SERIAL BAILOUTS MEAN DIMINISHED EURO / BARRON´S MAGAZINE ( VERY HIGHLY RECOMMENDED READING )

Up and Down Wall Street

WEDNESDAY, NOVEMBER 24, 2010

Serial Bailouts Mean Diminished Euro

By RANDALL W. FORSYTH

European crises leave dollar main reserve currency -- for now.

THE EURO IS NOT DEAD, but it may be fatally wounded as a viable alternative global reserve currency. For now, the dollar reigns supreme, by default, in every sense of the word.


Almost immediately after Ireland acceded to a bailout from the European Union and the International Monetary Fund, the international bond markets have set their sights on Spain as the next crisis point, sending its government bonds plunging and the cost of insuring its sovereign debt soaring.

Unlike last spring's bailout of Greece totaling €110 billion ($148 billion), which mollified the markets for a few months and stabilized bond yields, the package for Ireland—expected to total €80 billion-€85 billion—has failed to have a similar palliative effect for even a day. Ireland's government is about to be dissolved after a crucial Dec. 7 vote to approve another austerity budget amid massive protests against the debt burden the citizenry will take on.


Meanwhile, German Chancellor Angela Merkel warned that risk of serial bailouts is "exceptionally serious." As Europe's largest economy, it has fallen to Germany to assume the largest portion of the cost of those bailouts.


In the creditor and debtor countries alike, there is popular revolt against the bailouts. Not only is there a limit to how much German taxpayers are willing to pay to bail out the eurozone's prodigal debtors, the political opposition to the austerity measures imposed as conditions to bailouts is spilling over into the streets.


Notwithstanding the prospect of serial bailouts, contagion spread almost immediately from Ireland to Spain. Contagion was precisely what the bailouts aimed to prevent. The inoculation clearly isn't working, which makes the prognosis for the euro all the worse.

"With Ireland moving toward bailout, bond vigilantes apparently have decided to skip over the Portugal domino and target Spain," writes Uwe Parpart, Cantor Fitgerald's chief economist and strategist for Asia.


Spain's credit default swaps hit a record, topping 300 basis points (a premium of $300,000 to insure $10 million debt), to 305 basis points. The yield on 10-year Spanish government bonds has soared a full percentage point as their spreads over German bunds hit a record.


"Another point and Spain will find it difficult to continue refinancing its debt," Parpart observes. "Moody's says Spain is on more solid ground than Ireland. But with still €10 billion to raise this year, bond vigilantes will exact a pound of flesh."


Spain is vastly more important than Greece, Ireland and Portugal because its economy is 65% larger than the other PIGS and accounts for 11% of eurozone GDP, according to a recent Credit Suisse report. Moreover, "there are $876 billion of foreign bank assets in Spain, according to the [Bank for International Settlements] (75% of which are accounted for by European banks, with 40%--$340 billion—held by German and French banks alone)," according to CS.


Is Spain then too big to fail? Probably. Somehow, it is likely cash for another bailout will be raised from somewhere, even if it is throwing good money after bad.

While there are dire predictions of a breakup of the euro, the costs would be unimaginable. If, for instance, Greece reintroduces the drachma, what happens to its debt obligations denominated in euros? Would they be paid off in euros, which would vastly increase the real burden of that debt? Or would they be paid off in drachmas? And at what exchange rate?


So, the euro may lurch from crisis to crisis with serial bailouts, as Chancellor Merkel describes them. Does that sound like the formula for a global reserve currency as reliable as the dollar? For all its problems, the dollar is issued by a government where there is fiscal as well as monetary unity.


But that hasn't stopped searches for alternatives. China has urged a "supernational" currency, one not tied to any one state. World Bank President Robert Zoellick recently suggested creation of a currency basket with a role for gold.


Meantime, China and Russia have decided to use their own currencies in bilateral trade, Chinese Premier Wen Jiabao and Russian Premier Vladimir Putin announced during the Chinese leader's visit to St. Petersburg Tuesday. (Hat tip to John Brady at MF Global for passing along the report from the China Daily.) Cross-border trade almost invariably involves settling the transactions in dollars. "Since the financial crisis, however, high-ranking officials on both side began to explore other possibilities," the Chinese report said. Indeed, Brazil and China have begun to use their currencies for trade since China became Brazil's largest trade partner, supplanting the U.S.

There is no doubt that the international monetary system will be less dollar-centric in the years and decades to come. But the euro, whose inherent flaws now are being exposed, no longer looks like a viable alternative. While its exchange rate could rise at times, mainly because of America's financial vices rather than Europe's virtues, as long as the uncertainty created by serial bailouts exists, the euro is unlikely to attain the status of a reserve currency equal to the dollar.


Copyright 2010 Dow Jones & Company, Inc. All Rights Reserved