Recent financial turmoil in Greece and other European countries has raised doubts about the stability of the European monetary union and its currency, the euro.
From the start, many European countries bent the rules to adhere to EU requirements, while the EU turned a blind eye:
- Greece allegedly cooked its books in order to meet European Union fiscal requirements, with the help of Goldman Sachs
(NYSE: GS)and other banks.
- When France wanted to join in 1997, it lowered its budget gap by negotiating a deal with the soon-to-be-privatized France Telecom
(NYSE: FTE)-- receiving a lump-sum payment of 5 billion euros in exchange for assuming the company's pension liabilities.
- Portugal underreported its deficit in 2001, because of the misclassified accounting of subsidies for state enterprises.
In the following interview, Scott Mather, sovereign debt expert and head of global portfolio management at Pacific Investment Management Company (PIMCO), told this Fool that on many levels, the European monetary union was simply an illusion. Here is an edited transcript of our conversation about the euro's future.
Jennifer Schonberger: If we extend Greece's situation out to the EU as a whole, we recently learned that member countries were able to engage in investments in derivatives in order to adhere to eurozone requirements -- and in some cases, they took many actions without disclosure. We're also seeing now, in this time of crisis, that countries like Greece cannot devalue their currency to assist with their situation. Does this demonstrate that the European monetary union was simply an illusion?
Scott Mather: On many levels, yes. Of course, there were some rules imposed, but they were never enforced. So everybody ignored the master criteria almost from day one. By ignoring the debt limit -- and everybody found an excuse to do that at their own convenience -- [these countries] allowed debt to be piled up in peripheral Europe. Instead of heading in the direction it needed to go, it went in exactly the opposite direction.
Schonberger: What is the future of the euro?
Mather: The EU is going to have to undergo some severe changes. Ultimately, it's probably going to look quite different. Certainly it looked different over the last 10 years, in that there have been some new entrants in the eurozone. The assumption of many people was that the zone will just get bigger, and there will be more countries that keep entering it. It was never conceived that there might be countries that need to leave. Now people are beginning to think about that -- that's probably the reality. Unless there can be some stronger fiscal union, it's probably a reality that some countries won't be able to stay inside.
The other thing that doesn't get talked about, in terms of the EU promises that weren't fulfilled, was that there was supposed to be a lot of labor mobility. That's virtually nil -- even within countries, much less across borders in Europe. [European Central Bank President Jean-Claude] Trichet and other European policy makers like to compare the eurozone with the U.S. There are very large fundamental differences. One being that the fiscal transfers between countries are relatively small, compared with the U.S. So there's no ability to balance out when specific states have a problem. There's not broadly the same harmonization in tax policy, regulatory policy. The economy is different across regions in the EU [compared to] the U.S.
Then, without having labor mobility and the same language and cultural identity, it's very difficult to make the economies keep up with the political will. So what you saw was, the political will kept advancing, but there were lots of economic fantasies that were part of that promise, and people are waking up to the reality.
Schonberger: What is your outlook for the euro this year?
Mather: The rising tensions within the eurozone would portend for a weaker currency. The euro is still overvalued relative to the rest of the world. Most valuation models, which rely on purchasing power of parity, put the value of the euro between 10%-15% lower than where it is today...
Schonberger: Because of the recent sovereign debt issues, there is a lot of speculation about nearly every major currency in the world. Which currencies do you see as the winners and losers going forward?
Mather: In many ways, it's like, "What's the cleanest dirty shirt?" It gets passed around. There's no constant currency that looks good, and that goes back to the level of sovereign indebtedness. We've never seen a regime like this. So much of the developed world has an unstable debt dynamic -- far too much debt far too quickly. So that's why this risk will be with us for many years, and perhaps the baton will get passed around in terms of "Who's the worst for today."
In general, over the next several years, we think you'll see a revaluation of countries that don't have this unstable debt dynamic -- the countries with better growth and with low levels of debt. In general, that's true of most emerging markets ... most emerging-market currencies will be winners.
So, in the developed world, look for countries that can benefit from the growth in emerging markets, [and which] have better debt dynamics. Countries like Australia and Canada come to mind. Each has commodity exposure and a much better debt dynamic. Those should be currency winners in the old developed world.
Schonberger: Do you have any thoughts on the currency dance China and the U.S. are engaging in ... both short-term and long-term?
Mather: If we're right about our growth outlook -- we think there's going to be stubbornly high unemployment and lower growth than normal in the U.S. in years to come -- that is going to result in an increasing amount of tension with countries such as China, where the U.S. runs a large deficit, and where there's a perception that many jobs are slowly being lost to trade competition from China. The focus on the currency is there front and center.
Short term, we think it's likely China begins to move [on its currency]. One, to defuse the pressure; two, they can afford to. Their economy is growing by all measures above potential now. So in many cases, it's in their own self-interest. We don't think China will be moving outside of self-interest. Certainly, having a trade war is not in their interest, and probably not in the U.S.'s interest.
They can defuse some of the tension by allowing their currency to slowly appreciate within a band. That's most likely what they'll decide to do in the next few weeks.
What do you think about the future of the euro? Which currencies do you think will be the winners? Weigh in below!
Read more from Mather on Greece's situation and the debt crisis.