According to IMF data, central banks in emerging economies cut their euro holdings by 8 per cent, or €45 billion (HK$450 billion) in 2012. The world economy is moving towards a multipolar currency regime.

In the past three years, the euro has remained strong because wealthy depositors have moved their savings from the periphery to the core economies. After Cyprus, they may look beyond the euro zone.

Despite some gradual gains, the euro zone continues to suffer from a range of challenges.

• Monetary stability: In July 2012, European Central Bank President Mario Draghi provided a blanket pledge to do "whatever it takes" to preserve the euro. Last September, the ECB launched a plan to buy bonds of euro members. Until Cyprus, the liquidity pledge had created an impression of stability.

• Fiscal flaws: Until recently, most European economies have engaged in front-load austerity measures and promises of long-term fiscal support. As these fiscal adjustments weigh on growth, the euro zone is again in recession. Unemployment has soared to a record high 12 per cent, and twice as high in southern Europe.

• ECB risks: Since 2008, financial institutions from debt-stricken euro zone countries have borrowed extensively from the ECB. In the coming months, pressures for new liquidity will escalate in southern Europe, which, in turn, will erode fiscal health in northern Europe.

• Banking vulnerability: In the past three years, the euro zone has agreed on a banking union, a single supervisory mechanism for euro area banks, and a bailout fund, the European Stability Mechanism. The effectiveness of the new institutions, however, remains to be tested. While the bailout fund has access to €500 billion, the debt burden of Italy alone exceeds €2 trillion.

• Pro-growth policies: To sustain their competitive strengths, the euro nations need pro-growth policies, which require substantial structural reforms, including more flexible labour markets, higher retirement ages and greater investment in innovation.

• Insolvencies: The crises could be contained as long as it involves economies which individually account for less than 3 per cent of the euro zone gross domestic product

• As the highlight shifted to Spain and Italy, which together account for almost 30 per cent of regional GDP, the game entered a new stage.

The financial crisis in the West translated in 2008 to a massive negative demand shock in Asia. Today, things are changing, but Asia's manufacturing centres remain vulnerable to European recession.

In the past decades, advanced economies have transferred production capacity to China, which serves as an assembly hub for advanced economies. A shock from the euro zone would affect China's (derived) import demand - in Hong Kong, India, Malaysia, the Philippines and Vietnam.

The risk of a pure financial contagion via financial markets remains limited. However, while Asian banks have minimal exposure to government bonds in the southern euro zone, European banks play a vital role in Asia. If these banks are damaged by the crisis, they would sharply cut back their lending to Asia.

Massive liquidity injections by Europe's central bank have sustained some export absorption in the region, but they are exporting to Asia rising uncertainty via imported inflation, potential asset bubbles and disruptive appreciation.

A lost decade in Europe would also exhaust Asian policy strengths significantly - despite Asia's current fiscal and monetary manoeuvrability and foreign exchange reserves.

The euro zone's future will shortly be shaped by the post-Cyprus deal fallout, Italian politics and German elections.

Since 2008, the European deposit insurance regime has protected savings up to €100,000. However, the Cyprus case showed that small depositors' savings are not safe. After capital restrictions are expected to be lifted in a month, large depositors - about a third of which are wealthy Russians - may take their money out.

In Italy, a fragmented political landscape will defer reforms and could mean new elections, while in Germany, the upcoming elections in September could see Chancellor Angela Merkel - if she is re-elected - facing a stronger Social Democratic opposition.

Last year, Berlin and Paris opted to support Greece, hoping to give a two-year timeout for Spain and Italy to get their economic house in order.

In Spain, the government's austerity measures have contributed to a severe recession. In a benign scenario, this will eventually force Madrid to seek support, which will defer structural reforms. If, however, Madrid turns to Brussels for help, Italy is likely to follow.

Brussels is staying the course, but the direction is a wrong one. Asia will pay part of the bill.

 

Source of documents：South China Morning Post