The Euro Crisis Real-time updates and analysis of Europe's debt crisis January 11, 2013, 8:47 AM Draghi

May Regret a Stronger Euro

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By Nicholas Hastings

European Pressphoto Agency

European Central Bank President Mario Draghi

Mario Draghis commanding performance at Thursdays European Central Bank press conference appears to have been a game changer. He has convinced the financial markets that the euro-zone debt crisis has turned a corner and that normality is finally returning.

Global risk sentiment has improved, key bond yields among debtor countries have continued to fall and capital inflows have recovered. All very well and good. But there is one thing Mr. Draghi has delivered that he may regret. A stronger euro. By suggesting at the press conference that the ECB will not cut rates again just now, as many in the market had expected, the ECB president has given the single currency an additional fillip just when the euro-zone economies dont need it. Mr. Draghi himself admitted that the state of most euro-zone economies remains fragile and the risks for recovery remain on the downside. These export-driven economies have already had to face more than a 10% rise in the euro against the dollar over the last six months. Now they may have to face even more if investor inflows into the region start to take off again. Of course, recent signs of an improvement in the global economy mean that there should be an increased demand for euro-zone exports. If its fiscal problems are resolved, the U.S. should avoid the recession many feared would take place this year. Economic expansion in China appears to be back on course after months when it looked as if the country could be facing a hard landing. And even Japan, which has been stuck in recession for years, now looks set to pursue more aggressive monetary and fiscal policies aimed at ensuring recovery. All these countries are key markets for euro-zone manufacturers. However, the euro is now being faced with a lot more than just gains against the dollar.

With the U.K. economy still flat lining, despite government efforts to kick start a recovery, the Bank of England is expected to introduce even more monetarypolicy easing and drive the pound lower against the euro. With Japan seeking to deliver a cheaper yen at nearly any cost, the euro has already rallied sharply against the Japanese currency. And, with Swiss banks now essentially charging investors for holding deposits in Swiss francs, the euro is once again finding itself under heavy buying pressure against its Swiss counterpart. To make matters even worse, the euro could also become the focus of renewed reserve diversification by foreign central banks. In our view, the global FX reserves data show pent-up euro/dollar demand as emerging-market reserve managers are still overweight dollar and underweight the euro, according to the currency strategy team at BNP Paribas. So, just as the euro-zone economies are struggling to prevent a slide into recession over the next few months, the euro could be on the rise. This will not only make the recoveries of these economies more difficult, but it will also make implementation of key structural and fiscal reforms even harder. And Mr. Draghi may find that the strength of the euro could well make it even more difficult for the euro zone to recover from the debt crisis.