LONDON As the euro crisis intensifies to the point of investors openly contemplating a fracturing of the single currency, perhaps the most puzzling performance all year has been the stability of the euro exchange rate itself.
Government bond and bank equity prices have plummeted. Euro financial funding systems are creaking, European business confidence has evaporated and regional economies are heading for their second major recession in three years.
The bloc's failure so far to devise a credible firebreak to almost two years of rolling creditor strikes in its government debt markets -- from tiny Greece, Ireland and Portugal to trillion dollar economies such as Italy and Spain -- has cast a pall over the currency's future in the minds of many investors.
Yet Europe's single currency has more than held its own.
The euro's exchange rate index -- measured against currencies of the bloc's major trading partners -- is still almost two percent higher on the year.
And that's pretty much where it was before the whole credit crisis kicked off in 2007. Wind back further and it remains more than 20 percent higher than when euro notes and coins first hit the streets in 2002.
On the face of it, that is not a currency trading as if it will be history in a few years and some of the world's leading experts are baffled.
"I find today's relatively robust value for the euro somewhat mysterious," Harvard professor and former IMF chief economist Kenneth Rogoff said this month, adding he doubted that stability would last given a deepening of the crisis could eventually force the European Central Bank into printing money.
Financial firms are also scratching their heads.
"We struggle as a house to see why it (the euro) is where it is and also whether, in any situation, how it strengthens," said UBS Head of European Equity Strategy, Nick Nelson.
"If you go the ECB QE (quantitative easing) way where you have a weaker currency, or if you get to a break up situation with panic that leaves you with a weaker currency."
Trade-weighted euro index: link.reuters.com/haq94s
Euro/$ graphic, spec positioning: tinyurl.com/2bpyqhj
Global policy rates: link.reuters.com/dak94s
Eurozone balance of payments: tinyurl.com/cv6q74a
Rogoff on euro: tinyurl.com/cke9pa6
US and euro bank lending: tinyurl.com/cdqb25r
BIS paper on dollar shortages: tinyurl.com/an25rv
MIND THE GAP
But why isn't that risk priced in by currency markets now?
Rogoff offered a list of reasons, including the persistence of largely mechanistic central bank reserve management where the euro still attracts more than quarter of the $10 trillion (6.3 trillion pounds) hard cash reserves held by China and others.
Yet most prosaically, the euro's movements this year have probably been best correlated with short-term interest rates.
As the United States, and other governments of the major reserve currency economies such as Britain and Japan, all cranked up dollar, sterling and yen printing presses for the second time in four years, the European Central Bank pushed up its interest rates through the early part of this year.
Even though it partly reversed those hikes last month, it is that relative rate picture that seems to best explain the euro's modest shifts in an otherwise turbulent 2011. As it stands, deposit rates are a percentage point more than dollars.
It still seems odd that doubts about the very future of the currency are dominated by minor quarter-point tweaks in official rates. As the ECB will no doubt ease further into a looming European recession, you would expect the euro to weaken. But it is hardly panicked capital flight.
So what gives? Does the stable euro exchange rate reveal some deep-seated confidence in the currency's long-term survival that belies mounting angst elsewhere? Or is there a more complex and less understood blizzard of flows at play?
For a start, using the euro exchange rate as a gauge of the currency's "success" or "failure" has always been a fruitless exercise and market narratives on this tend to be skewed.
As it slumped almost 30 percent against the dollar in the two years after its launch in January 1999, there was a hue and cry from many financial and political circles about that being a damning investor judgment on the euro's soundness.
Yet, few saw the subsequent 50 percent surge of the exchange rate over the following three years as a badge of fortitude.
In fact, the 1999-2002 euro/dollar shifts were just as likely driven by the final throes of the U.S.-heavy dot.com bubble and bust diversification of euro zone asset managers to non-euro markets. And what it showed was functional financial flows can often be as powerful as sentiment or interest rates.
The most basic measure of the euro zone's foreign financing needs gives the best inkling to stability of the currency. The region's current account is basically in balance, in the red by less than half of one percent of the bloc's annual output.
The United States had a current account deficit last year of almost four percent of GDP. So, while Washington needs more than $10 billion a month of new overseas money just to balance the books, the euro zone is basically self financing.
Economists William Cline and John Williamson at Washington's Peterson Institute said a euro around $1.41 was approximately at fair value -- it is around $1.35 now -- and a steep depreciation to lift Europe's growth may even destabilise the world economy.
The web of financial assets and liabilities complicates the picture further. One important primer is what happened at the height of the Lehman Brothers bankruptcy in 2008.
Then, the dollar surged even though the epicentre of the crunch was in the U.S. mortgage market and dramatic policy easing followed from the Federal Reserve and Treasury.
Only part of that was due to global demand for a liquid "safe-haven" in U.S. Treasury securities. It was also due to the nature of dollar financing worldwide.
European banks held trillions of dollars in U.S. assets, many distressed mortgage-related assets, funded with much shorter-term dollar borrowings. The crux came as they were forced to write down their value even though they had to keep funding them fully to maturity.
That left banks with structurally short dollar positions that required one-off purchases to close out, fuelling a dollar exchange rate surge.
Now, concern about writedowns centres on euro government assets like Greece and any safe-haven demand for funds fleeing peripheral euro zone sovereigns is being satisfied largely by German government bonds, with no net exchange rate implications.
Adding to that "safe-haven" push is talk that some harder euro core of Germany, France and more fiscally-sound satellites like the Netherlands and Austria may push ahead with the euro without the likes of debt-laden Italy, Spain and Greece.
HSBC currency strategists on Monday said they felt the existing euro would pull through intact, but analysis showed a "core" euro would rise once the initial turmoil abated.
"An exit by one or more peripheral countries from the euro would ultimately put the currency under upward pressure as the remaining euro would behave a bit more like the Swiss franc."
True or not, the euro exchange rate may well fall further before any of this materialises. But the timing and extent of its fall is not at all obvious.
(Graphics by Scott Barber, editing by Mike Peacock)