After ending 2011 as one of the weakest currencies on the block, the euro’s fortunes appear to have turned quite significantly. It has appreciated by around four per cent against the US dollar since the beginning of the year with the bulk of the gains coming over the last month. A combination of improving risk appetite, global monetary easing, improvement in economic indicators, particularly German and the European Central Bank’s (ECB’s) long-term refinancing operation (LTRO) that removed the risks of a banking crisis in the region, emerged as important supports. However, the passage of the second Greek bailout programme that reduced the prospect of the Greek government facing a near-term default provided the final thrust to the euro rally. The important question is can this rally sustain over the medium term? We think it is highly unlikely. Though recent measures taken by ECB and European Union (EU) policymakers have provided a temporary reprieve, we think that a weaker euro will have to emerge as an integral part of the solution to the regions’ debt crisis.
Markets might have cheered the passage of the second Greece bailout programme that amounts to euro 130 billion (and will remain in place until 2014) but difficult times might still lie ahead. The first stumbling block for the euro could be the private sector involvement (PSI) debt swap offer that is a key element of the bailout agreement. Private sector participation is essential to ensure that Greece’s public debt-to-GDP ratio moves towards the 120 per cent mark by 2020 that the International Monetary Fund considers important. Private investors could refuse to play ball. This could force the Greek government to invoke collection action clauses (CAC) that it recently placed into existing bond contracts. This means that the Greek government could impose losses on private investors who are not willing to participate in the PSI. The losses on the private sector could qualify as a “disorderly default” and could roil the markets triggering possible payments on outstanding Credit Default Swaps (CDS). Since the bulk of CDS is issued by US banks, this could quickly transmit Europe’s problems across the Atlantic. The results of the PSI deal and future implications will be possibly known by 12-14 March, 2012.
Even if CDS payments are not triggered in the near term, concerns about Greece’s fundamentals and its fiscal path are unlikely to abate in a hurry. Greece might deviate from prescribed deficit targets on the back of weak growth and growing public discontent over austerity measures. This combination of austerity fatigue and uneasiness among lenders to provide additional support could keep anxieties about Greece alive. The situation in Greece should serve as a warning to other stressed nations that have embraced austerity about the difficulty in achieving targets. The problem is the (now clichéd) “austerity paradox” that austerity slows growth further and actually worsens a government’s budget balances instead of improving them. Hence, unless the struggling nations get a growth impulse that will boost revenues and help in reducing the debt-to-GDP ratios, the crisis is likely to continue to fester. This argument is slowly gaining ground as senior European political leaders such as Italy’s technocrat Prime Minister Mario Monti voice their concerns about the pitfalls of excessive austerity. The good thing is that leaders from lender nations including Germany’s Chancellor Angela Merkel seem to be giving the likes of Monti a patient hearing.
But the key question is from where will the growth impulse come? Two possible sources could emerge as growth stimulators for the region. The first could be a possible moderation in the magnitude of austerity. However, even though EU leaders have acknowledged the harmful effects of austerity, an immediate dilution in austerity demands on fiscally-stressed states seems unlikely, especially since EU nations just signed a fiscal compact. Given the weak domestic backdrop, the euro zone will need to rely more on external sources to boost growth prospects. ECB will be forced to play an important role in stimulating export performance via an ultra accommodative monetary stance as it seeks to ensure that the region undergoes only a mild recession in 2012.
So far, ECB has adopted a more passive quantitative easing (QE) approach by providing unlimited liquidity support to the banking sector via its two LTRO programmes. However, the European banking sector will need to rely on further ECB support to fund bond purchases and cope with the ramifications restructuring of Greek debt. The bottom line is that ECB will have to inject additional liquidity and might be forced into a more traditional QE programme wherein it purchases sovereign debt since the European banking sector could run out of collateral to pledge at any additional LTRO offerings. The net result will be an increase in supply of euro liquidity into the financial system that will ensure a depreciation bias for the currency that could help revive growth prospects in the region. An accommodative monetary stance will also help in arresting concerns about sovereign bond auctions and a banking sector crisis and that could lift market risk appetite.
Tailpiece
What are the implications for the rupee? While liquidity injection from the ECB over the course of 2012 could ensure fund flows remain more than adequate into the region, risks from rising oil prices could well temper rupee appreciation. Indeed, rising oil prices could emerge as a major dampener for domestic assets since it will drive inflation rates higher while widening both the fiscal and current account deficit (CAD). The rupee could get trapped between the diverging pressures of strong capital inflows and a wider CAD. The net result will be a moderate pace of appreciation and the rupee emerging yet again as one of the weakest Asian (excluding Japan) currencies in 2012.
The authors are with HDFC Bank. These views are personal
