Amid a scorching heat wave, Germany worries that Russia could cut off or cut natural gas supplies, devastating the economy and leaving homes without heat in the winter. Italy’s government is on the brink of collapse. French President Emmanuel Macron has been weakened after losing his parliamentary majority. And the euro recently fell to a 20-year low against the dollar, in no small part because the European Central Bank has lagged far behind the Federal Reserve in raising interest rates.
That began to change on July 21, when ECB President Christine Lagarde made a bigger-than-expected rate hike of half a point. It ended the ECB’s era of negative interest rates in one fell swoop, bringing the deposit rate to 0% from minus 0.5%.
Lagarde also said more increases would be needed in the coming months, even though economic growth is slowing and the outlook is uncertain.
The ECB has two problems, according to Paul De Grauwe, a leading researcher on the euro since its inception, speaking to the financial publication Barrons.
The first to share with the Fed, namely the worst inflation in more than 40 years. The second is unique to the institution, which sets monetary policy for 19 individual countries — any rise in interest rates risks spilling over into a much larger increase in borrowing costs for some countries than others.
After the rate hike, the first since 2011, the yield on Italy’s 10-year government bond rose to around 3.6%. In contrast, German 10-year bond yields were little changed at around 1.2%. This difference of 2.4 percentage points makes a huge difference in the capacity of governments to borrow money.
The ECB raised interest rates for the first time in a decade
The Central Bank also approved the Transmission Mechanism Protection Instrument
–
The mismatch threatens to unlock the same “Pandora’s Box” that fueled the 2010-12 euro crisis, when the currency bloc almost broke apart as more indebted countries faced a sudden, harsh tightening of financial conditions and investors sold off your bonds. This nearly led Greece to quit the euro and ultimately required a five-nation bailout.
“If you don’t want a sovereign debt crisis, you shouldn’t fight inflation too much,” says De Grauwe. “This explains why the ECB is more cautious about raising interest rates.”
To tackle the problem of widening bond spreads between countries, the ECB announced a new tool on 21 July. The transmission protection tool will allow the ECB to buy bonds of troubled eurozone countries “to counter unwarranted, chaotic market dynamics that pose a serious threat.”
Although the exact details remain unclear, Lagarde said there would be no funding cap. There will be four acceptance criteria related to the country’s macroeconomic and budgetary policies, but ultimately this will depend on the ECB’s judgment.
There are, of course, other reasons why the ECB has waited until now to raise borrowing costs, even after the Fed started in March and is now moving in colossal 0.75 percentage point intervals. Germany, the region’s biggest economy, could lose its main source of natural gas if Russia retaliates against sanctions after the Ukraine war, while China, one of its biggest export markets, has been hit by a Covid-19 lockdown. 19 which never seems to be over for long. Meanwhile, Italy’s government is reeling after Prime Minister Mario Draghi – the former ECB president credited with rescuing the bloc a decade ago – resigned on July 21, raising the prospect of new elections. None of this makes the time right to tighten monetary policy.
The expanding connections between countries considered safe and those considered risky don’t just create economic problems—they also create political and social problems. Disproportionate penalties and rewards are sure to make disadvantaged countries wonder if sticking to the euro is worth the pain of issuing debt in a currency they cannot control. Yet leaving would call into question the whole European project of working towards an ever-closer union. The fear is that frustration on one side will start a domino effect. (The United Kingdom, the only country to leave the European Union, never adopted the euro).
–
Will bank loans become more expensive after the ECB’s decision?
Is the property bubble coming to an end and are prices likely to fall?
–
This time the stakes are even higher because Italy is one of the biggest problems. Like Greece a decade ago, it cannot afford its bond yields to rise too much. Unlike Greece, it is a huge economy, the third largest in the Eurozone.
Any decision to widen bond spreads will raise a new set of problems. But if the ECB, say, sells German bonds to buy Italian, isn’t that unfairly raising interest rates in Germany? The trick will be to make the rules – known as “conditionality” in ECB parlance – acceptably fair to all parties.
The euro’s 10% fall against the dollar this year adds further complications. Normally, a weaker euro would provide a boost to the economy by making exports cheaper. But the euro’s decline against the currencies of export markets such as the UK and China has been much less pronounced than against the dollar. Compared to the Japanese yen, it even became more expensive. This takes away a lot of the benefits.
At the same time, things like oil and gas, priced in dollars, remain much more expensive to buy, fueling inflation, which rose to 8.6% in the euro zone in June. The ECB aims to keep the interest rate around 2%.
“Most people look at the depreciation of the euro and see it as good for Europe,” said Cedric Gemmell, Europe analyst at Gavekal Research. “But that’s just a tailwind for part of the export market, and Europe is also a big importer of energy that’s mostly paid for in dollars. So, overall, the depreciation of the euro is actually negative.”
Germany’s latest current account figures illustrate the problem. Despite strong exports, Germany fell into a trade deficit for the first time since 1991 in May as imports outpaced sales abroad.
The ECB should take into account that most of the inflation in the euro area is imported through the weak currency, but raising interest rates will only further worsen domestic demand. That could be a problem for consumer-facing companies like Boozt and Jumbo, among others, which get more than three-quarters of their revenue from Europe.
While the fall of the euro may not lift the economy as a whole, some companies may benefit if the US is a significant market for them and energy is not a large capital expenditure. L’Oréal, for example, the French cosmetics maker, gets nearly 70 percent of its sales outside Europe, according to FactSet data, while skin care giant Beiersdorf gets about 52 percent of its revenue from abroad. Other companies that have large foreign exposure include Siemens Energy, Puma and drugmaker Bayer.
Overall, the impact on markets of the turmoil that has gripped the bloc has been fairly muted. The Stoxx Europe 600 is down 13% in 2022, less than the S&P 500’s 16% drop.
If there is one positive side to everything Europe has been through with the euro sovereign debt crisis and the Covid-19 pandemic, it is that the ECB’s crisis-fighting tools are stronger than before. This makes solving problems in the European bond market much easier.
“We’ve moved on,” says De Grauwe. “But will the progress be enough if there’s another really big shock? And we’re close to a really big shock.”
–
The Governor of the BNB: Entry into the Eurozone will be one of the strategic tasks in the next year and a half
“Additional permanent budget expenditures increase the risk of inflation,” commented Dimitar Radev
–
The end point, the expert explains, is for the eurozone to agree to a fiscal union, where countries agree to give up some sovereignty over their tax and spending policies.
*The material is analytical in nature and is not advice to buy or sell assets in the financial markets
–
