domingo, março 29, 2015

Euro illusions - How wrong was that ?

Analyses of the European Single Market  and the Euro as the Single Currency, then and now, suffer from a fundamental analytical error about the sustainability of external debt denominated in Euro, a currency not controlled by the Single Currency members.

Already in 1990 (see below) the DG ECOFIN  was telling us the intra-EU external imbalances wouldn't matter within the Single Currency.  And we foolishly beleived them.  

Reality in the diverging Eurozone turned out to be radically worse: A country's CAB Current Account Deficit is financed by increases in External Debt, which has to paid by net exports, as if it was FX-denominated.

Resultado de imagem para eurozone imbalancesNot only did the external constraint not disappear, it became nearly uncontrolable as the smaller countries lost access to the traditional balance of payments adjustment instruments, like devaluation or capital controls.

In effect, for a Eurozone country, the Euro functions as a foreign currency, so its debt can be considered FX denominated.

In 2015, 25 years later, we see   intentional confusion between exiting the Euro or defaulting on debt repayment.  A weakened debtor country may be unable to repay its external debt and forced to default, regardless of whether it stays or leaves the single currency.
Credit risk is currency-blind, so risk analysts need to be very clear eyed.

"CEC 1990: The problems arising from external current account deficits that may occur from the fixing of exchange rates before inflation rates have converged should only be of a transitional nature. After the initial adjustment period the expectations that underlie the process of wage and price formation should adjust and inflation rates should converge. However, the countries with initially high inflation might have accumulated in the mean time a considerable stock of external debt because they will have had a current account deficit in the mean time. In EMU an external debt should net create any particular problems by itself since the intra-Community balance of payments constraint will disappear. But the debt service will, of course, reduce the standard of living of the population, unless the debt has been used to finance productive investment."

See also Big creditor and 16 Hong Kongs