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If sterling goes down on 'Brexit', it's taking the euro with it

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Britain's referendum on its membership in the European Union isn't just a threat to the pound. It's raising currency-market risks across the continent.

[LONDON] Britain's referendum on its membership in the European Union isn't just a threat to the pound. It's raising currency-market risks across the continent.

While the pound led declines among major currencies on Monday with its biggest slide since 2010, the euro had the second-largest decline, weighed down by signs of slowing growth. The cost of options protecting against losses on Europe's 19-nation currency also jumped.

The UK's potential exit may damage trade and encourage other members to renegotiate their relationship with the EU, signaling scope for further losses in the euro in the run-up to Britain's June 23 referendum.

"If we have increased Brexit risk, we will have a negative risk for the euro," said Daragh Maher, New-York-based head of US currency strategy at HSBC Holdings Plc, Europe's biggest bank.

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"Not to the same extent as sterling, but in the same direction. Brexit is still a background story for the euro."

Though European Central Bank President Mario Draghi may welcome a weaker euro to help revive the region's economy, depreciation stemming from systemic risk would be more troubling.

The UK's exit from the EU would call into question the whole European project, which champions integration within the region, according to Frederik Ducrozet, an economist at Banque Pictet & Cie SA in Geneva.

Draghi's Pledge

With the euro region still struggling to recover from its sovereign-debt crisis, the bloc can ill afford additional growth-threatening turmoil. Mr Draghi has already pledged more than a trillion euros in asset purchases and cut policy interest rates below zero in an attempt to boost inflation, and the prospect of more stimulus at next month's meeting is further weakening the euro.

The euro slid 0.9 per cent on Monday as reports showed the region's manufacturing and services activity both slowed.

The pound slumped 1.8 per cent. The shared currency rose 0.2 per cent on Tuesday at US$1.1045 as of 12:37 p. in Tokyo, while the pound fell 0.3 per cent to US$1.4115.

The median forecast among analysts surveyed by Bloomberg is for the euro to decline to US$1.08 by March 31, and end the year at the same level.

"Brexit is a European issue and not just a UK issue," said Donal Kinsella, London-based investment director of fixed income at Henderson Global Investors, which manages about US$130 billion.

"Policy responses might be necessary from central banks outside of the Bank of England, especially if the ECB believe Brexit will damage growth in the euro zone."

Europe's Recovery

Seven of the UK's nine biggest trading partners are in the EU, according to data compiled by Bloomberg, meaning an exit may be a blow to both sides if business conditions worsen.

Smaller European countries including Ireland, Luxembourg and Malta would fare the worst if the UK loses some its access to the single market, economists at Germany's Bertelsmann Foundation said. Even the continent's heavyweights such as France, Germany and Italy don't come away unharmed.

EU nations would be relegated to second-class status if the UK exits, according to Deutsche Bank AG, the second-largest currency trader. The bloc, which includes the 19 nations that share the euro as their currency, is underestimating the fallout from a Brexit, the bank's head of research David Folkerts-Landau said last month.

"The euro will weaken and remain weak as part of the healing process for the euro zone," said Alan Wilde, head of fixed income and currencies at Baring Asset Management in London, which manages about US$34 billion.

"If the markets have to face up to the consequences of the UK leaving the EU, there are downside risks for the EU and the whole euro zone construct as well - but we have not got to that point yet."

Survation Poll

The UK's exit from the bloc is far from assured. A telephone poll carried out by Survation on Saturday showed 48 per cent of respondents want the UK to stay in the EU, compared with 33 per cent who would vote to leave and 19 per cent who are undecided.

The options market is also signaling a shift in sentiment toward the euro. The premium for options protecting against a decline in the currency versus the dollar, compared with those insuring against an increase, gained 19 basis points to 124 basis points on Monday, the biggest jump in more than a week, according to six-month risk-reversals.

Before a deal between the UK and the 27 other EU nations was reached, the Maltese Prime Minister Joseph Muscat said he will insist other nations have the opportunity to benefit from any concessions the UK wins on social benefits and movement of EU citizens. 

French President Francois Hollande said last week Europe must stand ready to take initiatives right after the UK referendum, regardless of the outcome.

"Even if we don't get Brexit, it shows the UK gets special considerations and weakens the bond for the EU in general if other nations are clamoring for special circumstances as well," said John Hardy, head of foreign-exchange strategy at Saxo Bank A/S in Hellerup, Denmark.

"The whole argument of a two-tier Europe is risky politically speaking. Net-net it's a negative for the euro."

BLOOMBERG

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