By Frances Coppola
The 2011-12 Eurozone crisis ended when the European Central Bank (ECB) agreed to do "whatever it takes" to prevent the European Economic and Monetary Union – better known as the "euro area" – from fragmenting, and initiated reforms to stabilize Europe's wobbly banking system.1 That made the Eurozone more attractive for businesses and, in the last year or so, Europe's economy has finally started to recover.
But now, the euro-dollar exchange rate is becoming volatile again as doubts grow over the willingness of some Eurozone countries to abide by the fiscal rules agreed in 2012-13, threatening the long-term ability of the ECB to keep the euro area single-currency market together – and, more immediately, threatening the stability of the euro exchange rate.
The Eurozone crisis of 2011-12 was the first serious threat to the integrity of the euro as a single currency since its creation in 1999. Between May 2011 and July 2012, the euro-dollar exchange rate fell from nearly $1.50 to $1.21 as investors, fearing that the euro area would break up, dumped euros in favor of "safe haven" currencies such as the yen,2 the dollar3 and the Swiss franc.
Until 2012, Europe appeared to have weathered the financial crisis of 2008-9. France and Germany had bailed out their banks, and some smaller countries such as Latvia4 needed assistance from the International Monetary Fund (IMF); but the bloc as a whole didn't suffer the deep recession that the U.S. experienced. Then, in 2010, the first signs of the euro area crisis emerged, when Greece said its budget deficit was far higher than previously thought. Although Greece immediately took steps to reduce its deficit, and the ECB dismissed suggestions that Greece might have to leave the euro, concern grew about Greece and other highly indebted Eurozone countries – Portugal, Ireland and Spain.5 In May 2010, the first bailout for Greece was agreed. Ireland's bailout followed in October 2010, and Portugal's in May 2011.6
Greece's bailout did not end speculation that it would be forced to leave the euro.7 The first link in the chain between that speculation and the euro-dollar exchange rate was that Greece's sovereign bonds were owned by banks all over Europe.8 Next, investors feared that redenominating all those bonds in a new currency worth considerably less than the euro could bring down the European banking system and cause the disorderly collapse of the euro area.9 Consequently, the euro's exchange rate plummeted relative to the dollar.10
By August 2011, the crisis had spread beyond Greece. As fears grew that Italy and Spain, as well as Greece, would default and leave the euro area, stock markets around the world crashed and the euro's exchange rate versus the dollar fell significantly. To stave off sovereign default and euro area breakup, the ECB agreed to buy Spanish and Italian government bonds.11 But as the Eurozone entered recession, some openly doubted whether the euro area could continue.12
In March 2012, Greece was bailed out for a second time – but this shone the spotlight on other indebted countries. Shortly afterwards, Italy's sovereign borrowing costs started to rise sharply, followed by Spain's.13 In June, as sovereign bond yields headed higher, the U.K.'s Prime Minister, Gordon Brown, warned that some of the Eurozone's largest countries might be forced to leave the euro area.14
By July 2012, the euro was fragmenting into de facto national currencies, as banks refused to lend across borders and investors retreated behind national boundaries. In a landmark speech, Mario Draghi, the President of the ECB, said that the central bank would do "whatever it takes" to preserve the euro.15 "Believe me, it will be enough," he said. Draghi's remarks convinced investors that the euro would not break up, and the euro-dollar exchange rate stabilized.16
Since then, the ECB has provided copious liquidity support to banks. It has also taken steps to reform the banking system, requiring banks to increase their capital reserves and improve the quality of their assets, and supervising larger banks more closely. It has introduced a standard method of rescuing or closing down failing banks without resorting to government bailouts.17 And it still stands ready to buy the bonds of distressed sovereigns, provided they agree to fiscal reforms supervised by the EU.18 Consequently, when the Greek crisis reappeared in mid-2015, the euro-dollar exchange rate remained largely unaffected.19
Reforming the banking system has been crucial for the stability of the euro-dollar exchange rate. But so too have been fiscal reforms. Underpinning the ECB's commitment to do "whatever it takes" to preserve the euro is a similar agreement at the level of government fiscal policy. During the Eurozone crisis, as it became clear that the primary cause was excessive sovereign indebtedness, most EU member states agreed to a set of fiscal rules intended to ensure that no state would ever again allow its public deficit and debt to rise high enough to threaten the euro area. Provided these rules are obeyed, the ECB can support economically distressed countries without breaking its mandate, which does not permit it to finance government deficits.
