European Central Bank in currency war
ECB might have set off the economic equivalence of World War III. On 22 January, Mario Draghi, president of the European Central Bank (ECB) announced a new programme of asset purchases. This is not the first time that ECB will be buying debt securities. However, this will be the first time it will be buying sovereign bonds issued by member countries of the euro area. The amount of monthly bond purchases, including purchases being done under the existing programme, will be €60 billion. Those who are interested in the details can refer to the website of ECB. The programme will run at least up to September 2016 with the announcement leaving room for further extension. The market thinks that ECB is serious and that it amounts to a credible currency debasement.
The euro-dollar exchange rate has dropped from 1.16 to around 1.12 as I write this. The market is right to believe that the ECB president is serious about debasing the single currency. The following sentence in his introductory remarks at the press conference is a plaintive cry to the market to weaken the euro: "...today's decisions will support our forward guidance on the key ECB interest rates and reinforce the fact that there are significant and increasing differences in the monetary policy cycle between major advanced economies..." It is evident that the expanded asset purchase programme is actually all about weakening the currency. It is a beggar-thy-neighbour policy. Draghi's anxiety to draw the attention of the market to the diverging monetary policy stance between the euro zone and, say, the US, is noth- ing but an attempt to push the euro down against the US dollar.
This validates the point that Reserve Bank of India governor Raghuram Rajan made at the Brookings Institution in April 2014 that quantitative easing (QE) was nothing but quantitative external easing (QEE), something that the West took exception to when emerging economies followed such an approach.
Whether it is QE or QEE, the question, as always, is whether these measures would help revive economic growth in the euro zone and improve employment prospects. Let us examine the QE aspect of the ECB announcement, first. We start with his confession: "...second, while the monetary policy measures adopted between June and September last year resulted in a material improvement in terms of financial market prices, this was not the case for the quantitative results..." Draghi acknowledges that the measures launched last year have boosted asset prices in financial markets but done little else.
If anything, euro zone economies slid further into recession and a possible deflation. That should make sensible people wonder if they have been administering the wrong medicine to the patient. But, the policy czars at central banks in the developed world are cut from a different cloth. If the medicine proved ineffective, their only answer is that the dosage must be increased.
In his introductory statement, the president of ECB laid great stress on fighting deflation. In fact, deflation disappears if we examined core CPI inflation in the euro zone. Core consumer prices rose (all items ex-energy) 0.6% year on year in the eurozone in December 2014. That is reasonable for the euro zone economy considering that it is in recession (or almost) with high unemployment in many countries. Consumer price deflation at the headline level is mainly due to the collapse in the price of crude oil. That should already translate into an economic stimulus for euro zone consumers. Now, the weaker euro will offset the advantage of consumption stimulus from the oil price plunge. Further, Draghi spoke of the need to support money and credit growth in the euro zone. Do euro zone sovereigns really need a lower interest rate? As things stand, yields on the 10year sovereign bonds issued by Italy and Spain (around 1.5% to 1.6%) are lower than that of the yield on the US 10-year Treasury note (around 1.8%).
France and Germany have even lower yields. Investors are, for reasons best known to them, willing to lend money to Italy and Spain at these yields. Hence, cost of capital does not appear to be a deterrent either for euro zone sovereigns or for willing non-sovereign and non-financial borrowers. The impact of the weak euro will be felt more in China. It announced a gross domestic product (GDP) growth rate of 7.4% for 2014.
M1 money supply growth suggests a much lower GDP growth. On its part, the International Monetary Fund (IMF) has downgraded its growth forecast for China to below 7% for 2015 and further lower in 2016. The real risk, however, is that China's growth rate falls not just to 6.8% from 7.4% but much lower. In that event, what will China do? It cannot sit by and watch passively as Japan and the euro zone take market share away from it. Hence, the ECB decision of 22 January has narrowed the odds on a maxi-China monetary policy move considerably.