European Affairs

paul horneOnce again, the euro survived a crucial electoral test and strengthened in financial markets clearly relieved that the world’s second reserve currency will carry on despite populist politicians pandering to voters blaming economic stagnation and high unemployment on the European Union and the euro. The euro’s bounce against the dollar came just hours after the first round of France’s presidential election on Sunday, April 23, resulted in Emmanuel Macron, a pro-European centrist; and Marine Le Pen, head of the hard right and anti-European Front National, winning through to the run-off vote on May 7.

Markets assume Macron will benefit from the so-called “Republican front” of traditional political parties from left to right that coalesced in past elections to defeat the Front National.[1] But in the run-up to the final vote, markets and pollsters will be haunted by the Brexit and Trump surprises that weaken the easy assumption that Macron will benefit from a united front against Le Pen. Moreover, she is more a more charismatic speaker than Macron who has a more measured and less energetic podium style, a point that may become more important during the next ten days of intense campaigning.

If elected to a five-year term, as markets hope, Macron would be, at age 39, France’s youngest ever President and would lead only his “En Marche !” (“Forward !”) movement which he founded just a year ago. It is unaffiliated with any of France’s established political parties and depends on an enthusiastic base of volunteers. Before he became an independent, however, Macron served as deputy Secretary-General of Socialist President Francois Hollande’s staff from 2012 to 2014, then as Minister of the Economy, Industry and Information Technology from 2014 to 2016.

Markets were also relieved that the isolationist and leftwing Jean-Luc Mélenchon, whose fiery oratorical skills had propelled him to being a serious contender in the past month, did not make it into the second round. Since both Mélenchon and Le Pen wish to exit the European Union and euro, as well as adopt protectionist and isolationist policies, markets would have seen such an electoral choice on May 7 as threatening France’s future as co-anchor, with Germany, of the EU and the euro.

When markets realized that Macron could well be France’s next president, committed to strengthening European political, fiscal and monetary union, the euro rose sharply against the dollar from $1.06 before the election to $1.085 the day after (April 24) – as shown in Figure 1. This is significant because dollar/euro transactions remain the most important trade in FX markets which trade $5-to-$7 trillion daily, the dollar accounting for 87% of the value of daily two-currency transactions in 2016; and the euro 32%.

Figure 1. The USD-EUR exchange rate since Jan. 1, 2017.


Source: – April 24, 2017. See:


Other indicators of markets’ relief about the future of Europe and the euro included a surge in the Euro-STOXX 50 index of blue-chip shares in the Euro zone the day (April 24) after the French vote, as illustrated in Figure 2 below.

Figure 2. The Euro-STOXX 50 Share Price Index.


Source: – April 24, 2017. See:


Another important indicator of market confidence is the difference between the yields on France’s benchmark 10-year OAT government bond and the bund, Germany’s equivalent bond which is considered Europe’s safest sovereign debt instrument. The OAT yield spread had spiked to 75 basis points over the bund yield, triple its long-term average, as institutional investors headed toward the safety of the German bond before the French election. But with former banker Macron into the second round and expected to win against Le Pen, bond markets relaxed and France’s yield gap closed to 50 basis points on Monday, April 24.

More generally, markets stung by surprise outcomes such as Brexit, Trump and Italy’s rejection of constitutional reform, are further relieved that Europe’s populist politicians campaigning on anti-Europe and anti-euro platforms, have been defeated in recent elections in The Netherlands, Austria and now, perhaps France. (In June 2016 Spanish voters rejected the coalition of the populist Podemos and United Left movements and approved a new mandate for the centrist pro-Europe government.) Optimism is growing that France will choose Macron as president, supported by a viable parliamentary majority elected in legislative elections on June 11 and 18; and that Germany’s federal election on Sept. 22 will produce a new centrist government just as committed to Europe.

Still the No. 2 Reserve Currency

Although the euro’s reserve currency role weakened after the euro debt crisis began in 2009, it remains the world’s second most important reserve currency after the dollar.[2] In 2016, the euro represented 19.7% of the world’s central banks’ foreign currency reserves versus 64% for the dollar. The euro’s reserve role peaked in 2009 at 27.6% of FX reserves but has declined 8% since then as the dollar and other reserve currencies gained, notably sterling (up to 4.4% of FX reserves in 2016), the yen (4.2%) and China’s renminbi since it was added to the IMF’s Special Drawing Rights basket last year.

