How World Events Impact The Euro

The euro is the national currency of 19 of the 28 European Union countries and used by nearly 340 million people every day, according to the EU, making it the second-most widely used currency in the world after the U.S. dollar. The purpose of the euro was to create a common currency among European countries in order to facilitate commerce and payments, and remove the exchange rate risk in doing cross-border business.

Being a member of the EU doesn't require countries to use the euro, but most do. To join the euro area, each of the 19 countries had to fulfill the convergence criteria that set out the economic and legal preconditions for countries to participate in the European Economic and Monetary Union. The other EU member states must also fulfill the criteria before becoming eligible to adopt the euro.

Members of the European Union using the euro currently are:

Members of the European Union not using the euro are:^[1]

Andorra, Monaco, San Marino and Vatican City also use the euro under a formal arrangement with the European Community. Montenegro and Kosovo also use the euro, but without a formal arrangement.^[2]

While the U.K., which has never adopted the euro, voted to leave the EU in 2016, all remaining EU member states are legally committed to joining the euro at some point, with the exception of Denmark. However, since 1999, the Danish krone has participated in the Exchange Rate Mechanism II, where its exchange rate to the euro is fixed. Bulgaria and Croatia also peg their currencies to the euro.

The Creation Of The Euro

Economic and monetary union (EMU) was an ambition for the EU since the late 1960s, as it promised stability, greater economic growth and higher employment. Europe's leaders set up a high-level group led by Pierre Werner, the prime minister of Luxembourg at the time, to report on how EMU could be achieved by 1980. The Werner group set out a three-stage process to achieve EMU within 10 years, including the possibility of a single currency. In 1971, the EU member states agreed in principle to the plan and began the first stage, which involved reducing currency fluctuations, and in 1979 the European Monetary System (EMS) was launched.

The EMS was built on exchange rates pegged to a newly created ECU (European Currency Unit), a weighted average of EMS currencies, with an exchange rate mechanism (ERM) used to keep participating currencies within a narrow range. The EMS operated successfully for more than a decade, which led to further discussions to build an Economic and Monetary Union, including free capital movements within Europe, a common monetary authority and a single monetary policy. At the request of European leaders, European Commission President Jacques Delors and the central bank governors of the EU member states devised a plan, called the Delors Report, to achieve EMU in three steps.

The resulting Treaty on European Union, which contained the provisions needed to implement EMU, was agreed upon at the European Council held at Maastricht, the Netherlands, in December 1991. The Council also agreed on the convergence criteria that each member state would have to meet in order to join the euro area.

The Euro Launches In 1999

After a decade of preparations, the euro was launched on 1 January 1999. At the same time, monetary policy was transferred from the national central banks of the 11 EU member states to the European Central Bank (ECB), which was established on 1 June 1998.

For the first three years, the euro was an "invisible" currency, serving alongside national currencies and used only for accounting purposes as well as for electronic payments. Actual cash was not introduced until 1 January 2002, when it replaced the banknotes and coins of each national currency. The creation of the euro area and the ECB was a milestone in the long and complex process of European integration.^[5]

The European Central Bank's Role

Since the launching of the euro in 1999, the ECB has been responsible for conducting monetary policy for the euro area, much as the Bank of England does in the United Kingdom and the Federal Reserve does in the U.S. The ECB and the national central banks together constitute the Eurosystem, the central banking system of the euro area. The main objective of the Eurosystem is to maintain price stability and safeguard the value of the euro.^[6]

The ECB is also responsible for supervising banks and credit institutions in the euro area and participating non-euro area member states in order to promote the safety, soundness and stability of the banking and financial system within the EU and each participating member state.^[7]

The euro offers both advantages and disadvantages to its member states. Smaller countries and those with relatively weak economies benefit from lower interest rates than they might otherwise be able to obtain on their own. This is because of the safety conferred on the euro by its being backed by the area's biggest and strongest economies, such as Germany and France. In exchange for that benefit, member states give up much of their sovereignty to the ECB and the other states, such as having to adhere to the convergence criteria, which includes keeping their annual budget deficits at less than 3% of their gross domestic product and their debt-to-GDP ratio at less than 60%.

The larger economies benefit from more open markets for their goods and services exports throughout Europe. However, they often resent what they view as the profligate and irresponsible policies of the smaller countries and feel they are carrying a disproportionate share of the load. These differences came to a head during the several national debt crises following in the wake of the global financial crisis.

Euro Confidence And Acceptance

Since its creation in January 1999, the value of the euro has fluctuated fairly widely, much like other major currencies. Shortly after its introduction as an "invisible" currency, the euro was valued at about US$1.16 (the price of the euro is most commonly quoted by its value against the U.S. dollar, although of course it is quoted against all of the other major currencies). The euro then began a steady slide, quickly falling well below US$1.00. By the time the euro began circulating as a cash currency in January 2002, it was worth about 90 cents to the dollar.

