9.4 trillion reasons why Europe needs a weak currency

Frankfurt (July 26)  Continued ultraloose European Central Bank monetary policy, accompanied by a weak, or indeed weaker euro, must be an essential part of a euro zone policy toolkit being deployed to tackle a broader debt management issue than just that of Greece.

That has major implications for Asia's investors and manufacturers with euro zone exposure.

The currency bloc's latest response to Greece's problems illustrates the broader issues in a zone where government debt totalled €9.4 trillion (HK$79.9 trillion) at the end of the first quarter of this year.

Greece had a debt to gross domestic product ratio of 177.1 per cent at the end of last year, according to Eurostat, the European Union's statistics arm.

That is now set to rise to above 200 per cent in the next few years if the IMF's latest debt sustainability analysis, delivered to euro zone leaders during the latest talks on a possible new, Greek bailout, is accurate.

"Greece's public debt has become highly unsustainable" and "can now only be made sustainable through debt relief measures that go far beyond what Europe has been willing to consider so far," the International Monetary Fund bluntly concluded.

Yet the terms offered to Greece tellingly failed to incorporate the kind of debt relief envisaged by the IMF, instead incorporating a raft of austerity measures, and the sequestration of €50 billion of Greek public assets into a special privatisation fund as collateral for the proposed package of new loans.

The terms of the package have been deemed harsh, even humiliating, by some observers, and, although accepted by the Greek parliament, they will likely provoke resentment in Greece as a whole.

So why did the euro zone dictate a deal that can be portrayed as a humiliation for Greece but will also seemingly founder in the absence of the kind of debt relief felt necessary by the IMF?

It may be that the deal's architects felt the need to crush the Syriza-led Greek government's hopes for debt relief lest other countries might look for similar concessions.

Italy and Portugal, for example, had respective debt to GDP ratios of 132.1 and 130.1 per cent at the end of last year, according to Eurostat.

But managing the euro zone's collective debt burden, when a number of member countries continue to confront the unavoidable fact that austerity policies hurt economic activity in the short term, necessitates monetary policy offsets that then feed through to the value of the euro.

As austerity programmes bear down on a country's fiscal deficit, the inevitable short-term consequences are higher unemployment and by extension lower domestic consumption.

Higher joblessness puts upward pressure on government-provided welfare payments at the same time as direct and indirect tax revenues are being hit by the rise in unemployment and the drop in consumption.

By suppressing interest rate levels, ultra-loose ECB monetary policy reduces debt servicing costs across the euro zone and helps to compensate countries going through the painful austerity process.

That in turn makes the euro less attractive compared to currencies offering higher yields, thus leading investors to reduce their estimation of the euro's value, with the effect that euro zone exports to the wider world become cheaper.

That rise in exports creates economic activity inside the euro zone, providing added benefit to countries going through the austerity process where domestic activity is subdued.

The euro zone exported €164.4 billion of goods to the rest of the world in May, compared with €160.2 billion in the same month last year.

During that period, the euro fell in value to the US and Hong Kong dollars to US$1.097 and HK$8.505, respectively, from US$1.3607 and HK$10.549 at the end of May last year.

It would be absurd not to consider at least some of the export growth was driven by pricing advantages offered by the weaker euro.

Either way, the drop in the euro's value will have hit Asian investors' portfolios, while Asian manufacturers have lost export competitiveness compared to their euro zone peers.

The weaker euro has helped the euro zone to increase its exports, thus exporting deflation overseas through exchange rate-influenced lower prices and, by eating into local manufacturers' markets, effectively steal someone else's economic growth.

If this was not bad enough for Asia, the necessity for ultraloose ECB monetary policy, and its accompanying euro weakness, as the euro zone's pursuit of structural reform will continue, with the euro's weakness only likely to be exacerbated when the US Federal Reserve raises interest rates.

Euro weakness should remain, posing challenges for Asia's manufacturers and Asian holders of euros.

Source: SCMP.co.