Fri, 7 Mar, 11:55 GMT
FOCUS Rising euro, credit crunch testing European economic cohesion
LONDON (Thomson IM) - The combination of a record-high euro and scarce credit is straining the euro zone's economic union, raising new questions over how well a single monetary policy will be able to handle the region's looming economic slowdown.
So-called peripheral economies in the euro zone -- mostly in the South, including Italy, Spain, Greece, and Portugal but also Ireland -- are having a more difficult time coping with a strong currency and tighter lending conditions than Germany or the Netherlands.
Some, like Spain and Ireland, are facing the consequences of housing market bubbles that could lead to recessions, while others like Italy are plagued by political uncertainty and structurally lower trend growth rates.
This new economic divergence has become painfully apparent in financial markets, where the spreads between government bonds yields in Germany and peripheral economies have reached record highs, suggesting investors are wary of the future in these economies.
'It is a practical market indicator of the potential damage the high euro is having on the euro zone economies' and is based on the fiscal laxity in countries like Italy, Spain, Portugal and Belgium, said Simon Derrick at Bank of New York Mellon.
The euro, which is setting new records against the dollar and pound almost daily, has reminded investors that the coming economic slowdown in 2008 will be tougher in some countries than others.
Germany, where labour market reforms have helped unemployment and boosted the competitiveness of exporters, will have an easier time than Italy, where similar changes have been slow to come by.
'The more the euro heads higher the more these spreads will widen,' said Derrick.
This will cause borrowing costs to become more prohibitive in the peripheral regions, worsening the burden on economies that are already suffering the most.
At the moment, Italy's 10-year borrowing rate is 70 basis points higher than Germany's.
On top of this, the slowing economy will cause the rising stars of the euro zone economy -- specifically Spain and Ireland -- to slump as property market bubbles pop.
'Asset price bubbles bursting can easily turn soft landings hard,' said Leo Doyle at Dresdner Kleinwort, who sees a 50 pct probability of a recession in Spain.
Core economies like Germany are 'more likely to avoid the downside surprises that are likely to unfold in Spain, Ireland and some other previously fast growing economies,' said Doyle.
Beyond fundamental economic reasons, some experts note that the spread in government bond yields is rooted in the tighter liquidity conditions in financial markets: investors who are strapped for cash prefer the safety of German bonds.
Laurent Fransolet, strategist at Barclays Capital, said the phenomenon is essentially a result of the credit crunch, which has both caused worries over peripheral economies and triggered disproportionate market price movements.
'Some of it is driven by fears, but the moves are much bigger than in the past and go beyond fundamentals,' said Fransolet.
He believes the European Central Bank has not properly acknowledged the danger of this trend and the indirect impact on growth and stability it could have.
When asked at a press conference about the alarming widening in spreads, ECB President Jean-Claude Trichet treated the matter as part of the ongoing re-pricing of risk in fixed-income markets.
'It is certainly a wake-up call to be cautious about fiscal policy,' Trichet told reporters.But, as Fransolet points out, spreads have widened not only for peripheral countries but also for France or Holland, which are typically considered 'core markets'.
'Anything which is not the German 10-year has suffered,' which suggests this is mainly a liquidity problem, he said.
Whatever the cause, the risk that the euro zone's economic union may be torn apart has highlighted the downside to extending a single monetary policy to an array of different economies.
'In addition to a 'one-size-fits-all' refinancing rate, the stability and growth pact attempts to outlaw counter-cyclical fiscal policy,' said Doyle at Dresdner Kleinwort.
Bound by the Maastricht Treaty's fiscal requirements, governments are not able to boost spending in times of need in order to help their economies.
'As a result the burden of cyclical adjustment falls on real exchange rates,' Doyle said.
These problems were much discussed at the beginning of the monetary union in 1999 and remain a key argument for the countries, like the UK and Denmark, which decided not to join.
Countries like Italy or Greece, which have no space to launch a fiscal boost, would need a weaker currency to reflect their internal economic reality.
But the euro, driven by an inflation-fighting ECB, remains as high as ever.
'With no option now to devalue, something else would need to take the strain,' said Derrick at Bank of New York Mellon.
'With euro/dollar now trading close to 30 pct above where it started in January 1999, perhaps we are now starting to get a clear idea of exactly where these pressures work themselves out,' he said.
By Carlo Piovano ;
carlo.piovano@thomson.com