This is where the new headline-making Eurozone crisis comes in, because those rules are now under threat. Italy's recent election has resulted in a coalition government whose policies would increase government spending and reduce tax income, resulting in a budget deficit which would violate the fiscal rules. Furthermore, the coalition includes in its list of policies a review of all EU fiscal and monetary rules.20
Some economists believe the coalition's policies make at least some sense. Italy has suffered a long recession, as a result of which its debt-to-GDP ratio is very high (debit is over 130 percent of GDP).21 Under the EU fiscal rules, Italy's tax revenues would have to exceed government spending before interest payments on debt to bring down that ratio over time. This would involve reducing government spending and raising taxes significantly. But Lucrezia Reichlin, Professor of Economics at the London Business School, says this wouldn't help. She says Italy's economy needs investment, particularly in new innovative businesses and partnerships, and in public infrastructure and education. This would kickstart growth and make Italy a more attractive place for foreign investors and international businesses. And she warns that unless the EU adjusts the fiscal rules to allow Italy's stagnant economy to grow, Italy could be forced out of the EU, with potentially dire consequences for the euro.22
The possibility that Italy might leave the euro area has brought volatility back to the euro-dollar exchange rate.23 Italy is the Eurozone's fourth-largest economy. The single currency might not survive an Italian exit. Investors, fearing a euro breakup, are starting to flee to safe havens again. But some analysts doubt that the Italian crisis will lead to the end of the euro area.24
Ever since the Eurocrisis of 2012-13, the euro's exchange rate stability has depended on the ECB’s ability to support European sovereigns and banks. This in turn depends on the willingness of European sovereigns to abide by fiscal rules created during the crisis. Italy may be on the brink of challenging those rules. If so, the euro-dollar exchange rate could become considerably more volatile, raising FX risk for any U.S. businesses that trade with euro area countries.
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Speech by Mario Draghi, President of the European Central Bank, at the Global Investment Conference in London, 26 July 2012,” European Central Bank; https://www.ecb.europa.eu/press/key/date/2012/html/sp120726.en.html
2. “Euro reference exchange rates - JPY,” European Central Bank; http://www.ecb.europa.eu/stats/policy_and_exchange_rates/euro_reference_exchange_rates/html/eurofxref-graph-jpy.en.html
3. “USDEUR,” Fred Economic Data; https://fred.stlouisfed.org/series/DEXUSEU
4. “Financial assistance to Latvia,” European Commission; https://ec.europa.eu/info/business-economy-euro/economic-and-fiscal-policy-coordination/eu-financial-assistance/which-eu-countries-have-received-assistance/financial-assistance-latvia_en
5. “Timeline: the unfolding Euro crisis,” BBC; http://www.bbc.co.uk/news/business-13856580
8. “Greece debt crisis: how exposed is your bank?” The Guardian; https://www.theguardian.com/news/datablog/2011/jun/17/greece-debt-crisis-bank-exposed
9. “Disorderly default, almost as bad as civil war,” FT Alphaville; https://ftalphaville.ft.com/2011/09/27/686386/disorderly-default-almost-as-bad-as-civil-war/
10. “USDEUR,” Fred Economic Data; https://fred.stlouisfed.org/series/DEXUSEU
11. “Timeline: the unfolding Euro crisis,” BBC; http://www.bbc.co.uk/news/business-13856580
12. “William Hague: Euro is a burning building,” BBC; http://www.bbc.co.uk/news/uk-politics-15098567
13. “Timeline: the unfolding Euro crisis,” BBC; http://www.bbc.co.uk/news/business-13856580
14. “Gordon Brown says France and Italy may need bailout,” BBC; http://www.bbc.co.uk/news/uk-politics-18460596
15. “Verbatim of the remarks made by Mario Draghi,” European Central Bank; https://www.ecb.europa.eu/press/key/date/2012/html/sp120726.en.html
16. “USDEUR,” Fred Economic Data; https://fred.stlouisfed.org/series/DEXUSEU
17. DIRECTIVE 2014/59/EU OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL, EUR-LEX https://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=CELEX:32014L0059&from=EN
18. “Technical features of Outright Monetary Transactions,” ECB https://www.ecb.europa.eu/press/pr/date/2012/html/pr120906_1.en.html
19. “USDEUR,” Fred Economic Data; https://fred.stlouisfed.org/series/DEXUSEU
20. “Italy’s coalition: the main policy pledges,” Financial Times; https://www.ft.com/content/32b1daf6-5abf-11e8-bdb7-f6677d2e1ce8
21. “Italy – National debt in relation to GDP,” Statista; https://www.statista.com/statistics/270487/national-debt-of-italy-in-relation-to-gross-domestic-product-gdp/
22. “What Italy’s Crisis Means For Europe,” Project Syndicate; https://www.project-syndicate.org/commentary/italy-crisis-europe-future-by-lucrezia-reichlin-2018-05
23. “EURUSD,” Bloomberg https://www.bloomberg.com/quote/EURUSD:CUR
24. “Euro exchange rate: Will Italy’s political crisis bring about the end of the Euro?” Express; https://www.express.co.uk/finance/city/967001/Euro-exchange-rate-Italy-political-turmoil-end-of-the-Eurozone-European-Union