The latest threat to the euro?

Michael Collins

Search around Europe and encouraging signs emerge amid the immense unemployment and political agitation. The eurozone economy expanded 0.3% in the three months to December, to mark three straight quarters of growth after six of shrinking.

Confidence and business indicators are rising – the Markit purchasing managers index is close to a three-year high. The combined fiscal deficits of eurozone governments in 2013 fell to the target 3% of GDP for the first time since 2008. The 18-country bloc is recording its biggest monthly current-account surpluses in five years. Officials have made progress on a banking union. Greece in April sold its first government bonds since its default two years ago, at the lower-than-expected effective rate of 5% compared with 30% in 2012, while Portugal’s first bond sale since its rescue in 2011 was oversubscribed too. Sovereign yields for the bailout countries are at their lowest since 2005. European government and corporate debt is trading at its narrowest spread over benchmark German equivalents since 2007. Moody’s Investors Service reports that credit rating upgrades for the March quarter outdid downgrades for the first time in more than six years. Equities have jumped on the promising signs – the STOXX Europe 600 Index has rallied more than 26% since mid-2012.[1]

July of two years ago is taken as the point when confidence in Europe improved for that’s when the European Central Bank pledged to do “whatever it takes” to save the euro. These words instilled a belief that the euro will survive a crisis in its fifth year. But this optimism has spawned a fresh peril. This is the more-than-15% rally in the euro over the past 22 months to just below 1.40 to the US dollar – 1.3934 on March 18 is the euro’s post-crisis high compared with 1.2061 on 24 July 2012. The surge in the currency creates two dangers. The first is that it undoes the region’s improved trade competitiveness. More alarming, the mighty euro is fanning deflationary forces as it lowers the price of imports. Deflation is a poison for such an indebted region and could place the single currency under threat again.

European policymakers have remedies at hand; above all, quantitative easing by the ECB. Ideology and practical limitations, however, make this cure problematic. The questions for investors are whether the ECB will launch an asset-buying program in time and whether one would prove effective in rekindling economic growth and staving off deflation.

The bloc’s problems are far bigger than just a strong euro, of course. The economic crisis has spawned a nationalistic revival that makes it harder to achieve the political union a common currency needs to survive. A generation of young is being lost to joblessness. The worsening debt-to-GDP ratios of many countries could spell default sooner than later without deflation – “lowflation”,[2] as the IMF calls it, is as toxic for a region where net government debt stands at 96% of GDP.[3] Austerity is a bigger cause of disinflation than the strong euro anyway, for in a fixed-exchange-rate regime lowering wages and other costs is the only way to regain competitiveness within the bloc. A drop in global energy, commodities and food prices is putting downward pressure on inflation, so the villain’s not just the rising euro. Some people argue that, while eurozone inflation is too low, the ECB will still meet its inflation goal of keeping price rises to below, but close to, 2% over the medium term.[4] The Federal Reserve could remove much upward pressure on euro by accelerating the end of its asset-buying, which would boost US interest rates and thus the US dollar. These factors, though, don’t mitigate against the facts that the high euro limits Europe’s ability to trade its way out of the doldrums and could be the final shock that enshrines deflation. It shows the conundrums, or even the hopelessness, facing eurozone policymakers – even their successes generate a bigger risk of failure.

Upwards and backwards

The euro is rising for a number of reasons that show no sign of abating. One cause is that the eurozone’s inflation is below that of its trading partners. Eurozone prices only rose 0.7% in the 12 months to April (after being as low as 0.5% in the 12 months to March) while the latest readings show annual inflation in Japan, the UK and the US was 1.6%, 1.6% and 1.5% respectively and is higher in most other countries. Docile inflation supports a currency because, in theory, exchange rates should adjust for inflation over the long term to keep the real costs of goods steady across countries.

A second force is the eurozone’s improved trade performance. Austerity has crippled domestic demand in bailed-out Europe, and thus fewer imports are flowing in. At the same time, austerity has reduced labour and other costs, making exports more competitive. The current-account surplus of the eurozone stood at 2.9% of GDP last year, compared with a deficit at 0.7% of output in 2007.[5] Trade performance is another fundamental determinant of exchange rates for it governs the balance of demand for a currency between importers and exporters.

The third reason behind the strong euro is that Europe’s interest rates are higher than elsewhere. Lingering uncertainties about peripheral countries mean their bonds are trading at premium yields over equivalents in Japan, the UK and the US where central-bank asset buying has lowered interest rates. This promotes the so-called carry trade where investors borrow in the currency of a country with low interest rates to invest in higher-yielding euro-denominated securities (while hoping exchange rates don’t move against them). A fourth reason propping up the euro is that European banks are understood to be selling foreign assets and converting the proceeds to euros to bolster their balance sheets to meet capital ratios.

On top of these reasons sits the confidence that the ECB has rescued the euro. This optimism is inspiring the bond buying that has driven down yields on European government and corporate debt from their crisis highs. It is encouraging other investment flows into the eurozone, even into the bailed-out countries. Other sources of demand for European securities and thus the euro are investors fleeing emerging markets, central banks diversifying their foreign-exchange reserves away from US-dollar denominated assets and investors pouncing on cheap euro-priced assets. Foreigners drive up the euro when they buy euro-denominated stocks, debt and other securities because they need to convert their currency into euros to take hold of the assets.

