The euro should not exist. In a perfect world (run by economists) the euro would never have been created. Sadly, however, the world is not perfect ― and it is run by politicians. The result is an entirely dysfunctional monetary union. 

The Spanish economy has youth unemployment approaching 50 percent. The Greek economy is in its fourth consecutive year of negative GDP growth and is likely to embark on a fifth year of negative growth later in 2012. Euro area countries have to share a common interest rate and a common exchange rate with Germany ― where unemployment is at a 20-year low and growth is positive if unspectacular around 2.5 percent. This is an unworkable situation ― what Greece needs is very different from what Germany needs.

Will the euro break up? We must hope not. The consequences would be devastating (a weak country could see its economy halve in size on exit). The social unrest we have today is minor compared to what could take place if the euro were to fragment. As the euro was essentially a political creation, it must be political will that keeps it together ― and it would be wrong to underestimate that political will.

So what will happen? Because so much rests on political decision making, the path for the euro area is hard to determine. But it seems highly likely that there will be a recession this year. How bad that recession is depends on what happens to the banking sector.

Euro area banks are increasingly reluctant to lend money ― and with all the risks that they have been through over the last six months, this is hardly a surprise. Slower bank lending growth will hit some economies particularly hard.

Fiscal austerity is being urged by Germany. In the wake of France’s downgrade (and with the U.K. outside the euro and unlikely to ever join) it is Germany’s voice that is loudest in setting the euro policy agenda. When the slowing credit creation is combined with further fiscal austerity, the consequence is likely to be negative GDP growth. Not all countries will be negative, of course, but Italy, France and Spain all seem likely to see a drop in economic activity.

So why do the convulsions of the euro area matter to Asia? There are three reasons why Asian companies and investors need to follow the euro drama.

1. The euro area is big

The euro bloc is the second-largest economy in the world. Over a third of APEC’s exports go to the euro bloc, making it the second-most important market for Asia after the United States. If the euro area is to have a recession ― falling demand ― followed by poor growth ― slow demand ― then Asia needs to adjust its growth model accordingly. Of course, Asian dependence on export led growth has faded in the wake of the global financial crisis, but there can be no complacency about exports to the euro area.

2. The euro area is globally integrated

Euro financial institutions have been involved in the global economy for decades. Global trade, in particular Asian trade, has been financed by euro area banks. As euro banks retrench and the importance of the home market is emphasized, Asia will have to look elsewhere for funding. That is not to say that alternative sources are impossible to find ― clearly they are not. But it means that Asia must change.

Similarly, the euro area as a globally integrated market will have an impact on other economies in the world. The euro bloc is over 20 percent of U.S. exports outside of the NAFTA trade bloc. The U.S. may not be an export led economy, but there is potentially an impact from a euro area slowdown on U.S. growth, which in turn has implications for Asia. In a globalized world economy with a complex web of trade and financial links, what happens in Athens can clearly have global ramifications.

3. The euro area is rich

The wealth of the euro area can be discovered in surprising places (Italy, for instance, is a wealthier country than Germany). Overall, the Euro area is wealthy. Thus the euro area has a role as an investor in the rest of the world. The political pressure on euro area banks and financial institutions to concentrate their investment efforts in their home markets is increasing. Popular hostility to overseas investment by multinational companies has also increased. Investment from the euro area into Asian stock markets, bonds and companies may well slow in the years ahead.

The euro area is an economic mess ― but it is a mess that the rest of the world must pay attention to. The slow growth that will accompany euro area reform and the changing relationship between the euro area and the rest of the world will be critical to global economics. Now might be a good time to start taking an interest in euro politics. 

By Paul Donovan

The writer is managing director and deputy head for global economics at the UBS Investment Bank. The opinions expressed are his own. ― Ed.

(Asia News Network/The Jakarta Post)