Euro Bid to Challenge King Dollar Collides With Political Risk

(Bloomberg) -- Europe’s dream of turning the euro into a global reserve currency that can rival the dollar is proving more elusive than ever.

A rally on Thursday notwithstanding, the euro is trading within striking distance of its low this year as a confluence of political risks looming large over Europe damp sentiment toward the common currency.

Angela Merkel said this week that she won’t contest to be Germany’s Chancellor again in 2021 after her party suffered electoral setbacks in regional elections, while Italy’s coalition government is embroiled in a stand-off with the European Union over a wider deficit in its planned budget.

The flare-up of political risk across a landscape that shares the euro as its common currency shows European Commission President Jean Claude Juncker has his work cut out before realizing his vision of upending the global dominance of the dollar. The euro has lost almost a fourth of its value since before the euro-area debt crisis erupted in 2011, suggesting that central banks aren’t quite embracing Juncker’s dream just yet.

Euro Bid to Challenge King Dollar Collides With Political Risk

Merkel has been a constant in euro-zone politics for almost two decades, and one of its most vocal champions of economic convergence. The euro will struggle to gain traction as questions resurface over the European Union’s staying power with her departure, according to Deutsche Bank.

“Political dynasties only last so long,” said Alan Ruskin, global co-head of foreign-exchange research. Merkel’s departure “underscores the existing underlying concerns the market has about the fact that the euro monetary union has substantial imperfections and is vulnerable to political-led instability.”

European policy makers have been vexed by the dollar’s preeminent status in the currency world, with the bulk of the EU’s energy imports priced in dollars rather than the common currency even though shipments from the U.S. are negligible. The euro currently makes up about 20 percent of global currency reserves, with the greenback accounting for more than 60 percent, according to the latest data from the International Monetary Fund.

The euro traded at $1.1400 on Thursday, rebounding from a low of $1.1302 on Wednesday, just one pip shy of its low for the year.

Italy Wildcard

For the euro to decisively overtake the dollar as a reserve currency, the risk of the bloc breaking up needs to be “completely eliminated” and that’s not the case yet, said Ryan Myerberg, a money manager at Janus Henderson Investors.

Italian budget issues are set to continue to preoccupy investors into 2019, even after the country survived a brace of credit-rating reviews largely unscathed. The coalition continues to push for a higher deficit than allowed under European rules.

“To me the fundamental issue going into 2019 is whether Italy can resolve its budget issues with the European Commission,” Van Luu, head of currency and fixed-income research at Russell Investments Ltd., said. “It will be interesting to see whether populist or euro-skeptic parties can gain significantly in elections, if that was the case it could undermine the case for the euro.”

As the situation in Italy causes flashbacks to the euro-zone’s 2011 sovereign debt crisis, reserve managers will likely be deterred from loading up on the euro, Van said. Market nervousness since 2011 had probably already kept central banks from adding to their euro reserves, he added.

Another reason the euro has struggled to deliver on its promise to become the world’s currency of choice is the inchoate, fragmented structure of the European financial system, according to Investec Asset Management Ltd.

The lack of banking union in the euro zone and deep, liquid instruments that are comparable to the U.S. Treasury market are reasons the euro would struggle to challenge king dollar’s supremacy, said Russell Silberston, a portfolio manager at Investec. In that sense, the monetary union pursued by Europe for so long is “incomplete,” he said.

Still, euro bulls may get some help in their project from another politician. The unpredictable and isolationist policies of U.S. President Donald Trump could mean other currencies see more reserve buying going forward, according to Janus’ Myerberg.

“The long game is that the euro and yuan take market share from the dollar, but clearly the euro has many more challenges to face and surmount before we reach that end game,” he said.

©2018 Bloomberg L.P.