Kim Cramer Larsson
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Article / 27 August 2014 at 14:13 GMT

Optimism? In the Eurozone? Forget it

Managing Partner / Spotlight Group
United Kingdom
  • Eurozone weakness typified by Germany's poor Q2
  • Italy and France rapidly becoming Eurozone's sick men
  • Periphery may offer consolation, but only looks good from a very low base

By Stephen Pope

At successive press conferences, European Central Bank president Mario Draghi has responded to questions re the level of the euro. He has often stated that the currency rate was not part of the central bank's mandate.

However, while he clings to the medium-term projections for Eurozone consumer price inflation, there can be no doubt that he will be pleased that the rate cuts on June 5 can be seen as marking the start of a corrective channel for the EURUSD.

Indeed at the start of August, Draghi admitted that while he did not comment on the currency’s exchange rate, he was rather pleased with the post-June 5 decline. A weakening currency is just one of a number of factors that will help save the Eurozone from prolonged low inflation.

Why does the ECB think the currency has declined in the past 12 weeks?

The ECB chief has shown an uncharacteristic level of transparency as he has sought to give his explanation for the recent decline. On August 7, he said…

“…The fundamentals for a weaker exchange rate are today much better than they were two or three months ago… Markets have perceived that monetary policy in the Eurozone and United States are, and are going to stay, on a divergent path for a long period of time, …"

In addition to the perception of USD friendly interest rate differential, it is clear that in the past 12 weeks there has been a reduced level of capital inflow into the region and a reduction in Euro holdings by other central banks.

Underlining this scenario is the fact that the regional economy is pitifully weak.

Regional economic leader Germany is not faring at all well as in Q2, the economy contracted 0.2%. The French economy has stagnated and that has been a sore point for the government which said it would be open with the people about the state of the economy. Finance Minister Michel Sapin admitted that the government's forecast of 1.0% growth this year is impossible to reach.

Italy is in recession once again as GDP shrank 0.2% in Q2. The weak number follows a 0.1% contraction in Q1.

The obvious conclusion is that regional economic growth will be weaker in 2014 than has generally been expected. That implies the ECB will not be adjusting its official interest rates higher any time soon and the premium the currency once commanded has started to evaporate.

Even though the currency is weakening, it is not falling fast enough to stave off the risk of regional deflation. French CPI fell 0.4 percent month on month. Portugal's price index retreated 0.7% in July and Spain endured the steepest slide in consumer prices in five years.

Italy…a key worry

Tumbling inflation and economic contraction places Italy deep in crisis. There was hope that the new Prime Minister, Matteo Renzi, would infuse the nation with a reforming zeal. However, when job creation is likely to be replaced by job destruction, the willingness to embrace reform will quickly run into a sand trap.

This is the root cause of the Italian problem − it is carrying a sovereign debt burden worth EUR2.1 trillion which is equal to 136% of GDP. If growth does not improve soon, it can only be a short while before any sane, rational investor will ask how Italy will service its debt. To stabilise the debt, the country would have to run a very strong primary surplus; that is highly unlikely.

…France is a nightmare

France is not only having to publicly admit that its growth projections are too ambitious it must also confess that it will miss its target for reducing its public deficit as agreed with the European Commission. Despite President Hollande having insisted for month after month that France could reach its targets the shocking fact is that the budget deficit will stand above 4.0% GDP so overshooting the promised target of 3.8%.

Don’t be blinded by apparent bright spots

It is a common fact that champions of the Eurozone will point to the Eurozone periphery as a way of claiming some success.

The Spanish economy has seen a surge in exports; however, mostly Spain is active in shipping semi-finished car components to Germany. It operates at the low end of the value chain and does not actually accrue much value added cash. The unbelievable layers of red tape does not encourage new business and it is no surprise to see national unemployment at 24.47% in Q2 2014 and youth unemployment rate in Spain increase to 53.50% in June of 2014 from 53.00% in May.

Greece is arguably where the Eurozone problems began. Much has been made of the primary budget surplus but its economy is still shrinking. It contracted 0.20% in Q2 2014 over the same quarter of the previous year. Projected growth is still far too weak to significantly reduce its debt burden which in 2013 stood at 175.10% of GDP. Greece will need renewed assistance in the form of additional aid and debt forgiveness.


If you think Spain is a bright spot among general Eurozone gloom, a glance at its horrific unemployment rate should disabuse you of that notion. Photo: Jasper Juinen \ Thinkstock

Dither and delay is a dereliction of duty

If it were not so serious and sad, the typical European summer do nothing approach could be seen as comical. Not until September will the TLRTO programme officially begin and then one will need to wait a month or two to be able to gauge the efficacy of the bank to borrowing loan transmission system.

In reality it is time for the Eurozone to send a few ferrets down the many holes in the system and see what startled rabbits pop up. With growth stalling, debt to GDP rising the reality is that the current structure of government yields is a skinny as a reforming politicians promise.

-- Edited by Martin O'Rourke
Stephen Pope is a 30-year plus veteran of the markets


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