giovedì 25 giugno 2009

How long will the Eurozone (and the ECB) cohabit with an overvalued Euro? Why the euro’s fall is key for the Eurozone economy...

According to all major international agencies, 2009 and 2010 economic growth is likely to be more subdued in the Euro area than in the US. In their latest Reports, both the IMF and OECD have predicted a contraction above 4% for the Eurozone in 2009 with a slightly negative growth rate also expected in 2010. By contrast, the two agencies have estimated flat US growth in 2010 in the face of a less severe downturn in 2009 (-2.8% and -4% for the IMF and OECD respectively). In the recently published Global Development Finance report, the World Bank has been more positive on the Eurozone’s outlook for 2010, assuming a 0.5% growth rate. Nevertheless, this is well below the 1.8% rate forecast for the US.
All European countries have been hit hard by the global turmoil, even though for different reasons. Indeed, while countries such as Ireland and Spain have borne the brunt of the bursting of the housing bubble, Germany, Europe’s largest country, has suffered the consequences of a slowing international demand due to the manufacturing sector’s strong dependence on exports. France has weathered the crisis relatively well so far, while Italy has felt the pain of the credit crunch without the possibility of taking effective countermeasures as the high public debt level is a big constraint for the Italian government.
Notwithstanding the monetary and fiscal stimulus packages launched in the last few months, the outlook for the Eurozone remains gloomy. No economic factors are likely to provide any boost to economic growth.
The countries that have reaped the benefits of the house prices bubble in the last few years (i.e. Spain and Ireland), which increased consumer spending and broadened the current account deficit, are now paying for past excesses and should post modest growth (if not negative) in the years to come.
On the other hand, the countries that are highly dependent on exports (i.e. Germany) should not be favoured by an upswing in global demand, which should to remain sluggish for a long time. Indeed, demand in emerging markets is highly unlikely to offset a weakening demand trend in the US, at least in the near term. The real challenge facing these countries will be building a stronger domestic demand going forward.
With the Refi rate at 1% and the ECB unwilling to carry out a sweeping quantitative easing programme following the EUR60bn package established to fix the covered bond market, the only boost for the European economy could come from the Euro’s devaluation. A study presented in 2001 by some OECD’s economists (“Standard shocks in the OECD interlink model” by Dalsgaard, Andrè and Richardson) indicated in +0.6% both in the first and second year of estimate the increase in Eurozone GDP due to a 10% depreciation of the Euro. The projected rise in the inflation rate (+0.4% in the following two years) should not be cause for concern in this current scenario as the yearly inflation rate was flat in May and negative readings are expected in coming months.
Moreover, researches conducted by the INSEE and Morgan Stanley in the last few years have highlighted that Eurozone GDP would react to a currency shock with almost no lag, while a rate cut in short-term interest rates would take much longer to feed through the economy.
In spite of the decline against the US Dollar from the record level hit in 2008 (slightly above 1.60), the Euro remains overvalued against the greenback: according to the Purchasing Power Parities estimate of the OECD, for example, a fair Euro/Dollar exchange rate should be 1.20, implying depreciation potential of above 15% for the single currency. The nominal effective exchange rate relative to the 12 major international countries calculated by the ECB suggested that the Euro is 10% above the long-term average and various measures of real effective exchange rates painted a similar picture.
Based on the above-mentioned researches, it is easy to understand that the overvaluation of the Euro is heavily weighing on the economic prospects for the Euro area. A fall in the Euro to a level more in line with the long-term average and with the PPP should help lessen the uncertainty over the Eurozone outlook...

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