The European Economic and Monetary Union (EMU) and its common currency, the euro, and single central bank, the European Central Bank (ECB), were created with the primary objective of achieving economic stability in Europe. January 1, 2009 marked the 10th anniversary of the introduction of the euro. Broadly speaking, a high degree of macroeconomic stability has been achieved, with a welcome end to exchange-rate turbulence.

However, this anniversary year happens to coincide with the most severe test of the EMU and the euro to date, due to the deep recession that is rocking Europe and the global economy. The declines in industrial production in the eurozone in the 4th quarter of 2008 were extremely severe. This week ECB President Trichet said available data point to “very negative quarter-to-quarter real GDP growth in the last quarter of 2008.” Questions are being raised as to whether the Union can survive this test.  We believe the EMU will muddle through this difficult period, but important weaknesses in its architecture have been revealed and need to be addressed.

It was hoped that the EMU would lead to a convergence of economic performance among the separate member economies, a development which would greatly strengthen the efficacy of a single monetary policy.  The progress towards convergence has been limited in important respects, and serious divergences have become apparent in recent months.  The elimination of restrictions on financial flows within the EMU and the mandatory use of a common currency, the euro, resulted in a high degree of integration of the euro area money market (the short-term interbank market), essentially from 1999.  Short-term lending rates varied little within the EMU until the period of credit market turbulence and greatly increased volatility began in mid-2007. Over the past year and a half there have been greater concerns about national differences in credit risk and increased preference for national counterparties.

Convergence in the European securities markets has been far more limited due to differences in market standards and practices, liquidity, and the availability of developed derivative markets. Another factor which has increased in importance due to the current economic strains is perceived country differences in credit risk – sovereign risk in the case of government securities.

The ECB calculates “harmonized long-term interest rates” to assess the progress towards market convergence.  As recently as December 2007, while spreads over the benchmark German 10-year bond rate had started to widen, they were only 14 basis points for France and 33 basis points for Italy. By December of 2008, these spreads had widened sharply to 49 basis points for France and 142 basis points for Italy. Very large spreads developed for other EMU members, including Spain (81 basis points), Ireland (152 basis points), and Greece (203 basis points).  This serious divergence reflects significant differences among the EMU member economies with respect to their competitiveness and perceived ability to recover from the recession while maintaining price stability and avoiding an erosion of confidence in their solvency.

Budget deficits have worsened due to the recession, with economies in which housing growth has been particularly strong being hit the hardest (Spain, Ireland). Also, increasing government guarantees to loans, capital injections, and purchases of toxic assets have been a factor.  Ireland is notable in this respect; guarantees offered to Irish banks amount to 221% of GDP.  In addition, the current account positions of some members (Greece, Spain, Portugal, and Ireland) have deteriorated sharply. They do not have the option of depreciating their currencies or cutting short-term interest rates.

Underlining these differing situations, Standard & Poors has downgraded the sovereign debt of Spain, Greece, and Portugal in recent weeks and Moody’s has issued a warning that it may downgrade Ireland.

The ECB is quite limited in its ability to assist individual member countries whose economies are suffering the most from the recession. It has to apply the same monetary policy across the EMU. It is not permitted to buy sovereign bonds in the primary markets (a restriction designed to protect the independence of the ECB from the kind of political pressures to which European national central banks were subject prior to 1999). The ECB could buy debt in the secondary market, but this would require agreement across the EMU as to what debt to buy, how much, on what terms, etc.  There is no provision permitting the EU to support a country should it default.

On the other hand, countries for which spreads and hence borrowing costs have widened substantially are unlikely to be driven to leave the Euro area and reintroduce and devalue a national currency.  The costs for doing so would be high and their already high sovereign spreads would very likely widen significantly more. The country would find itself under even greater pressure to undertake needed economic reforms.

Aside from these problems, the ECB, with its mandatory single policy objective of price stability, maintained a restrictive monetary policy for too long last year. It continues to be somewhat behind the curve in responding to the global recession, apparently reluctant to lower interest rates as aggressively as the US Federal Reserve and the Bank of England. 

National governments within the EMU have announced substantial fiscal stimulus programs and in various ways have stepped in to shore up their financial institutions and unfreeze credit markets. However, economic recovery will be hampered by continuing rigidities in labor and other markets.  Economic hardships create strong headwinds for needed economic reforms, as was demonstrated by the massive national protests in France in recent days against economic reforms and layoffs in that country.

The eurozone economies as a group are expected to decline by 2% this year, following an estimated 1% advance in 2008 (this latter number may well be revised downward). The projected decline this year is similar to that expected  for the US, but the time path will be different, with recovery in the US becoming apparent in the second half of this year, leading to a near potential growth rate of 2.5 - 3% in 2010.  Recovery in the Eurozone will likely be slower for the reasons cited above, with 2010 growth around 1.5%.

At Cumberland we are continuing to under-weight the eurozone as a region in our International and Global Multi-Asset Class portfolios.  We are monitoring the individual eurozone countries closely, for some are likely to do better than others in the coming months. We also expect the US dollar to strengthen further in 2009, in particular, versus the euro.