Over the next several years, as the euro found its footing and gained acceptance among eurozone citizens and around the world, it eventually reached its historic peak of about US$1.60 in mid-2008—just as the global financial crisis was reaching its nadir. In the five years following the crisis, the euro traded in a fairly narrow band of about US$1.50 at the high end to about US$1.25 on the low end, as the ECB lowered interest rates and purchased billions of securities as part of its monetary stimulus measures.

Perhaps the darkest days for the euro were during the sovereign debt crisis, as many people questioned the currency's survival amid the threat of default, the Greek bailout, and concern that one or more countries would leave the zone. The ECB's mammoth asset-purchase program also had the effect of flooding the financial markets with euros, effectively devaluing the currency. Although the euro came close to reaching "parity" with the dollar, it never reached that point. Throughout 2015 through early 2017, it traded in a narrow band around US$1.10, rising or falling a few cents above and below that figure.

The euro has risen sharply since then, though some of that strength is likely due to weakness in the value of the dollar, which has been falling against most of the world's major currencies. As of January 2018, the euro had climbed past US$1.25, its highest level since the end of 2014.

World Events That Impact The Euro

Like most currencies, the value of the euro is affected by many factors, including but not limited to economic growth, inflation, monetary and fiscal policies, and interest rates, as well as forces beyond anyone's control, such as acts of terrorism, natural disasters and weather. The euro is affected not just by political and economic events within the euro zone itself but also those outside its borders. Let's look at a few of them.

The Global Financial Crisis And The European Debt Crisis

The global financial crisis that began in 2007 was largely sparked by the collapse of the subprime mortgage industry in the U.S., but it quickly spread and proliferated around the world as securities backed by those mortgages were held by investors and financial institutions in other countries. Europe was not immune. Many countries found themselves in financial difficulties due to rising budget deficits as a result of weak or negative economic growth. Several countries ran budget deficits that far exceeded not only their obligations to the convergence criteria but also their ability to pay.

In 2009, Greece announced it might default on its debt. Greece had been less than honest in validating that its finances adhered to the convergence criteria when it joined the area in 2001, namely because its tax collection practices were lackadaisical and that its budget deficits were far higher than it had admitted to. Worries soon grew that other countries may also default, including Portugal and Ireland. Most worrisome of all were Italy and Spain, the third and fourth largest economies in the eurozone. Much of their debt was held by the region's banks and the ECB itself, so that also threatened the safety and soundness of the region's entire financial system and the value of the euro.

In August 2011, the ECB announced the Long-Term Refinancing Operation, or LTRO, in which it would buy government bonds issued by the various euro area nations in order to try to reduce bond yields and make it easier for them to pay their debts. Also, the ECB, along with the International Monetary Fund, organised bailouts of several of the countries to avoid default but also to protect the value of the euro. The EU assured investors that it would guarantee the debt of all eurozone members.

In return, the countries that were bailed out were required to adopt austerity measures to lower their spending and get their budget deficits under control. But these countries complained that these austerity measures were not only too painful but also hindered economic growth, making it difficult for them to repay their debts and reduce their budget deficits. That led to friction between the region's strongest countries, mainly Germany, and the weaker "peripheral" countries, as they became known, largely because they were clustered around the southern tier of the continent.

Notably, there was concern that Greece would be forced to leave the euro zone or would voluntarily leave, which led to worries that other weak but much larger countries, including Spain and Italy, would follow, calling into question the very existence of the euro and the euro area. However, the bailout was generally successful and maintained faith in the euro, although several countries, notably Greece, still face continual budgetary and debt repayment difficulties.

Inflation, Interest Rates And Monetary Policy

The primary objective of the ECB is to achieve price stability, which is defined as keeping price inflation below 2% annually. Since the financial crisis, however, the ECB's biggest challenge, as it has been for other central banks around the world, is that inflation has remained well below that figure. This has triggered fears of deflation, weak economic growth and high unemployment. The ECB is concerned that inflation below 2% for too long discourages companies from hiring people. Weaker than normal economic growth since the financial crisis has been the principal reason for sub-2% inflation.

In response, the ECB tried to ignite inflation and economic growth by steadily lowering its refinancing rate, which is its principal short-term interest rate used for managing liquidity to the banking system. From 3.25% in 2008, the ECB gradually lowered the rate to zero in 2012. When that failed to get the desired results, the bank pushed the rate below zero, eventually reaching negative 0.40% in 2016. That policy led to sharply reduced yields on European sovereign bonds, including those issued by countries outside the eurozone, such as Switzerland, which also fell to below zero.

