A Mighty Euro Made in Germany

Credit markets have been thrown into a tizzy in recent weeks as investors focused on Ireland and Greece, two euro zone countries with world-class fiscal problems. Now markets are wondering how this will affect the euro, a currency that has been on a tear thanks to Germany's export-fueled growth.

Markets certainly fear an Irish flameout. Irish bond yields have climbed to records relative to German bunds, reflecting heightened default risk. An index of credit-default swaps, which measures the cost of protecting investors in Greek, Irish, Portuguese, and Spanish government bonds from nonpayment, has more than doubled since May 12.

Yet the euro has climbed 9 percent since May, and at a recent value of $1.37, it is a healthy distance away from a four-year low of $1.19 on June 7. Goldman Sachs (GS) analysts even predict the euro will strengthen to $1.55 in a year.

The euro's relatively strong performance signals confidence that the euro zone countries collectively have the firepower to handle another sovereign debt crisis. The zone's officials pledged in May to back any struggling members by tapping the European Financial Stability Facility, which will make up to $1 trillion in loans and guarantees available if things get dire. "Earlier this year, the currency market was worried that the euro zone would not survive politically," says Thomas Stolper, an economist at Goldman Sachs in London. "But now if there is a fire in one of your rooms, it no longer means that the whole house will go up in flames."

This cautious optimism stems from traders' new sense of proportion as they assess risk in the euro zone. "It's only when the big countries like Spain get involved that it's relevant for euro-dollar," says Bilal Hafeez, global head of foreign-exchange strategy at Deutsche Bank (DB) in London. Greece, Ireland, and Portugal are less consequential because "in GDP terms they're tiny, they're like Idaho. Right now it's the Germanic aspects of the euro area that are driving" the currency, he says. Ireland's gross domestic product accounted for just 1.8 percent of the euro region's $12.6 trillion economy last year. German output, in contrast, amounted to 27 percent.

Germany's exports have rebounded from a four-year low in May 2009, largely fueled by Asian demand. German gross domestic product has grown for five consecutive quarters since the nation emerged from recession in the second quarter of 2009, including a 2.2 percent jump in the three months through June. Traditional export titans like chemicals maker BASF and Bayerischen Motoren Werke have recorded strong profits.

The Germans are not even fazed by the recent strength of the euro, arguably a drag on their exports. For Raimund Muecke, a German pensioner from the Frankfurt suburb of Harheim, the euro's surge since June against the dollar signals a return to the days when a thriving Germany and an appreciating deutsche mark powered a robust Europe. "A strong euro is good for Germany," says Muecke, 63, who, along with his wife, was babysitting his grandson at a farmer's market one day in early November. "If Germany is doing well, others do well too."

Signs are emerging that the euro may be peaking, despite the bullishness of some analysts. The currency is off its recent high of $1.42 and jitters about Ireland and Greece won't go away. Traders are also gradually shifting their focus to the region's fiscal challenges. Europe may well prevail if another sovereign debt crisis erupts. A second big bailout won't be a pretty picture, though.

The bottom line: Robust German export growth is powering the euro, despite market jitters about the debt crises in Ireland and Greece.

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