped on Thursday, to $1.4062 from $1.4088, one day after Jose Socrates, the Prime Minister of Portugal, offered to resign and the prospect rose of a regional bailout for the country. Yet there is little risk that it will drop to the $1.20 range of last spring.
It appears that a bailout of Portugal is likely. Austerity measures recommended by Socrates were voted down in parliament, making a bailout even more difficult to implement, even if the EU offered it. Fitch downgraded the countrys debt to A- from A+, and interest rates on the countrys debt rose to a record 7.71 percent. A bailout could run anywhere from 50 billion euros ($71 billion) to twice that amount.
Yet the odds that the Euro will revisit last years level of $1.20, the lowest in four years, are relatively slim. There is little talk of the breakup of the euro zone. In fact, the currency is gaining in status as a reserve currency. The troubles in Portugal arent big enough to push the euro back down to far, says Ed Meir, senior commodities analyst at futures broker MF Global. Its value is more closely linked to the ECB, which has been more aggressive about inflation than we have been in the U.S. He expects the Euro to trade in a range of $1.35 to $1.45.
The European Central Bank has indicated it will begin to raise rates in about a month. Judging from the level of real short-term interest rates (below -1 percent) in the euro area, monetary policy has become more accommodative than at the peak of the crisis. The ECB needs to take account of this reality and ensure that policy accommodation does not turn into a curse, ECB chief economist Jurgen Stark argued in the Wall Street Journal on Thursday.
The fiscal problems in Spain are far larger than those in neighboring Portugal, and could in fact create another problem for the Euro. But even that risk is limited.
Moodys on Wednesday lowered its rating on 30 small and mid-sized banks, although the ratings on larger institutions such as Santander were left alone.
Meir says these banks could require $200 billion to $300 billion worth of funds enough to tap the money available into the European bailout mechanism. But he says its more likely that these banks will recapitalize in the private markets or draw on the resources of Spain. A regional bailout is more remote, and the authorities have time to address the problem, a luxury that was not available in the case of Greece or Ireland.
It is true that banks in Spain have significant exposure to troubled lenders in Portugal, but their biggest problems are with the domestic housing market. It has yet to hit bottom. It is clear that the outlook for Spain is not completely independent of what happens in Portugal, but an automatic read-across would be misguided as well, Barclays Capital said Thursday in a note by Antonio Garcia Pascual.
The macro impact of the fiscal collapse of Portugal will be minimal, according to Pascual. The ECB is unlikely to delay rate increases simply because of troubles in Portugal, and the effects are on the currency markets will be limited, too.
The euro has been more driven by interest rate differentials (and, hence, the ECB) than risk aversion ... we would not expect large sustained moves either, he said.