Connect with us
Eurozone Eurozone


The Rising Costs of the Eurozone’s Persistent Institutional Deficit

 3 min read / 

The findings of the HSBC Reserve Management Trends 2017 report, released on April 3, seem to indicate that uncertainty in the eurozone is prompting markets to search for new regional safe havens. Responses from 80 central banks surveyed disclose that the majority of them have been reducing exposure to the euro over the past months, pointing to sterling as a safer alternative.

A Run on the Euro?

Despite not having adopted the single currency, the British economy closely entangled its economic future with that of continental Europe via the European Union. This link is best showcased by the financial integration between the British Isles and the continent. To date, London retains the deepest markets for over-the-counter Euro foreign exchange transactions and interest rate derivatives, with daily turnover reaching close to €1trn.

In this context, under normal conditions, the practice of dumping euros in favour of pounds reflects strong opportunities to reduce risk through diversification.

A Rebalancing Act

However, standard hedging explanations fall short when one analyses recent EU and UK capital flows. Despite markets treating the pound with extreme caution today, demand for long-term bonds is rising. This hints at a potential overshoot in UK investment: while markets recently have been treating the British pound with increased caution, the attractiveness of the currency in the long term appears untarnished (if not strengthened).

Waning confidence in the Eurozone adds to the description of the recent impetus for portfolio rebalancing, as markets shift towards the UK in search of a new regional safe haven. Since June, when the results of the Brexit referendum were announced, the yield on a representative European security has jumped by a whopping 66%, to a monthly average of 1.45% for March. Over the same period, the equivalent British security decreased by 8.89%, dropping to 1.19% for March, following a 1.43% peak in December.

The Eurozone Needs Better Institutions

On the back of a heightened level of global uncertainty, this reversal in valuations reflects the rising importance of institutions for economic stability. In this respect, the UK – a financial, trading and monetary powerhouse since the dawn of the first wave of globalisation in the 19th century – dwarfs the eurozone, a young currency union amongst European states which exhibit sporadic cyclical synchronicity and fading political motivation for joint action.

This gap in terms of institutional quality leads to significant differences in the way uncertainty is perceived on each side of the English Channel. In particular, markets view Brexit-related volatility as ephemeral, yet are gravely concerned with the consistent stagnation faced by the eurozone. Notably, according to the HSBC survey, current sluggish growth rates, the persistence of negative interest rates, and political instability across the eurozone are the main sources of concern in 2017.

In a sense, the recent impetus towards rebalancing exposure away from the single currency comes as little surprise. Despite presenting itself to the world as an economic behemoth, the eurozone still needs significant institutional groundwork before it becomes a well-functioning (if still sub-optimal) currency area. As long as the institutional status quo remains unchanged, markets will be looking towards (as it turns out, a not-so-isolated) Britain for a safer regional alternative.

Sign up to Mogul News.

Click to comment

Leave a Reply

Your email address will not be published. Required fields are marked *

Send this to a friend