The Euro Shrinks To Four-Year Lows As Investors Rush To Drop The Currency

With the euro tumbling to four-year lows, concerns about the stability of the European Central Bank are rising. Although there is some speculation that additional moves by the …

With the euro tumbling to four-year lows, concerns about the stability of the European Central Bank are rising. Although there is some speculation that additional moves by the US Federal Reserve could temporarily provide stronger support for euro-dollar exchange rates, growing concerns about increased fallout from other indebted Eurozone nations could create more problems for ECB. See the following article from Money Morning for more on this.

The euro’s recent struggles have done more than bring the currency’s viability into question. They’ve put the European Central Bank (ECB) on a collision course with a liquidity crisis.

The ECB is running low on dollars, and that problem could escalate when the U.S. Federal Reserve closes swap lines that were temporarily reinstated as the Greek debt crisis escalated. Additionally, more deposits are being yanked from the central bank as holders question whether or not the ECB has enough juice to stop a classic bank panic.

The euro yesterday (Wednesday) remained at a near four-year low against the dollar, tumbling 0.5% to $1.2306. The beleaguered currency dropped against the yen and British pound, as well.

The currency has come under tremendous pressure as investors wonder if Greece’s fiscal crisis will spread to other heavily indebted nations.

Greece’s deficit-to-gross domestic product (GDP) ratio is a staggering 13.6%, but Greece is No. 2 on the list of over-spenders. No. 1 is Ireland, whose deficit-to-GDP ratio is 14.3%. Spain comes in third at 11.2%, and Portugal is fourth at 9.4%.

The euro in the past six months has dropped by about 15% against the dollar, as investors rushed to ditch the currency. That has stretched dollar liquidity in the Eurozone, and there’s no indication that demand will ebb in the weeks ahead.

“A shortage of dollar liquidity is being increasingly reflected in the sharp rise of dollar LIBOR and this is expected to get worse as the month-end approaches with pressures in money markets likely to build over the coming days,” Hans Redeker, an analyst at BNP Paribas (OTC: BNPQY), told the Financial Times.

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Data from the British Bankers’ Association showed the three-month U.S. dollar London Interbank Offered Rate, or Libor, rose to 0.53781% from Tuesday’s 0.53625%, the highest fixing since July 6, 2009. Libor – the rate banks pay each other for three-month loans in dollars – is a liquidity indicator.

Libor has more than doubled this year as the European debt crisis fueled speculation that the quality of banks’ collateral has been degraded and financial institutions questioned their peers’ creditworthiness.

Banks also are making greater use of the ECB’s deposit facility, leaving cash with the central bank overnight for rates of interest that are lower than what they would earn lending to other banks.

The fear among banks was compounded when four of Spain’s savings banks with more than $165 billion (135 billion euros) in assets announced earlier this week that they plan to merge. That announcement stoked fears that some of Europe’s biggest banks – which have broad and interlinked exposure to one another – are on the verge of toppling.

“It’s all part of concern about the system, about whether the sovereign-debt crisis will morph into a bigger systematic crisis,” Padhraic Garvey, head of investment-grade strategy at ING Groep NV (NYSE ADR: ING) in Amsterdam, told Bloomberg News. “We’re not quite at a point where that’s imminent, but that risk is being priced in.”

The U.S. Federal Reserve on May 9 reinstated swap lines with the ECB in an effort to alleviate some of the stress on the central bank – but only as a temporary measure. There is growing speculation that the Fed will reduce the rate on dollar-euro swaps, but Federal Reserve Chairman Ben S. Bernanke has not indicated that that would be the case.

“While the market was hoping that the rates on this facility would become more favorable, Mr. Bernanke has been reminding the market that the dollar swap lines are not a permanent device,” said BNP’s Redeker, referencing comments Bernanke made yesterday in Tokyo.

Even so, the higher costs of the Fed’s loan program have done nothing to stymie demand.

The ECB allotted $5.4 billion to three banks at its dollar swap tender Wednesday, despite the funds being twice as expensive as rates in the interbank market.

“The swap facility is continuing evidence of the rising demand for dollars,” Don Smith, an economist at ICAP, told the Wall Street Journal.

Of course, if no further action is taken and investors continue to pursue dollars at the expense of the euro, there’s a growing likelihood that the European debt contagion will evolve into a systemic failure.

“What happens next is down to the central banks; the dollar funding hole needs plugging,” Credit Agricole said in a research report. “We doubt that central banks are sitting on their hands at the moment and imagine that another 84-day dollar facility will be announced soon and then perhaps term-auction facilities, or any number of the older facilities.”

The ECB could opt to cut its refinancing rate, used to lend to commercial banks, which is now at a record low 1%, or reintroduce regular six and 12-month refinancing operations in unlimited amounts, which were first used at the height of the financial market turmoil in 2007-08.

“It could decide to diminish the cost of the USD liquidity,” Barclays economist Laurent Fransolet told Reuters. “But we would note that it did not do so even at the worst of the crisis when the demand for USD funding was much higher and conditions were much worse than currently.”

Use of the Fed’s swap facility reached $583 billion in December 2008, whereas foreign banks have only tapped the program for some $9 billion since it was reinstated earlier this month.

Pushed to extremes the ECB could also be forced to intervene by propping up the euro. However, that would only be an option if the euro slumps considerably below its long-term average, which it currently is not.

This article has been republished from Money Morning. You can also view this article at
Money Morning, an investment news and analysis site.

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