QE: Com­pet­i­tive de­val­u­a­tion, or stealth bank re­cap­i­tal­i­sa­tion?

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

The bat­tle for morale is half the war. So it is likely to prove in the eu­ro­zone, where the im­pact of quan­ti­ta­tive eas­ing will hinge on how in­vestors per­ceive the Euro­pean Cen­tral Bank’s pol­icy. If they re­gard it pri­mar­ily as a com­pet­i­tive de­val­u­a­tion, which would be deeply de­fla­tion­ary for the world econ­omy, then it will make good sense to re­main long eu­ro­zone bonds and short the euro. On the other hand, if mar­kets de­cide QE amounts to a back­door re­cap­i­tal­i­sa­tion of Europe’s bank­ing sec­tor, then the out­look will favour eu­ro­zone eq­ui­ties in gen­eral, and bank stocks in par­tic­u­lar.

So far, it looks as if mar­kets are lean­ing to­wards the com­pet­i­tive de­val­u­a­tion sce­nario. Per­haps that should not be too sur­pris­ing. The eu­ro­zone as a whole al­ready has a siz­able cur­rent ac­count sur­plus, and Ger­many is run­ning a mas­sive sur­plus, equal to 7% of its gross do­mes­tic prod­uct. For such a ma­jor econ­omy to op­er­ate such a big cur­rent ac­count sur­plus ex­erts a heavy re­ces­sion­ary in­flu­ence on the rest of the world. Nor­mally this is a sign that its ex­change rate is un­der­val­ued and that the econ­omy in ques­tion is pur­su­ing a mer­can­tilist pol­icy. sur­plus econ­omy ex­pan­sion­ary pol­icy.

Yet what have we seen in the last few days? Far from revalu­ing, the coun­try with prob­a­bly the most for­mi­da­ble in­dus­trial sys­tem in the world has just de­val­ued mas­sively. The prob­lem is that Ger­many is tied into a fixed ex­change rate sys­tem with a bunch of coun­tries in­clud­ing Italy, France and Spain which are not re­motely com­pet­i­tive with Ger­many. As a re­sult, their in­dus­trial pro­duc­tion in­dexes have col­lapsed since the in­tro­duc­tion of the sin­gle cur­rency. As a good Ital­ian, ECB pres­i­dent Mario Draghi has de­cided that the so­lu­tion is to de­value the euro to re­store Italy’s com­petive­ness, not against Ger­many, which is im­pos­si­ble within the sin­gle cur­rency, but against the rest of the world out­side the eu­ro­zone.

Ac­cord­ing to one of our an­a­lysts’ work on pur­chas­ing power par­i­ties, PPP be­tween Ger­many and the US im­plies an ex­change rate of around EUR 1.40. For France it is about EUR 1.20, and for Italy and Spain EUR 1.10. So at EUR 1.12 to­day, Ger­man ex­porters are pos­i­tively coin­ing it. French com­pa­nies are at last mak­ing prof­its again, while Ital­ian and Span­ish firms have stopped los­ing money. But for France, Typ­i­cally the so­lu­tion to revalue and to is to follow press the a more Spain and Italy the gains will be muted. En­joy­ing ab­nor­mal prof­its, Ger­man com­pa­nies will be in a po­si­tion to ramp up cap­i­tal spend­ing, en­sur­ing the rel­a­tive de­cline of their eu­ro­zone com­peti­tors con­tin­ues as pro­duc­tiv­ity in Ger­many ex­plodes.

Mean­while, be­cause de­val­u­a­tions al­ways im­pov­er­ish the con­sumer, Ger­man, French, Ital­ian and Span­ish im­ports from out­side the eu­ro­zone will fall. As a re­sult, Ger­many’s cur­rent ac­count sur­plus will reach 10% of GDP, ex­ac­er­bat­ing the de­fla­tion­ary and re­ces­sion­ary pres­sures on the rest of the world. In short, un­der the com­pet­i­tive de­val­u­a­tion sce­nario we are back to the 1930s.

The ques­tion is: Which way will per­cep­tions swing? The an­swer, we sus­pect, will show up in the per­for­mance of Euro­pean bank stocks. If they out­per­form over com­ing weeks, it is likely eu­ro­zone stocks in gen­eral will out­per­form by enough to com­pen­sate for the fall in the euro, and QE will be seen to have worked. If, on the other hand, eu­ro­zone banks and eq­ui­ties fail to out­per­form, then all we are left with is a pol­icy of com­pet­i­tive de­val­u­a­tion from an eco­nomic zone al­ready run­ning a siz­able cur­rent ac­count sur­plus. In that case, the im­pli­ca­tions for the global econ­omy and mar­kets will be deeply de­fla­tion­ary.

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