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          Covid's Economic Fallout Puts Euro to the Test

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          05/08/2020 | 04:53am EDT

          By Caitlin Ostroff

          Europe's response to the economic turmoil brought about by the global coronavirus shutdown is rekindling debate about the European Union's financial unity.

          The euro has dropped 3.5% this year to $1.08, near its lowest level against the U.S. dollar since May 2017. The currency could lose another 5% by year-end, according to forecasts from Bank of America. That marks a sharp turnaround for a currency that posted its calmest year on record in 2019, when it slid 1.8%.

          Tensions resurfaced in recent weeks with wealthier nations like Germany and the Netherlands resisting taking on additional debt to help beleaguered nations in the eurozone such as Italy and Spain. The discord has hobbled the European Central Bank's efforts to follow in the Federal Reserve's footsteps by offering sweeping measures to bolster the eurozone economy and backstop financial markets.

          "Whatever happens, regional cohesion in the eurozone is going to be challenged in the wake of this crisis," said Richard McGuire, head of rates strategy at Rabobank. A perception that there will be insufficient aid for the southern European nations "is only likely to feed into the hands of euroskeptics," he said.

          The eurozone is headed for the deepest recession in its history, with the economy expected to contract 7.7% this year, the European Commission forecast on Wednesday. Any recovery is expected to be slow, halting and uneven, and is likely to lag that of the U.S. economy. Capital Economics, for instance, has forecast that the eurozone might not get back to precrisis levels until after 2022.

          The damage from the outbreak is particularly severe in southern European nations, whose economies are struggling and where the public-health crisis has been even more acute. Italy's debt burden -- along with that for Greece, Spain and France -- is expected to reach its highest levels on record, the European Commission has said.

          The ECB has delivered a more modest response to the economic crisis stemming than either the Fed or the Bank of England. That is in part because Germany and the Netherlands have opposed proposals such as issuing common debt, which would share the fiscal burden among member states. Some local leaders are also opposed to a more aggressive bond-buying program by the ECB, viewing it as coming perilously close to financing governments' spending.

          "The ECB is saying whatever it takes, but if investors start thinking there seem to be limits, that changes the basic picture," said Nick Kounis, head of financial markets research at ABN AMRO. "Italy is a much bigger country and a much bigger threat to the eurozone" than Greece or other nations that have threatened the region's unity in the past, he said.

          In the latest shock to the eurozone, the ECB's ability to increase the purchase of government bonds under a program started in March 2015 has come into question. A top German court on Tuesday said the ECB needs to demonstrate that it is meeting certain criteria on the amount of bonds bought from each country.

          Any limits on the ECB's ability to buy bonds might add to the turmoil in the region's financial markets and lead to a deeper, more protracted recession for the eurozone. The ECB's Vice President Luis de Guindos sought to stave off further national legal challenges by saying Thursday that the bank is subject to European law.

          The court's ruling is being viewed by some investors as an attempt by Germany to limit the independence of -- or assert Germany's authority over -- the ECB. That is likely to have political ramifications, especially as the divide between the member countries deepens.

          "As we go into the next phase, which is the market trying to work out the relative points of strength and weakness, the politics for the euro are going to be a flashpoint," said Jane Foley, head of currency strategy at Rabobank. "The market needs to know how united the eurozone will be."

          Concerns that Italy's debt load will become unsustainable without sufficient support from the ECB pushed the spread, or the extra yield that investors demand to hold Italian 10-year government bonds over the German equivalent, to about 2.4 percentage points Friday, up from about 1.28 points in mid-February.

          The yield on Italy's benchmark debt briefly surpassed 3% in mid-March, at the peak of the global market turmoil, from less than 1% a month earlier. Commitments by the ECB to purchase southern European bonds have assuaged the market to some extent, bringing the yields down to 1.855% on Friday.

          Some investors are speculating that a continued rise in borrowing costs could prompt Italy's populist government to clash with the European Union.

          "If the path for Italy is many years of austerity, this increases the risk of populism," said Athanasios Vamvakidis, head of foreign-exchange strategy at Bank of America Global Research. "All these considerations will be extremely important after we have put coronavirus behind us."

          --Pat Minczeski contributed to this article.

          Write to Caitlin Ostroff at caitlin.ostroff@wsj.com

           

          Stocks mentioned in the article
          ChangeLast1st jan.
          BANK OF AMERICA CORPORATION -0.77% 24.35 Delayed Quote.-30.86%
          EURO / US DOLLAR (EUR/USD) 0.01% 1.1656 Delayed Quote.3.41%
          RISE, INC. -9.38% 29 End-of-day quote.-3.33%
          THE GLOBAL LTD. -2.27% 215 End-of-day quote.-54.35%
          THE LEAD CO., INC. 2.24% 365 End-of-day quote.-6.41%
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