Greek crisis poses challenge to euro

The Greek debt crisis has become the biggest test not only of the European Union, but of its fledgling currency, the euro, which until recently had been enjoying newfound status as a reserve currency second only to the U.S. dollar.

The challenge to the cohesion of the EU, which has grown steadily into the world’s largest trading bloc since its beginnings after World War II, was illustrated vividly last week when Greece threatened to seek aid from the International Monetary Fund if the EU did not offer a bailout.

Despite public sentiment against a bailout, EU’s wealthier countries, France and Germany, are expected to eventually arrange loans to Greece to avoid the embarrassment and fallout from an IMF rescue of a core European country.

The euro currency crisis has been less visible but has been rocking world markets for weeks. Created a little more than 11 years ago to solidify and expand economic relations among EU countries, the currency had been ascending against the dollar since 2002, with occasional interruptions caused by the global financial crisis.

But the euro has lost 10 percent of its value against the dollar since the Greek debt crisis erupted in December, and some influential investors are betting that it will tumble further. The crisis has highlighted the serious debt problems of EU countries such as Greece, Portugal, Spain and Italy. It also has raised the prospect that the entire euro area will fall back into a recession as sharply rising interest rates threaten the weak growth that started last year.

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Billionaire currency speculator George Soros, who made his fortune taking on the Bank of England and driving down the British pound in an earlier era testing the European Monetary Union, now stands to profit from the euro’s fall. He has said the currency union may be fatally flawed and is leading the charge for speculators this year who are betting that the euro will crumble.

“Mr. Soros once made over $1.1 billion in a single day by betting against the Bank of England’s monetary policies, and his words are still heeded by many traders and investors,” said Karl Schamotta, a market strategist at Custom House, a Canadian foreign-exchange firm. Contracts taken out by investors betting against the euro rose to a record high on the Chicago Mercantile Exchange last month.

“Political consensus has proven to be extremely difficult to achieve” in Europe, and the Greek crisis shows how that can undermine the European economy and currency, Mr. Schamotta said. “In the years ahead, this issue is likely to come up repeatedly as countries like Italy, Portugal and Spain test the limits of fiscal restraint. Until this is effectively resolved, many analysts will continue to question the long-term viability of the common currency.”

Adarsh Sinha, a currency analyst at Barclays Capital, said most of his clients expect the euro to keep falling because of big and intransigent debt problems in countries on the fringe of Europe such as Greece and in major European capitals from London to Madrid.

“The next five years truly look to be an exceptional test of fiscal courage and credibility across Western Europe,” Mr. Sinha said.

Even taking into account major budget cuts adopted by the Greek parliament last week, “Greece faces still a marathon task of additional further adjustment in the years ahead,” he said. “Very few countries have achieved this scale of adjustment,” and similar challenges face Spain, Ireland and the United Kingdom, he said.

Greece’s government last week adopted drastic spending cuts and tax increases to try to reduce the country’s budget deficit from 12.7 percent of economic output to 8.7 percent this year. The budget cuts were well-received in financial markets and helped Greece sell a $6 billion bond issue on Thursday. German Chancellor Angela Merkel remained noncommittal despite Greece’s explicit calls for aid and its threat to go to the IMF for assistance.

After meeting Friday with Greek Prime Minister George Papandreou, Mrs. Merkel said she was optimistic that Greece wouldn’t need any assistance, given the progress it made last week. The austerity plan sent “a very important signal to strengthen markets’ confidence again in Greece and so also in the euro,” the German leader said.

Mrs. Merkel added that the EU and the Group of 20 economic powers need to do more to prevent “speculators profiting from the difficult situation in Greece.” She suggested that the G-20 adopt rules prohibiting speculators from attacking sovereign nations and attempting to profit from their financial woes.

In a meeting Sunday with the Greek leader, French President Nicolas Sarkozy expressed similar sentiments about dealing with speculators, though he did not mention nor detail any specific measures.

Mr. Papandreou headed next for the United States, where he will meet Tuesday with President Obama and give a speech in Washington on Monday.

Greece’s feisty government labor unions staged violent protests against proposed deep cuts in salaries and pensions. But the strong reception in financial markets enabled Greece on Thursday to re-enter the bond market with a surprisingly good auction that was oversubscribed with $9.5 billion in bids.

“We are pleased because there is very heavy demand, and that means something,” said government spokesman George Petalotis, although the government had to pay about double the interest rates paid on German bonds. Athens has to borrow or roll over about $72 billion of debt this year, including $20 billion by the end of May. Because it cannot afford such exorbitant rates on publicly sold bonds for long, analysts say, Greece eventually will need low-cost loans from larger EU countries.

While the drop in the euro has tarnished its standing as the world’s second most predominant reserve currency, it helps ease some economic problems plaguing Greece and the rest of Europe. A weaker euro increases the competitiveness of exports and helps promote growth and tourism.

“A weakening of the euro would be quite useful for Europe to stimulate its exports,” Hans-Werner Sinn, president of German’s Ifo Institute for Economic Research at the University of Munich, told Bloomberg News. Overenthusiasm about the euro among investors in recent years caused an overvaluation of the currency, he said, pushing it “way out of line” with respect to the dollar and other currencies. After peaking at close to $1.50 last year, the euro by Friday had fallen to about $1.36 in New York trading.

Germany, the biggest exporting country in Europe, stands to gain the most from the decline of the euro, but Mr. Sinn was unsympathetic to Greece. “Greece should never have entered the eurozone because they did not qualify, and they are now blackmailing the other European countries via the euro,” he said.

Economists and political advisers say Europe ultimately must stand behind Greece to ensure the success of the monetary union. Joseph Stiglitz, a U.S. Nobel Prize winner in economics and adviser to the Greek government, has warned that speculators sense blood in the water and that European officials should intervene in markets to make bets against the currency unprofitable to speculators.

The IMF has made it clear it is ready to lend to Greece and already is providing technical support, but analysts expect Germany and France ultimately to relent and arrange loans to Greece, perhaps through state-owned or private banks.

Another alternative that European officials discussed over the weekend would be to create a kind of internal IMF for the European Union, which would provide loans to member states in financial emergencies.

The IMF has provided assistance to Hungary, Romania and Latvia, but those countries are not part of the 16-nation bloc that has adopted the euro currency.