Its reserve role may be growing today since short and medium-term euro interest rates are so much lower than comparable U.S. dollar rates. Borrowing in euros has increased significantly in the past six months, thereby enhancing the euro’s reserve role. The ECB’s activism succeeded in lowering capital costs and stimulating economic growth. Its monetary policy provided the very timely stimulus needed by the Euro zone as the debt crisis forced fiscal policy to become more restrictive. The ECB’s explicit, firm and successful management of extraordinary monetary policy has enhanced global respect for the world’s second most important central bank.


Despite the ECB’s proven leadership role and markets’ optimism about recent favorable election results, some fundamental risks remain for the euro. Sizeable minorities of disenchanted European voters have been willing to vote for politicians whose programs could disrupt Europe’s post-WW 11 order. With the startling voting surprises of Brexit and the Trump election, political risk remains high.

If, for instance, France were to unexpectedly elect Marine Le Pen president on May 7, there could be market turbulence since she is committed to calling a referendum on remaining in the EU, hence in the euro system; and would move to close borders. Although she would probably face “cohabitation” with an opposition majority in the National Assembly after the June legislative election, the French constitution allows her to dissolve the National Assembly at any time after consultation with the Prime Minister and presidents of the Assembly and Senate. The new National Assembly elected following such a dissolution cannot be dissolved during the first year of its term. This situation could make governing France and intra-EU cooperation difficult, causing markets to be nervous.

The EU just celebrated the 60th anniversary of its founding Rome Treaty but the heads of government spent much of their time dithering over the tough decisions still needed to ensure the euro’s long-term viability. These decisions require fiscal and budget measures to reduce the large deficit and debt burdens of some key euro zone governments to sustainable levels. At the same time, unacceptably weak economic and productivity growth, particularly in southern Europe, needs to be stimulated to reduce the excessive unemployment that fuels the populist backlash against the EU and euro. This implies increased north European transfers and lending to the slower growth countries.

Further structural changes in euro zone governance are also essential for the single currency, notably fiscal integration that would permit more equitable sharing of budgetary burdens between member countries. Cross-border budgetary cooperation and harmonization of tax codes and rates would also help. Mutualization of borrowing and debt servicing by euro governments would also reassure international creditors and reduce the yield gaps between euro government bonds. Completion of banking union, including adequate capital reserve requirements and deposit insurance for euro zone financial institutions, is essential before the next market downturn stresses the euro system.

A “two-speed” Euro zone, based on economic and fiscal performance, has been suggested at various times as a way to resolve these structural problems. But the technical and policy challenges of creating and managing the interaction between two currencies and interest rate structures inside a single trade zone guaranteeing free movement of goods, services and people are virtually insurmountable.

Experience during the past seven years of euro debt crisis suggests that competitive adjustments within the single currency and monetary zone needed to be made inside member countries. Although often associated with politically difficult austerian policies and high(er) unemployment, Spain, Portugal, Ireland and even Greece have made such internal competitive adjustments that did lead to higher productivity, improved competitiveness and accelerating economic growth.

Looking ahead.

The recent victories of pro-European politicians and governments have been accompanied by growing signs of improving economic growth in the euro zone. The European Commission and ECB agree that GDP growth will be about 1.5%-to-1.7% this year, accelerating somewhat next year. Moreover, the euro zone consumer price inflation rate is reached 2% in February although the core inflation rate in March in the first quarter of 2017 was well under 1%. The ECB is encouraged that inflation is approaching its medium-term target rate of just below 2%.

Given the improving economic situation and more positive political environment, the ECB is increasingly expected to accelerate normalization of its extraordinarily stimulative monetary policies which began with the financial crisis in 2008. Bloomberg’s most recent survey of market economists shows the ECB could start this process by advertising a shift toward less stimulus after the German election on Sept. 22. It would then slow its current EUR 60 billion average monthly rate of purchases of fixed income and other publicly-traded securities under its Asset Purchase Programs (APP). See: )

The ECB’s extraordinary actions have kept the cost of capital low and injected massive amounts of new capital into the euro zone economy since the quantitative easing (QE) began in March 2015. The ECB held EUR 1.77 trillion in such assets by end-March 2017. The next step by the ECB would be to raise its key short-term policy interest rate from today’s unprecedented negative 40 basis points and allow bond yields to rise on a more country-differentiated basis, depending on individual euro countries’ credit ratings. See Fig. 3 below.

