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Will Europe's Financial Problems Spread?



Ron DeLegge, On Monday March 1, 2010, 2:06 pm EST
SAN DIEGO (ETFguide.com) - Few moments in economic history have been as big or as important as January 1st, 1999. It was then that the euro dollar made its debut on the world scene. Former currencies like the French franc, Italian lira, and German Deutsche Mark were out. The euro dollar was in.

Convincing a melting pot of countries, each with distinct financial histories and cultures, to adopt a common currency wasn't easy. But eventually, it became the shared view that the power of a few would become the power of many.

Today, just a few short months after flirting with invincibility, the euro is in crisis.

Greece's deficit soared to 12.7% of gross domestic product (GDP) in 2009. That's well above the European Union's 3% ceiling and even beyond debt levels of countries that recently suffered economic crisis like Argentina and Russia.

Will Europe's economic problems be contained to problem countries or will they spread throughout the region? And what impact will these issues have on the rest of the global economy?

From Top to Bottom

In the Q4 2009, the euro dollar (NYSEArca: FXE - News) climbed to 14-month highs versus the U.S. dollar and the only thing preventing it from going higher was the moon. At that time it was the popular view that the euro was well on its way to overtaking the sagging greenback as the world's reserve currency. A few short months later, the Euro-zone looks like a dysfunctional coalition of members each with their own financial agenda.

If Europe couldn't win the war of worldwide currency supremacy with a strong euro can they win it with a weakened one?

Structural Flaws

Currently, there are a total of 16 countries using the euro dollar; Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Italy, Ireland, Luxembourg, Malta, the Netherlands, Portugal, Spain, Slovakia, and Slovenia.

George Soros suggests the euro dollar is in deep trouble because of its structural flaws. In an editorial piece written for the Financial Times, he argued even if Greece gets a financial bailout, other problem spots like Ireland, Italy, Portugal, and Spain still loom. And the financial problems of these other countries could prove too much to overcome.

A principal flaw of the euro, according to Soros, is its lack of a central Treasury agency. While central banks can inject more liquidity into troubled financial systems, only a Treasury can handle with problems of solvency.

In 1992, Soros scored more than $1 billion in speculating profits by shorting the British pound (NYSEArca: FXB - News).

Contagion, the 'C' word

Europe's monetary system is a textbook example of contagion. By virtue of the fact that they use the same currency, each of the 16 member nations are so intertwined with each other that their financial victories and failures are essentially shared. If you think it's a difficult feat trying to get one country to correctly fire on all economic cylinders, you ought to try 16!

Here's what ETFguide's Weekly Pick/Pan wrote on January 20th: 'FXE shares closed at $140.78 and financial contagion is a huge factor for the euro because one country's financial woes become the problem of other Union members.'

So far in 2010, the stock market doesn't like what it sees. After recording a handsome 32.04% return last year, the Vanguard European ETF (NYSEArca: VGK - News) is already down 6.79% year-to-date. Single country ETFs within the region like France (NYSEArca: EWQ - News), Germany (NYSEArca: EWG - News) and Spain (NYSEArca: EWP - News) are performing even worse.

What about bonds? Currently, there aren't any U.S. listed ETFs that focus specifically on bonds from troubled countries like Greece or Spain. But the SPDR Barclays Capital International Treasury Bond ETF (NYSEArca: BWX - News) has around 50% of its exposure to European Union countries. Greece and Spain represent a small slice of total exposure. Thus far, BWX is down just 1.22% for the year.

What Now?

While sovereign debt defaults are indeed problematic, bailing out troubled euro-zone countries isn't far behind. The fragile state of the global economy makes either scenario quite dangerous, but what are the alternatives?

Don't underestimate the significance of Europe's financial problems on the rest of the world.

The eurois the second largest reserve currency and is used daily by some 325 million Europeans. According to IMF 2008 GDP estimates, the Euro-zone is the second largest economy in the world.

What would a total collapse of the euro dollar mean to the rest of the world? Will it be contained? Or will it ignite a global currency crisis?