The eurozone looks increasingly weak. The euro slipped to parity with the dollar last week and a peripheral debt crisis threatens if interest rates rise sharply. With Italian Prime Minister Mario Draghi’s departure announced on Thursday, the stability of the euro is anything but certain.
It would not be the first time that Europe witnessed a meltdown. Exactly 100 years ago, inflation started to soar in Germany - during the summer. A year later, hyperinflation was in evidence. Naturally a comparison with those days is barely valid, but even now, the risks of a major economic upheaval on the continent are considerable.
Italy’s Five Star Party, the second largest party in its parliament, stopped a vote on Thursday on a 26 billion euro package to protect Italians from the effects of rising inflation. As a result, Prime Minister Draghi offered his resignation, which President Sergio Mattarella has so far refused.
The crisis in Italy comes at an inopportune time. Draghi, the former president of the ECB, gave the country back its credibility as prime minister of Italy, partly thanks to reforms and 6 percent growth in the economy in 2021. But with inflation high and purchasing power eroding in Italy, memories of the trauma of the previous euro crisis in 2012 are quick to come back and haunt markets. Investors fear the eurozone has little ammunition left to successfully defuse a new crisis.
ECB meets on Thursday
This week’s meeting of the European Central Bank will shed light on Europe’s next steps in terms of monetary policy. The ECB has flagged a rate hike for Thursday - 25 or maybe even 50 basis points - but since these indications were given last month, market talk of a recession in Europe has picked up. If the eurozone economy indeed reverses, hiking rates may not be the most effective medicine.
Europe’s weakness against the US was made painfully clear again this week when the euro fell to parity with the dollar, the aesthetic 1.00 exchange rate, for the first time in 20 years.
The decline stems from Europe’s economic outlook. Expectations that the eurozone would benefit from a robust recovery after the pandemic have given way to fears of recession. This was due to higher energy prices and record inflation. Europe’s dependence on Russian raw materials and the slowness with which the ECB appears to be acting are driving investors to safe havens. The safest haven this year appears to be the dollar.
At the same time, government bond spreads between the northern and southern eurozone countries are diverging due to the end of net asset purchases and an impending recession. As a result, borrowing costs in peripheral countries have risen to the highest level in almost a decade.
Concerns are high
The weak euro and widening spreads and thus high borrowing costs for southern governments add to the crisis forecasters› concerns. “The concerns about a crisis of confidence within the eurozone are extremely high,” Harald Benink, professor of Banking and Finance at Tilburg University, told BNR Nieuwsradio.
“If the ECB raises interest rates without offering support to highly indebted states, the market will attack Italian government bonds, thus ushering in a new crisis in the euro system,” said Benink. “We can no longer wait for the developments in the Ukraine.”
Han Dieperink, CIO at Auréus Asset Management, noted that every bear market victimises a country or large financial institution. “In 2008 it was Lehman and this time it might be the euro and with it the European Union,” says Dieperink.
Germany hurt
Germany - the most important economy in the euro area and number 4 in the world - is itself in serious trouble. Consumer confidence hit an all-time low. The German capitalisation of the total global market has reached a new historic low of 1.94 per cent. This is due to the underperformance of German shares and the weak euro. There are only 14 German names left in the global top 500 largest listed companies. Germany’s much-vaunted trade surplus also disappeared in May due to soaring import prices.
The low appreciation of the euro should, according to mainstream economic theory, provide a better export position for eurozone countries, but extremely high energy prices challenge this thinking. Germany’s position within the eurozone is of great importance, and a declining German economy could undermine the European Monetary Union.
Inflation dynamics
Monetary union has always been a project where the economy is overshadowed by political ambitions. High inflation, economic malaise, a sluggish ECB and weak institutional performance are a stick for Eurosceptic politicians to beat with.
According to Nobel Prize winner for economics Daniel Kahneman, the inflationary dynamics risk encouraging even more populism. “In some ways it is reminiscent of what happened in Italy and Germany in the 1920s and early 1930s. The dynamics lend themselves to exploitation by unscrupulous politicians. And so yes, I think there is a lot of cause for concern,” Kahneman said earlier this month in conversation with Investment Officer.
ING says fears exaggerated
ING›s economic desk thinks fears of a new euro crisis are exaggerated. There are few signs of economic divergence. “Debt levels are sustainable and support for the monetary union has increased significantly in recent years. Still, speculation about a crisis could be a self-fulfilling prophecy and much will depend on politics.”
Despite memories of rising bond yield spreads in 2010-2012, the risk of a further escalation seems manageable, ING said. However, «past experience shows that market speculation can quickly turn into a real crisis and liquidity problems can quickly turn into solvency problems,» the bank’s economic desk wrote.
ING is concerned that the ECB is now fighting inflation rather than deflation. “This cannot be done successfully without creating new tensions in the bond markets. Therefore, the question of who in the eurozone is the lender of last resort must be answered quickly and convincingly. It is politics that must decide. As always, the fate of the monetary union lies in their hands.”
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