How Greece’s euro stalemate is hurting currency markets

In need of a lifeline. EPA/Jens Buettner

The drawn-out negotiations between Greece and its European creditors have the financial markets in turmoil at the idea of a Greek exit. The uncertainty brought about by the new Syriza government can be seen in the effect it has had on currency. The euro has depreciated sharply against most major currencies in recent months, including about 8% against sterling, as uncertainty over Greece’s relationship with the eurozone has increased.

The implications of a deal not being struck and Greece leaving the eurozone would be huge – for the country itself, the eurozone as a whole and countries outside it. Just the increasing prospect of a Greek exit affects international financial markets, especially the foreign exchange markets.

The euro’s decline against the pound since mid-November. www.xe.com

Studies show

A number of studies have shown that the increase in the probability of a euro member leaving causes a fall in the currency’s value and an increase in its perceived riskiness. This has implications for investment and trade in the eurozone, as increased exchange rate volatility can inhibit trade and therefore economic growth.

So an increase in the chances of Greece exiting the euro will only accelerate the drop in the euro’s value and its volatility. If Greece were to exit the euro, then in the short term these effects would probably be exacerbated, affecting not just the euro, but the entire euro based financial system.

A number of studies have concentrated on the implications of eurozone instability on the value of the euro. Economist Stefan Eichler, for example, found strong evidence that the euro only depreciates when the risk for the sovereign states increases. Risks within the banking system do not significantly affect the currency’s value. Cho-Hoi Hui and Tsz-Kin Chung found similar results showing that instability in the eurozone area was harmful to the value of the euro and, more worryingly, also caused exchange rate volatility to increase.

Not all bad

The depreciation of the euro does have its upsides. A weaker euro can be potentially beneficial to the eurozone economy, especially as it is currently suffering from deflation. Exchange rate depreciation tends to induce inflation, which can be harmful if excessive, but this is not the case in the eurozone.

A weaker euro also increases the competitiveness of the region’s exports, which as a result causes them to rise in value and encourages economic growth. This in turn could go some way to increasing tax revenues for the eurozone and solving the budget deficits.

A deeper problem

The problem goes back further than the latest Greek election. The eurozone first entered a crisis towards the end of 2008, as a result of the financial crisis, which exposed high levels of European debt. This sent financial markets into chaos and left the eurozone in a precarious position. Greece was particularly badly affected and the prospect of a Grexit was first raised in 2010 before the country was bailed out to the tune of €45 billion.

Governments and central banks alike have gone to great lengths to control things. As well as multi-billion dollar bailouts, the European Central Bank (ECB) announced it would be the lender of last resort for government bonds and also introduced the Outright Monetary Transaction programme, which allows it to buy sovereign debts if needed. Most recently, the ECB announced it would start quantitative easing, buying €60 billion of bonds a month, hoping that this might encourage economic growth.

Despite these policies, the crisis is far from over and little progress has been made in addressing the fundamental and structural problems hindering the eurozone. This has added to the current problems in Greece and the increase in the likelihood of a Greek exit.

This recent crisis highlights the need for greater fiscal integration within the Monetary Union. Many economists, including Alan Greenspan (former head of the US Federal Reserve), have gone as far to say that a fiscal union should be formed in order to prevent future crises and that even this may not be enough as a political union could also be required.

Without some form of fiscal or political union, the single currency area will always remain vulnerable to the consequences of asymmetric shocks and macro-economic imbalances, which in turn will potentially affect the Euro exchange rate. Further fiscal integration will reduce the likelihood of future crises and would provide a platform for co-ordinated and quick responses to any future problems. It would also reduce the incentives for countries to live beyond their means and accumulate unsustainable levels of debts.