Europe Still Under Stress

8/2/2010


Now that more than 92% of the 91 European banks subject to stress tests have passed those tests, and regulators have attested that the results “confirm the overall resilience” of the banking system, the euro is extending its rally.

The currency has risen 1.4% relative to the U.S. dollar since stress-test results hit the market on July 23 and is up 9% since dropping below $1.20 in early June on fears of a financial meltdown and slow economic growth.

EU regulators concluded that a substantial decline in the value of sovereign bonds would drop the capital positions of seven European banks below comfort levels. Combined, those banks were told to raise 3.5 billion euros, or about $4.55 billion in U.S. dollars. Given that some U.S. banks were required to raise $10 billion or more individually, the numbers are not that large, and several banks have already begun to issue debt.

However, while the stress tests allowed for declines in the value of sovereign bonds, or government debt, they did not consider the possibility of default. And given the precarious position of some European countries, that lack of a worst-case scenario undermines the credibility of the tests.

While the threat of defaults still weighs on companies that own European sovereign debt, the biggest impact on many individual investors will come via the euro. Sluggish economic prospects already weigh on the euro, and if the global financial community loses confidence in the stress-test results, the euro could remain weak. A weak euro erodes the purchasing power of Europeans, potentially putting downward pressure on the earnings of U.S. exporters.

 


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