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The Sinking Euro

Chart created using Omega TradeStation 2000i. Chart data supplied by DialData.

Not surprisingly the Euro is almost a mirror of the US$. The Euro makes up 57% of the US$ Index. Quite simply if the Euro goes up the US$ goes down and if the Euro goes down the US$ goes up. The Euro is the world's second most traded currency. It is also a secondary reserve currency as while all central banks carry US$ as the world's reserve currency most if not all carry the Euro as well. It is estimated that upwards of 27% of central bank reserves are held in Euros. Other reserve currencies include the Japanese Yen, the British Pound and the Swiss Franc. The Euro's symbol is €.

The Euro is the official currency of the Eurozone. It is used by 17 of the 27 member states of the European Union as well as the institutions of the European Union. The Euro is also used by another 5 European states plus the disputed state of Kosovo all of who are not members of the European Union. Further there are another 23 countries that peg their currency to the Euro including 14 in Africa, 2 African island countries, 3 French Pacific territories, and a Portuguese Atlantic territory. Some EU member states that are not a part of the European monetary Union also peg their currency to the Euro including Bulgaria, Denmark, Lithuania and Latvia. More recently Switzerland pegged the Franc to the Euro.

The Euro is managed and administered by the European Central Bank (ECB) and the Eurosystem (which is composed of the central banks of the Eurozone countries). The Eurozone countries are obliged to meet certain monetary and budgetary requirements. And herein lies the problem. Not all states have adhered to those requirements most notably Greece and Italy but as well Portugal, Ireland and Spain.

The trouble was while the ECB was supposed to be the central bank of the Eurozone in order to maintain their sovereignty the Eurozone countries as noted also had their own central bank. This would be akin to all the Canadian provinces having their own central bank even as the Bank of Canada was the Federal central bank. This caused a lack of control at the centre as the individual countries often went their own way when it came to their country's monetary policy. The weak countries economically (Italy, Greece etc.) used their membership in the Eurozone monetary union to try and bring their standard of living (pensions, salaries etc.) up to the standards of the strong economy countries (Germany, France) quickly. This was a significant flaw in the original Eurozone monetary union.

The Euro banks and major North American banks did not hesitate to lend to the individual members because of their ties to the Eurozone monetary union and believing that their credit was tied to the strongest members (Germany, France). Now the Eurozone sits on the edge of a potential sovereign debt default in Greece which could in turn trigger considerably larger problems in other countries particularly Italy and Spain. Greece is a small component of the Eurozone but Italy and Spain are large economies with GDP's in excess of $1 trillion.

Further while the banks have purchased insurance in the form of credit default swaps (CDS's) these swap agreements are only triggered if the country actually defaults. Greece has not as yet done that. The question is then who owns these CDS's and if they are called upon to deliver payment can they deliver? That is not clear. As some pundits have pointed out - no one knows what the exposure is nor do they know exactly who owns the CDS's (well someone does but they are not telling anyone - regulator's maybe?). According to the Bank for International Settlements as at December 2010 there was globally notional US$29.9 trillion of CDS's outstanding with a gross market value of US$1.4 trillion. As at the same period there was a notional US$601 trillion of over the counter (OTC) derivatives outstanding. Global GDP is roughly US$52 trillion.

As the US discovered during the 2008 financial crisis AIG was a major writer of CDS's and when they were asked to deliver at the height of the subprime crisis they couldn't as to deliver meant their capital was wiped out. That in turn meant the banking system was pushed to the brink of collapse and the US Treasury was forced to step in with taxpayers money to bail them out. The current situation is very similar as was seen at the time of the Lehman Brothers collapse only if Greece were to default it could bring down the global banking system. That in turn would impact negatively on all of the major economies.

The choices are stark. Cut interest rates (the ECB just cut interest rates to 1.25%) or bring in quantitative easing (QE) which is an official word for "print money". Some have stated that QE is the only solution. In turn that could oddly be positive for the stock markets and of course gold would soar. It would unleash monetary inflation and as some have suggested it could unleash hyperinflation.

As the Euro crisis lurches from possible solution to no solution the markets swoon and rally. It is the same with the Euro. If a solution appears to be at hand the Euro rises in value and if not the Euro falls in value. The reality is worse as seen recently when the Japanese tried to push down the value of the Yen this past week. It was a one day blip only and the Japanese had to quickly abandon the idea. All fiat currencies are in a race to the bottom as each needs to push their currency lower so as not to lose competitive advantage. As well all the major economies (US, Eurozone and Japan) are in the throes of a financial crisis that has few solutions and may eventually end in default or bankruptcy.

All of the current activity is merely to stall the problem, even temporarily, or push it out to another day. Except another day is happening faster and that is usually the next day.

The Euro has major support near 1.33 and major long term support is between 1.15 and 1.20. If Greece defaults and pulls out of the Euro it could mean the beginning of the end of the Euro. Europe keeps trying to find a rescue plan, but as the recent cover of The Economist (October 29th - November 4th 2011) shows the rescue boat is a sieve. The global banking system hangs in the balance.


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