Figure 3. Economists’ expected normalization of ECB monetary policy through 2018.


Source: – April 24, 2017.


But institutional investors such as banks and insurance companies still worry that a significant minority of euro zone voters are apparently willing to quit the single currency. Which raises the theoretical question whether the euro system could fail ? We note that serious debt and economic crises failed to force Greece, Spain, Portugal and Ireland out of the euro. And that convincing majorities of their voters choose to remain in the euro.

In the past the euro’s successive crises have, perversely, strengthened the system. The member countries have created new emergency stabilization funding; improved prudential regulation of the financial sector; taken first steps toward fiscal union and banking union; improved and unified supervision of financial and insurance markets; and prompted the ECB to use extraordinary monetary policies to stimulate the economy and prop up weak banks and non-bank financial institutions.

For the euro to fail today, it would require one of the three main euro-founding countries, Germany, France or Italy, to withdraw from the system. We are confident that the French and German elections will produce centrist and pragmatic governments firmly committed to European union and the euro. Although two of Italy’s populist parties, the Northern League and the Five Star Movement, want to withdraw from the euro, neither of them seems likely to win control of parliament or even enter a coalition government.

But if unexpected political developments should lead to a founding euro country to quit the euro, what would happen ? There would be FX chaos; and equity markets would crash as investors sold stocks to head toward the (relative) safety of New York, London or Tokyo. Unilateral withdrawal, Brexit-style, by a euro member country would enormously complicate that country’s cross-border movement of people, goods, services and financial assets.

The world would immediately face a crisis in the Euro debt market since euro-denominated debt totals more than EUR 14 trillion, approximately 125% of the Euro zone’s 2016 GDP. (See ECB data at: ) The country deserting the euro system would have to redenominate its euro debt into its new national currency. Legally, this is an immensely complex problem and many euro debt issuers and investors have not agreed on revision of the covenants governing their debt securities. Covenants which do include redenomination clauses usually enable holders (investors) of the euro debt to block the issuer’s redenomination of those securities into a national currency.

Even more difficult would be the default risk. The debtor country, having quit the euro zone and established a new national currency, would still be obligated to repay the euro debt holders in equivalent value or default. This poses the problem of how that country could stabilize its new national currency exchange rate against the euro. Interest rates high enough to stabilize the exchange rate would sink the economy into recession. It is an impossible dilemma as proponents of “Grexit” learned when they analyzed the consequences of quitting the euro. And if the government defaulted on its euro debt, it would lose access to borrowing on international markets, as Argentina learned when it reneged on its debt.

The ECB and remaining euro member governments would find it difficult to help the exiting country, especially since the ECB is still trying to unwind its extraordinary monetary policies used to deal with the 2007-2009 financial crisis. Non-European central banks, notably the Fed, would also be disinclined to help except to safeguard the interests of U.S. financial institutions. The remaining euro zone governments would also be similarly constrained by weak economic growth and excessive debt, not to mention the political resentment they would feel toward the exiting country.

The negative consequences of exiting the euro would be such that it is difficult to imagine any government quitting the system, even if voters approved it. Moreover, international pressure on the country to remain in the system would be enormous because of the international FX, monetary and market turbulence that would ensue if a major country quit the euro, jeopardizing the world’s second most important economy and monetary system. Such a situation could dwarf the 2007-09 financial crisis.

J. Paul Horne is an Independent International Market Economist based in Alexandria, VA and Paris where he was chief international economist for Smith Barney for 24 years.


[1]This occurred in the December 2015 regional elections when the Front National emerged as the front-running party in the first round but was defeated the second by coalitions of “republican”, or traditional parties. In 2002, Jean-Marie Le Pen, Marine’s father, made it to the second round of the presidential election. But the “Republican front” elected Jacques Chirac president with 81% of the vote.

[2]See “The Euro at Age 15 — Is it a Reserve Currency Yet?”, published by European Affairs on Feb. 3, 2014. See: