There was once a time when the euro was one of the
world’s most favoured currencies, the must-have foreign exchange asset sought
by traders, investors and currency reserve managers. It is no longer the case.
In recent years the currency has fallen from grace and become more of a pariah with
international investors.
Last week’s news that China’s yuan will be included
for the first time in the International Monetary Fund’s basket of reserve
currencies is likely to deal another blow to the euro’s waning appeal. It will
lead to a re-jigging of global investment preferences away from the euro’s
failing fundamentals towards the yuan’s growing allure, backed up by much mightier
economic and financial resources.
The euro is plagued by deep rooted problems. The European
Central Bank is struggling to jump-start faster recovery in the euro area and trying
to prevent a slide into deeper deflation crisis. There are mounting credibility
issues too with signs of growing internal dissent evident within the ECB’s
ranks over its stimulus strategy. And the euro could be hit hard next week when
the US Federal Reserve finally hikes rates for the first time in a decade.
It is not looking encouraging. Investors could be
deserting the euro in droves, putting a test of parity versus the resurgent US
dollar squarely in the frame in the coming weeks.
Nobody wants a currency that fails to protect
intrinsic value and loses investor confidence. The euro might have enjoyed a
sharp 3 per cent rebound in the wake of the last week’s ECB policy decision,
but it was nothing more than a short-covering rally, sparked by investors being
wrong-footed by misleading official hints in the lead up to the meeting.
For weeks, the central bank had stoked up expectations
that it would deliver a much more effective stimulus package, comprising lower
rates with an accelerated quantitative easing programme, releasing much-needed extra
cheap cash into the economy.
But last week’s ECB measures fell well short of expectations.
The market had hoped for more than the meagre 10 basis point ECB deposit rate cut
to -0.3 per cent and the bare-minimum six month extension of the 60bn euro
monthly bond buying programme. The disappointment has triggered concerns about
a fierce internal row raging inside the ECB.
Germany’s Bundesbank has openly criticised the risks
of QE overkill and warned that further monetary accommodation is unnecessary.
It is a dangerous rift that casts serious doubts about future strategy and not
good news for the currency if policymaking stays divided.
There is a very real danger the ECB will never fully
get on top of the crisis, if Germany blocks future policy initiatives. With the
ECB’s asset purchase programme already extended to March 2017, the euro will in
any case stay chronically depressed for a long while yet.
The inclusion of China’s yuan into the IMF’s basket
of reserve currencies, due to take place in October 2016, will be another
factor working against the euro in the long run. The euro’s current weighting
in the IMF’s Special Drawing Rights basket will be cut to 30.93 per cent from
37.4 per cent. The yuan’s weighting will enter the SDR basket with a 10.92 per
cent share.
This is bound to affect relative asset allocation
preferences among the world’s central banks as currency reserve managers begin
to rebalance investments in favour of the yuan to reflect the new SDR
weightings. The yuan looks set to enjoy a honeymoon period in the next few
years and mainly at the euro’s expense.
From a standing start in 1999, when the euro was
first introduced, the single currency enjoyed a surge in demand with its share
of world foreign exchange reserves rising to a 28 per cent peak in 2009. But, in
recent years, its popularity with reserve managers has been badly blighted by
the euro zone crisis and unsettling market volatility. The euro’s share of
world reserves has since fallen back to 2002 levels around 20 per cent and the
decline looks set to continue.
With the euro losing investor confidence and its
currency fundamentals on the slide, central bank reserve managers will continue
to diversify away. The US dollar will prosper thanks to its rising interest
rate appeal. So too will the yuan, reflecting its economic and financial
strengths.
There seems little the ECB can do to stop the rot. Global
investors have lost patience and faith in the euro.
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