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Bill Jamieson Europe stares into a Japan deflation
COMMENT
BILLJAMIESON | Executive Editor of The Scotsman
Europe stares into a Japan deflation
Now the problem is a strengthening euro.
Never say Europe’s economies lack surprises. Two years ago the eurozone crisis was so acute there was widespread concern that the single currency would not survive. Greece would almost certainly be forced out. Spain and Portugal were tottering. Cyprus looked sick. Italian bonds were screaming northwards. A wholesale flight out of the euro seemed likely.
Today it is the strength of the euro that is causing problems. Indeed, the single currency zone is now facing a Japan-style resort to negative interest rates. In recent weeks it has experienced a further upward twist by widespread stress experienced by several emerging market currencies.
The prospect of an end to quantitative easing in the US and UK and the piecemeal approach of the European Central Bank to do “whatever it takes” as Mario Draghi confidently promised some 18 months ago has caused investors to pull funds out of developing country markets and repatriate funds in the expectation of higher (and safer) yields at home.
The danger is that the strength of the euro may push the currency zone towards deflation – the very outcome that worldwide central bank intervention has been most anxious to avert. Such has been the concern that Banque de France Governor Christian Noyer recently commented that “any appreciation of the euro exchange rate would run counter to our price stability objective and would be negative.”
The effects of a strong euro are by no means all negative. The eurozone’s trade surplus with the rest of the world has continued to grow as imports fell more sharply than exports. The result in November was an external trade surplus of €17.1 billion (£14.25 billion). The rise in shipments from the southern periphery is a sign that the bloc’s worst-hit economies are regaining competitiveness. Exports from Spain, Portugal and Greece were up by four per cent in the January to November period, compared to a year earlier.
But now the eurozone is edging ever closer to deflation. While the strong euro has helped to boost the competitiveness of exports from the single currency zone, it also has the effect of making imports more expensive and discouraging domestic demand. The danger of deflation for businesses is that it weakens the propensity of consumers to purchase goods and services – opting instead to defer in the expectation that prices will be lower in the period ahead.
Companies still deleveraging
At present market expectations are that the year-on-year inflation rate in the first three months of 2014 will pan out at just 0.65 per cent, well down on the ECB’s current forecast of 0.95 per cent. The key question now is whether it feels confident enough about a return to headline inflation rates of around one per cent in the second quarter and beyond – climbing to 1.1 per cent in 2014 and 1.3 per cent in 2015) to argue that its monetary policy stance is still appropriate. If its summation is ‘yes’ it is unlikely it will see any need to change its interest rate stance or loosen monetary conditions further.
But this would be to ignore the evidence, not just of a reluctance by eurozone companies to invest but of a continuing preference to pay back borrowings (‘de-leveraging’) rather than step up bank borrowing.
Figures for December showed that private sector deleveraging continued, albeit at a slower pace. The ECB may take heart from evidence in a January bank lending survey that the net proportion of banks loosening their lending standards had increased to its highest level since the final quarter of 2006. But firms continue to pay down existing debt.
And that’s not encouraging when recovery within the eurozone not only trails that of the US and UK but has become an embarrassment domestically (France in particular) and internationally. This creepy-crawly recovery pace is the dominant problem facing eurozone policymakers who have no evident conviction as to how to tackle it.
Policy options range from further cuts in interest rates, more long-term refinancing operations for SME lending and direct asset purchases of the type undertaken by the US and UK, if not on the same scale. For the moment there is still a real prospect that if the currency continues to strengthen the ECB will ‘go negative’ on interest rates in the second quarter of the year.
But the problem with this is that different economies within the eurozone are performing at different speeds – a phenomenon that has bedevilled the single currency since its inception. Current ultra-low ECB interest rates have encouraged a splurge of property investment in Germany and a move to negative rates would risk fuelling an asset price bubble. Yet the rise in the euro needs to be contained – and some commentators suggest that the eurozone’s peripheral economies need to see a domestic demand stimulus equivalent to a euro devaluation of 30 per cent. A single currency may bring advantages. Across diverse economies it continues to bring multiple headaches. n