Many European officials have voiced concern about the high exchange rate. Jean-Claude Juncker, a leading candidate to be EC president this year, warned as he stopped presiding over meetings of European finance ministers in January 2013 that the euro was “dangerously high” when it was 1.34 to the US dollar.[6] More recently in March, Herman Van Rompuy, the president of the European Council, said that the euro is “too strong for our exporters”.[7] In April, Belgian Finance Minister Koen Geens warned the strong currency “creates a risk of deflation”.[8] In central-bank jargon, ECB President Mario Draghi echoed the same concern when he spoke of the euro “becoming increasing relevant in our assessment of price stability”,[9] which is the ECB’s only goal. (Unlike the Fed and the Reserve Bank of Australia, the ECB is not charged with fostering full employment.)

Decision time

The pressure on the ECB to haul in the euro is building. Draghi on May 8 said the high euro was “a serious cause for concern” and promised action at the ECB’s next policy-setting meeting in June when the central bank releases its next inflation forecasts. “The governing council is comfortable with acting next time,” he said, after the council just met and made no change to monetary policy.[10]

The big jolt for the euro would be if the ECB mimics the Bank of Japan, the Fed and the Bank of England by implementing a quantitative-easing program. Among other options are negative interest rates on bank deposits with the ECB to encourage banks to lend the money instead or pruning the cash rate from its record low of 0.25%.

Until now, political constraints have stopped the stateless ECB from expanding its balance sheet to buy assets. The biggest opposition has come from inflationphobic Germany (even though such programs barely budge inflation, for quantitative easing is not printing money, which falls under fiscal policy even if it requires the help of a central bank). Since the eurozone crisis erupted in 2009, two Germany central bankers have quit the ECB, in part due to their hostility towards asset buying in forms that fall short of quantitative easing. In 2011, Alex Weber resigned as president of the Bundesbank, a role that sits on the ECB’s policy-setting board, and Jüergen Stark quit as ECB chief economist because they said the ECB was acting outside its mandate when buying small amounts of sovereign debt of struggling countries on the secondary market to drive down interest rates. These purchases weren’t under the guise of a quantitative-easing program because they were sterilised – the ECB took counteracting steps to keep the money supply steady, whereas quantitative easing expands the monetary base.

Weber’s successor as head of the Bundesbank, Jens Weidmann, has spoken out against many of the ECB’s attempts to stabilise the eurozone. He opposed the ECB’s powers to buy unlimited amounts of bonds under its yet-to-be-implemented-or-even-detailed Outright Monetary Transactions program, the scheme that enforces Draghi’s promise to save the euro, a program under which bond buying of deadbeat sovereigns would be sterilised. But as threats shift so too is Germany’s thinking. The danger of deflation, even in Germany, prompted Weidmann on March 25 to concede that quantitative easing “isn’t generally out of the question” when considering the legal restrictions on the ECB.[11] (Five of the 18 euro-using countries suffered deflation in the year to March.)After the ECB policy-setting meeting on April 3, Draghi announced that board members were “unanimous” in backing “unconventional instruments within its mandate” such as quantitative easing to keep deflation at bay.[12] The extent and form of any such asset-buying are open questions, though, as is what would prompt the ECB to sanction such a step.

The euro has nudged up a touch amid all the ECB comments about quantitative easing because forex traders are dismissing Draghi’s talk as just that. At the same time, bond investors are pricing in a massive ECB buying spree (a trillion euros) and will be disheartened if political or any other constraints limit any ECB purchases. Hardliners in the stronger countries oppose measures that take pressure off bailed-out countries for they claim they will go slow on reforms that boost competitiveness. Nationalistic forces will oppose handing more power to a central authority such as the ECB. Countries, especially Germany, could face legal restrictions if their central banks take part in any quantitative easing by the ECB. Any ECB quantitative easing will probably be far more limited than, say, the Fed’s three bursts, which have quadrupled the US central bank’s balance sheet to US$4 trillion (A$4.3 trillion). If the ECB undertakes quantitative easing, it has debt from 18 governments to choose from, another political headache. The weaker countries with deflation have less liquid debt markets, which makes it trickier for the ECB to act where it can do the most good. Stronger-but-still-challenged countries such as France have more muscle to ensure their bonds are targeted instead. The ECB is understood to be keen to buy private assets such as asset-backed securities because such purchases would have greater chance of boosting lending to businesses in rescued countries. But such markets are illiquid and small, making pricing problematic and reducing any economy-wide effects. A side effect of quantitative easing would be to boost the value of bonds on bank balance sheets, possibly distorting the ECB’s stress tests on banks it will soon supervise. Emerging countries may well accuse the ECB of engaging in currency wars.

The ECB board members and national governments could easily fall out over these issues and no program is launched. On the other hand, if eurozone inflation readings head up the ECB will happily do nothing. After all, even in the middle of a jobless crisis, why do anything when under the cursed euro even achievements proved jinxed?

by Michael Collins, Investment Commentator at Fidelity

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Financial information comes from Bloomberg unless stated otherwise.