The euro is likely to gain status as a global reserve currency and expand its reach with new members in the coming years, according to Legg Mason subsidiary Western Asset Management, which manages $456bn of fixed income assets across the globe*.

Michael Story, economist at Western Asset, says that while some peripheral European countries will be unable to escape restructuring their debt, the euro is unlikely to collapse any time soon as a result, and should in the short to medium term strengthen its position as a leading currency as demand to join the eurozone grows from former Soviet-controlled states.

“Although subject to bouts of sharp depreciation pressure, the euro is unlikely to collapse and could even gain status as a global reserve currency,” he says. “Although we do not see how the peripheral countries can escape the current quandary without restructuring debt, we would characterise this as part of their efforts to remain a member of Europe’s monetary union. Indeed, it would not be surprising if the eurozone further expands its geographic domain as more countries adopt the euro.”

Reintroducing a hypothetical ‘New Drachma’ in Greece, for instance, would in Story’s view trigger a sequence of events – including currency devaluation and a flight by depositors to safer ground such as German banks – that would ultimately lead to Greece having to resort to drastically counter-productive measures.

Story points out that Estonia joined the euro only this year while Latvia, Lithuania and Poland have all targeted entry by 2015. “For the smaller economies on the outskirts of Europe, the euro represents the destination of a long journey from an anachronistic command economy to a modern free-market democracy,” he says.

For existing members, Story does not see how euro adoption can, despite the problems facing monetary union, be reversed anytime soon. Reintroducing a hypothetical ‘New Drachma’ in Greece, for instance, would in Story’s view trigger a sequence of events – including currency devaluation and a flight by depositors to safer ground such as German banks – that would ultimately lead to Greece having to resort to drastically counter-productive measures.

“In the end, the only solution would be for Greece to restrict deposit withdrawals, seal its borders, impose absolute capital controls and suspend operation of the bond market – actions that would likely be equally unpopular and far more damaging to the Greek economy than remaining inside the euro area,” he says.

If peripheral countries are reluctant to leave the euro, the core nations are, says Story, equally unenthused by the idea. “Germany might well be growing weary of its role as bailer-out of last resort, and a hypothetical ‘New Mark’ would not trigger a bank run,” he says. “But the euro has conferred tremendous benefits on the German export sector and is one of the reasons why the German economy is flush with surplus savings. Germany has been the biggest beneficiary of the euro and has a strong disincentive to exit.”

Indeed, for the eurozone as a whole, Story argues the common currency has been a key driver of increased trade openness and financial market integration, as well as labour market reform and a dramatic convergence in inflation rates. “Today the amount of dispersion across member countries in inflation and business cycles, even after the global financial crisis, is still less than it was prior to the formation of monetary union,” he says.

Going forward, however, Story points out that, while he believes Europe’s leaders are implementing substantial reform in an “impressively short span of time”, significant challenges remain, both in political and monetary policy terms. “Voters ultimately need to forfeit more of their sovereign autonomy than most are currently prepared to do,” he says. “Policy errors are possible, if not probable. The ECB’s decision to begin a tightening cycle now may prove to be the first such error. Such tightening may be correct based on a reading of the economic variables alone, but it is eroding what is left of the eurozone’s political legitimacy, the ultimate determinant of euro survival, just as political legitimacy was key to the fate of the gold standard.”