If you are studying for exams, you will hopefully, be learning that the value of a currency is generally influenced by factors such as:
- Interest rates – low interest rates lead to hot money flows out of economy and a weaker exchange rate.
- Relative inflation rates – Higher inflation makes a countries exports uncompetitive and weakens exchange rate
- Relative competitiveness compared to other trading prospects
- General prospects for economy.
- More detail: See Factors which determine exchange rate
At the moment, the most important issue is that of government borrowing that is impacting on the fortunes of the Euro.
In short fears of debt default in Greece and potentially other Euro countries is making investors nervous of holding Euro assets. The Euro no longer looks the rock solid currency it did a few years ago.
Weakness of the Euro.
After being quite strong during the financial crisis. The Euro has taken a battering following the Greek fiscal crisis. The Greek economy is a small % of the Euro economy. But, there are fears that the problems of Greece will spread to other Euro countries like Portugal and Italy.
Why is Euro Falling?
Markets have lost confidence in the Greek ability to repay their government debt. It is not just that they have a high public sector debt (approx 116% of GDP). It is also the forecasts for growth are also very low. Therefore, it is hard to see how Greece is going to manage to improve its finances. This raises possibility of default on Debt. If Greece did default on paying its debts. It would mean many banks and investors would simply lose their investments. Therefore, they would be less willing to hold bonds and gilts denominated in Euros.
Because Greece is in the Euro, (with no prospect of leaving it), it means that all other Euro economies will be affected by a default in a member country.
The problem is that if Greece defaults, markets may expect a similar event to happen in countries like Italy, Portugal e.t.c. Therefore, markets will be less willing to hold Euro debt.
When the Euro started, many felt the Euro was a very safe investment. In a way this made it easier for Greece to borrow at cheap interest rates. They had little incentive to reduce borrowing, because the clout of being in the Euro, meant bond yields were lower than they would have been with their own currency.
It was only when markets realised that other Euro economies might actually allow a default in a member like Greece, that the interest on Greek bonds started to rise.
Given the nature of the crisis, it is hard to predict how the Euro will react in coming 12 months. But, there are no easy solutions on the horizon. The scale of the Greek problem is quite worrying, and there is a lack of political will within Euro to bailout other countries debt.
- Will Debt crisis spread to UK? – What are the prospects of UK relative to Greece