QE: Competitive devaluation, or stealth bank recapitalisation?
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.