Despite such drastic and unprecedented steps, inflation and economic growth failed to respond as the ECB hoped. In 2014, the ECB unveiled an expanded asset-backed securities purchase program to try to stimulate the eurozone economy. In addition to its earlier purchases of bonds issued by agencies and sovereign governments within the region, the ECB would now buy bonds issued by private corporations as well.

At the program's height, the ECB was purchasing €60 billion a month. In October 2017, the bank announced that it would reduce its monthly purchases by half, to €30 billion, beginning in January 2018, with the purchases scheduled to end in September. Although, ECB officials have said the program may be extended depending on economic data.
By 2017, the economy of the eurozone began to respond. However, it's difficult to gauge the effect of the ECB's various stimulus programs, including lowering interest rates and buying bonds, as opposed to simply the passage of time since the financial crisis. Notably, the U.S. economy and other major global economies have been growing more strongly throughout 2017 as well.

According to the European Commission's autumn 2017 economic forecast, GDP growth was expected to reach 2.2% in 2017, which would be its fastest pace in a decade. That was "substantially higher" than its 1.7% growth forecast made just three months earlier. Looking ahead, the EC forecasts growth of 2.1% in 2018 and 1.9% in 2019.

The Coronavirus (COVID-19) Pandemic

The onset of the COVID-19 pandemic in March 2020 turned the world upside down. Unprecedented volatility swept through the financial markets as mass quarantines, travel bans and trade restrictions fundamentally changed commerce. The influence was severe, prompting governments and central banks to attempt to mitigate the damage.

The contagion had a profound impact on all foreign currency valuations. No matter the pair—major, minor, cross or exotic—volatility approached all-time highs. For the euro, a period of chaos quickly gave way to appreciation.

March 2020: The Onset Of COVID-19

As a general rule, uncertainty drives investors away from risk assets to financial safe-havens. Due to the fact that no country escaped the reach of COVID-19, the world's reserve currency became a short-term safe-haven. The US dollar (USD) saw immense bidding during the first half of March 2020, gaining marketshare vs other world currencies. Nonetheless, the EUR/USD closed March near flat (+0.04%) as the EUR quickly stabilised against the USD.

Comparatively, the EUR held its own against the currencies of other world powers during March 2020. In fact, the currencies of China, Russia, Japan and Canada traded mixed versus the EUR during this period:

• The EUR/JPY fell modestly for the month (-0.38%) as the Japanese yen became a preferred safe-haven asset among many investors.
• Over the years, the Russian ruble (RUB) has been an embattled currency. During the uncertainty of March 2020, the EUR/RUB rallied 17.54% as COVID-19 fears sparked risk-off sentiment.
• Amid falling oil prices, the euro posted robust gains versus the Canadian dollar (CAD). For March 2020, the EUR/CAD spiked by 5.02%.
• Although China was deemed the point of origin for the virus, the Chinese yuan (CNY) held its own vs the euro. At the monthly close, the EUR/CNY ticked higher by only 1.33%.

Past performance is not indicative of future results.

Appreciation

After the initial spring 2020 shock of COVID-19 resided, the euro began a strong period. In fact, from 1 April 2020 to 31 December 2020, the EUR became a sought after asset on the forex:

• Over the seven-month period, the EUR/CNY gained just over 2% in value.
• Upon the forex close on 31 December, the EUR/JPY rallied 6.3% from April's open.
• Perhaps the most impressive performance of the euro was against the USD. For the period, the EUR/USD posted a 10.7% gain.
• A steep rally in crude oil prices helped the CAD hold its value on the forex. Subsequently, the EUR/CAD traded flat, moving higher by only 0.2%.
• The COVID-19 year of 2020 was challenging for exotic currencies. This is illustrated by the EUR/RUB, which rallied another 4.4% from April to year's end.

Past performance is not indicative of future results.

In the aggregate, the euro showed resilience during the COVID-19 year of 2020. With the aftermath of Brexit still looming, forex traders backed the EUR as pandemic uncertainty took hold of global economics.

Summary

The euro is the common currency of 19 of the 28 European Union countries and used by 340 million people, making it the second most widely-used currency in the world after the U.S. dollar. It was created in order to facilitate commerce in the area by eliminating exchange rate risk among the various participating countries of Europe.

The European Central Bank is responsible for protecting the value of the euro and sets monetary policy for all of the nations who use it. The ECB's main goal is to keep price inflation at less than 2% per year, although since the global financial crisis its main challenge has been in raising inflation to that level in order to lift economic growth and employment.