Return to sovereign currencies wouldn't be as traumatic as assumed ...

The currency team at Bank of America Merrill Lynch have taken a stab at what "fair value" would be for the major legacy currencies in the euro in the event of a breakup. And they've come up with some quite surprising results (see bar graph below)

The conclusion is that Spain, Italy, Portugal and France are all overvalued against the US dollar as things stand, with Spain the most at around 20pc. That's not so surprising, you might say, and if anything probably understates the true position.

But look at the countries thought to be undervalued. Ireland, on the Merrill Lynch analysis, is the most undervalued even though it is undoubtedly completely bust, while Germany, which conventional wisdom would say was massively undervalued as a result of its membership of the euro, is actually only quite marginally undervalued ? by around 5pc. If Germany left, says the team, then the euro fair value would fall only 2pc against the dollar. If Italy left, it would rise only 3pc.

These are not big swings. The trouble with this sort of analysis is that there is a world of a difference between academic modelling of fair value and where a currency actually trades. Any break-up or withdrawal from the eurozone would unlikely be orderly. There would be large shocks to all currencies involved, and no model can fully account for these. Currencies often show extreme deviation away from fair value.

However, Merrill Lynch is adament that its modelling gives a reasonably accurate assessment of fair value once the respective exchange rates have settled. On this model, the effect on competitiveness were Germany to return to the D-mark would not be as negative as widely assumed. Even within the eurozone, the currency realignment would stretch to no more than 25pc, and against the dollar, it would be only 5pc.

This is perhaps not as odd a finding as it looks, since Germany is already a very large part of the eurozone; it's economic prowess is therefore already reflected in the strength of the single currency against the dollar. As for Ireland, bust it may be, but it also has high levels of productivity, again runs a current account surplus and still holds major attractions for inward investment.

In any case, it's possible that return to sovereign currencies wouldn't be quite as traumatic as everyone assumes.

Source: http://blogs.telegraph.co.uk/finance/jeremywarner/100013438/return-to-sovereign-currencies-wouldnt-be-as-traumatic-as-assumed/

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