The main drawback of currency debasement strategies through loose monetary policies is that they exaggerate appreciation pressures on those currencies whose central banks are not sweating their currency printing machines. As currencies start to move out of sync with underlying economic fundamentals, those regions that face undesirable appreciation retaliate. The euro is a classic case. Another problem with such wars is that they drive extreme volatility in exchange rates — volatility that markets already burdened by a plethora of risks and uncertainties could live without.
The unexpected rise in the euro in 2013 has happened even as real economic indicators are still consistent with a recession. Currency appreciation is acting as another headwind to a region already engulfed in a severe austerity-driven recession. Hence, European officials were forced to take rearguard action to stem the pace of appreciation by talking down the currency. In his monetary policy statement on February 7, ECB boss Mario Draghi pointed out that the rise in the euro might pose downside risks to ECB’s inflation outlook. His statements seem clearly focused on telling the markets that Europe is uncomfortable with currency appreciation. Consequently, the euro climbed down by two big figures to the dollar.
But just talking the currency down is unlikely to help beyond a point. Neither the Bank of Japan nor the US Federal Reserve is likely to budge from their respective monetary stances in 2013. Thus, the key driver of the currency markets is likely to be unsterilised asset purchases programmes that feed risk-appetite and induce the markets to use the dollar and the yen as the major funding currencies to sate this appetite. Were ECB not to follow up its recent apprehensions about currency appreciation with more concrete action (i.e. print more euros), the euro could be on the losing side of this battle.
The second development is the impact that ECB’s outright monetary transactions (OMT) programme has had on financial markets across the board. While it was designed essentially as a backstop for fiscally overstretched peripheral nations that found it difficult to float bonds in the market, it has turned out to be a much bigger game-changer for risk for the global financial markets as a whole. By reducing concerns about the possibility of a blowout emerging in the European region, it seems to have had a positive knock-on effect on sentiment indicators, such as consumer confidence, business and investors surveys both in Europe and, to a degree, even outside the region. The surge in the market for risky assets (commodities, emerging market stocks and US equities) over the past few weeks have been on account of the combination of improvement in sentiment indicators and ample liquidity present in the financial markets.
The third trend relates to the complacency in the markets about the state of the global economy and the impending risks up ahead. The markets seem to have shrugged off concerns about the upcoming fiscal battle up ahead in the US economy. The assumption seems to be that deals at the eleventh hour will always save the day. But as the saying goes, when fear disappears from the market, it is time to be afraid. The next round of political negotiations to raise the sovereign debt ceiling could get messier. The risk of a partial government shutdown in the April-May period, thus, remains high as does the possibility of a US sovereign rating downgrade.
It is also legitimate, I think, to fret about the euro zone. The ECB’s OMT programme has created only a backstop facility, but not helped in altering the weak economic outlook that the region finds itself trapped in. The weak growth backdrop, particularly in the peripheral region, could mean that fiscal progress continues to disappoint. For instance, the International Monetary Fund forecasts that the Spanish total government debt to the gross domestic product ratio could rise from 91 per cent in 2012 to 97 per cent in 2013 and to the 100 per cent mark by 2014. The prospect of fiscal slippage could put the focus back on to Europe by mid-year. The upshot is that once markets start to re-focus on the bearish fundamentals of the global economy, the return of a “risk-off” trade could see a complete realignment of exchange rates.
The author is with HDFC Bank. These views are personal