Euro Faces `Challenges' on Deficit, Japan Can Learn Lessons, Sumitomo Says

The euro will face further challenges as concern over budget deficits in nations such as Greece and Portugal damp its attraction as an alternative to the dollar, according to the research unit of Sumitomo Corp.

The emergency funding measures announced by European Union policy makers this week have eliminated the immediate risk of default from Greece, yet it remains possible that some nations may still drop out of the euro area, said Soichi Okuda, chief economist at Sumitomo Shoji Research Institute Ltd. in Tokyo. Japan should take note and address its increasing debt levels before its bond yields begin to rise, he said.

“The crisis in Greece is likely to settle down following the decisive action by EU leaders,” said Okuda at the unit of Japan’s third-largest trading house by the market value. “This won’t remove all challenges surrounding the euro. Greece will struggle to fully implement the required fiscal consolidation so concerns about a possible dropout from the euro won’t go away.”

EU leaders on May 10 unveiled an unprecedented loan package worth almost $1 trillion and a program of bond purchases to stop a sovereign-debt crisis. The announcement helped the euro rally from a 14-month low of $1.2529 to as high as $1.3094 before paring those gains. The currency traded at $1.2639 as of 7:41 a.m. in Tokyo.

‘Unrealistic’ Conditions

“Given the unrealistic conditions imposed on member countries, the market will continue to scrutinize the qualifications of the single currency as an alternative to the dollar,” Okuda said.

Marek Belka, director of the International Monetary Fund’s European department, said on May 10 he doesn’t consider the rescue package a “long-term solution” to the crisis and Federal Reserve Chairman Ben S. Bernanke told U.S. senators the package isn’t a cure-all.

The euro may resume its decline as the European Central Bank’s decision to buy outstanding debt issued by financially weak countries hurts trust in the currency, Okuda said.

“Given the possible fallout from fiscal consolidation, the ECB won’t be able to embark on normalizing interest rates anytime soon, and it has to accept a gradual weakening in the value of the euro,” he said. “Besides, the ECB’s action itself may jeopardize trust in the euro.”

Bundesbank President Axel Weber said after the EU package was announced that buying bonds has “significant risks.” Weber’s predecessors said it would be irresponsible for central banks to finance deficits, arguing this would kindle inflation and increase reliance on government assistance.

Different Market

Japan has so far avoided much fallout from the European debt crisis, though this may only be temporary, Okuda said.

“Japan has a different debt market structure to Europe,” he said. The fact Japanese investors hold over 90 percent of outstanding debt issued by the government and sizeable financial assets accumulated by households “has so far served as a buffer against sovereign risks,” he said.

This has helped Japan’s 10-year yields stay mostly below 2 percent in the past decade even as the nation increased spending to counter deflation.

“But it is also true that Japan is approaching times where these positive elements can’t fully offset sovereign risk,” Okuda said. “The next few years may become the key as baby boomers retire and begin receiving pensions in force.”

About 8 million people, or 6 percent of the population, were born between 1947 and 1949, government data show, a generation referred to as Japan’s baby boomer generation. Almost 23 percent of the country’s 126 million people will be older than 65 this year, according to Bloomberg data.

“If 10-year yields rise above 2 percent again, that may be the beginning of a sustained and unfavorable spike,” Okuda said. “Lessons that we should learn from the Greek crisis are that we can’t leave the situation unaddressed and we should embark on fiscal consolidation sooner rather than later.”

The benchmark 10-year bond yielded 1.305 percent yesterday, according to Japan Bond Trading Co.

To contact the reporter on this story: Yasuhiko Seki in Tokyo at Yseki5@bloomberg.net; Saburo Funabiki in Tokyo at Sfunabiki@bloomberg.net.

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