ECB ready to save the Euro - In-between the lines - 02.08.2012

(PresseBox) ( Frankfurt am Main, )
- ECB ready to save the Euro
- Euro-area current account improves, while capital account is not collapsing
- Gold is too speculative to benefit more from Euro-debt crisis

Markets reacted with disappointment to the ECB decision today. The main disappoint was not the decision to leave rates unchanged but the statement regarding bond purchases following comments by president Draghi last week. Draghi said today that the ECB stands ready to take new exceptional measures including buying government bonds provided governments continue with fiscal and structural adjustments, EFSF and/or ESM are activated to intervene in government bond markets and the ECB itself deems the measures as necessary to serve its mandate. The ECB will decide later what measures it will exactly take, given these guidelines.

Markets were disappointed by the conditionality, vagueness and the lack of a timetable. In our judgment, however, the ECB made very clear that it views the current bond market conditions as a key risk for the Euro and is determined to act. Importantly, Draghi stressed that size and possible sterilization of the measures are to be adequate and not pre-determined. Concerning the conditionality, Greece certainly does not qualify, but Spain does. The Spanish bank rescue program also explicitly allows for the purchase of bonds by the EFSF. All that is missing is for the EFSF to take the first step. Thus, ECB action could come faster than markets expect.

Euro holds up better than feared

One notable outcome in the latest round of the Euro crisis has been the depreciation of the Euro itself. From its peak in the first quarter, the Euro fell about 9% against the Dollar. In effective terms, the Euro fell 6% over the same time period and is now weaker than it was in mid 2010 when it fell below 1.20 versus the Dollar. There are neither signs that the ECB deliberately drove the Euro weaker nor that it is uncomfortable with the depreciation. Indeed, gradual currency depreciation, whether deliberate or as a byproduct, has to be part of the Euro-area's monetary adjustment. Nevertheless, it seems curious why the Euro has not fallen more. The simple answer is that the Dollar is not in much better shape. A closer look shows three important factors.

First, the Euro-area current account is moving into surplus. Unlike the US, the Euro area never had a large permanent current account deficit. Shifts in the balance have been cyclical. However, regional differences have been huge, with the periphery running large deficits, which were offset by the surplus in Germany. This is changing. Germany still runs a large surplus, but the deficits elsewhere are shrinking, pushing the balance into surplus. Irelands current account balance, for example, moved from a large deficit into a surplus. Spain's and Portugal's deficits shrank by 65% and 50% respectively. The IMF estimates that the Euro-area's current account will move from a deficit of nearly 1% of GDP in 2008 to a surplus of about 1% of GDP this year. In our judgment, the adjustment will be even bigger.

Second, there is no large-scale capital flight. Clearly, the weakness of the Euro is a sign of capital leaving or avoiding the Euro area. However, the exodus is not as large as one would expect. Net portfolio outflows amounted to EUR47.4 billion over the first five months of the year, which is just 0.1% of GDP. The outflows are largely due to foreign investors, such as US money market funds. Domestic investors, on the other hand, have not rushed for the door. Instead, the capital movements are largely within the Euro area. This is particularly true for banks and explains the huge bank deposits at the ECB and the widening gap in sovereign bond yields between the core and the periphery.

Third, reserve managers are still buying the Euro. Reserve managers in the rest of the world, especially Emerging Markets express concern over the Euro and there are reports that some are reducing their positions. Official reserve figures also show that the share of the Euro in global reserves has fallen from 28% in 2008 to about 24%. However, this has more to do with the valuation effect of the Euro depreciation. In absolute terms, global reserve managers increased their Euro holdings by EUR250 since 2008. The increase in Euro holdings is most significant with those Euro-area neighbors that are managing their currency versus the Euro, such as Switzerland, Denmark and Norway. Their buying of Euros contributes to the strong performance of sovereign bonds in the core, including France.

Gold disappoints

While the Euro has held up surprisingly well, gold has not performed as well as it could, given market uncertainty. Two years ago, we predicted that the gold price could reach USD2,000 per ounce within two years, due to growing investment demand. We came close to our target last year at the height of the Euro crisis. Since then gold has underperformed. The gold price fell 15% in Dollar terms and barely held its level in Euro terms. Three factors explain the development. First, opinions over the fair value of gold differ widely. Nevertheless, hardly anyone views current prices as cheap. Second, gold benefited a lot from the rising fear of inflation in the first half of last year. The fear of inflation is not gone, certainly not in Germany, but global price and output dynamics make deflation currently the bigger concern. Third, gold was seen as save haven against global economic and financial uncertainties. However, gold turned out not to be a stable asset in itself. This should not have been surprising, given the various and traditionally volatile supply and demand conditions. What has increased the volatility of gold is the growing participation of investors. Many are not holding gold as long-term investments but for speculative purposes. The volatility was compounded by the use of leverage, mostly in the form of gold derivatives and structured products.


This analysis was prepared by Bernhard Eschweiler, Senior Economic Advisor, and was first published 2 August 2012, Silvia Quandt Research GmbH, Grüneburgweg 18, 60322 Frankfurt is responsible for its preparation. German Regulatory Authority: Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), Graurheindorfer Str. 108, 53117 Bonn and Lurgiallee 12, 60439 Frankfurt.

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