Euro-Zone & UK - Show Time

We continue with our watch list albeit I’ am not captioning it so.

Euro-zone has put together its own stimulus package. Given that the nature of the union where each country has its own typical problem and the political setup has to address its own constituencies it will interesting to watch how the union overcomes these issues keeping its common interest in view. DB research observes:

“At their recent summit the EU heads of state and government adopted the European Economic Recovery Plan put forward by the European Commission in late November. The 27 member states aim to raise 1.2% of GDP, or EUR 170 bn, to fight the recession in Europe (another EUR 30 bn will come from the EIB). The member states are free to choose instruments from a fiscal tool box in order to stimulate growth in their (national) economies. The EU has merely a coordinating role. This approach makes sense for two reasons: one is that the economic problems in the member states have quite different starting points. For instance, the United Kingdom and Spain are confronted with a serious crisis in the real estate sector, while Germany has to grapple with a slump in foreign demand. The other reason, though, is that in a single market with close economic ties it is vital that national measures do not cancel out the efforts of other member states and that these other members do not remain idle in hopes of benefiting from the economic policies implemented by their partners.”

Time Magazine has made a timely observation:

“The euro's 10th anniversary will see the euro zone take on a 16th member, Slovakia. Eight other central and East European countries have set the goal of joining within the next six years, including Poland, whose political establishment dropped its longtime opposition after a recent run on the Polish zloty. The euro has found some other unexpected converts too, thanks to the financial crisis. The Danes voted against joining the euro zone in 2000, but they are set to hold another referendum in March. Iceland — not even an E.U. member — is pondering "unilateral euroization" after seeing its krona plunge nearly 80% against the euro in September and October.

And the biggest prize of all, Britain, is said to be warming to the euro … recently claimed that London is "closer than ever before" to euro-zone entry and that "the people who matter in Britain" think it should join. That may be overstating things a bit, but a report by research group Chatham House warns that as the euro zone grows, the U.K. risks being excluded from "deeper intra-E.U. economic consultation and coordination, including in areas of significant national interest, such as financial market regulation."

It doesn't help that the pound is wilting. Two years ago, one euro was worth just £0.65. Now, humbled by bank crashes, government bailouts and a collapsing housing market that has forced massive interest rate cuts, Europe's currency is within a pence or two of parity with the pound. "The debate has changed from a total fantasy in the U.K.," … "The political obstacles still remain strong, but it has changed the perception of the U.K. as the perfect system."

…financial crisis has been a defining moment for the euro, but he cautions against too much praise. The euro is still some way from dethroning the dollar as a global currency; just 27% of global foreign exchange reserves are held in Euros compared with 62% in dollars.”

This development could be a key one to keep a tab on as it may have repercussion on majority of the asset classes.

We also need to see how the ECB responds to the US ZIRP (Zero Interest Policy). The ECB has already indicated that it will do what is necessary.

“The economy may be even weaker in 2009 than the ECB’s prediction of last month for a contraction of about 0.5 percent … The Frankfurt-based central bank will “act appropriately” and has room to do so if the slowdown threatens price stability, which the ECB defines as inflation just below 2 percent in the medium term …

The inflation rate fell to 1.8 percent last month, beneath the ECB’s target for the first time since July 2007, according to the median of 20 forecasts given by economists before a report scheduled for release in the coming week.

“If, in our assessment, the risks to price stability change further in the coming months, monetary policy could be eased further and we will act appropriately…
Bank of America Corp. is among those anticipating the economy will be weaker than the ECB projects this year with a forecast for a 2.5 percent contraction. They expect the ECB to cut its benchmark to 1.5 percent this quarter…”

Also BOE recently cut its policy interest rate by 0.5% to 1.5% - its lowest in the 314 years history. It noted that consumer spending has “weakened” the outlook for investment has “deteriorated” and the availability of credit has “tightened further.” The fact that it did not cut more aggressively as US did it appears is because it feels that with GBP’s massive depreciation import led inflation will check deflationary pressures while helping its export economy. Also its fiscal stimulus package is to be supported by a deficit that would be about 8% of GDP. It may therefore did not move to ZIRP and has kept the rate based handle. Beyond ZIRP would be quantitative easing – BOE buying government debt and releasing money into the system – which it feels may accentuate the inflationary pressures. It is also possibly looking to go slow to see if it can avoid the pains of reversal of the quantitative easing (by not adopting it) when shooting interest rate could create different set of problems to handle.

Further moves by BOE and the UK government will be based on to what degree its slight optimism (as reflected in policy action) fails. As Economist explains:

“The outlook for 2009 is dispiriting. Despite the fillip from the temporary reduction in value-added tax, consumer spending will fall sharply. Households will retrench as unemployment rises and those with jobs fear they may lose them. Spending will be hit, too, by weak stock markets and shrinking housing wealth. House prices fell by 15.9% in the year to December, according to Nationwide Building Society.

The economy will also be clobbered by cuts in capital spending. Since the prices of homes still have a long way to fall, housing investment will remain depressed. Businesses are already cutting their capital programs, with more to come in the year ahead. Capital Economics is predicting that GDP will fall by 2.5% in 2009, the biggest annual decline in the past 60 years.

A common cause of these downward pressures on the economy is the banking malaise, which has undermined equity and property markets and curtailed the routine provision of finance to business. That makes it all the more ominous that banks are expecting to restrict credit still further. A survey by the Bank of England published on January 2nd found that lenders had reduced the availability of credit to both households and companies in the three months to mid-December and expected to curb it still further in the first quarter of 2009."

Reports say that after criticizing UK for its inane Keynesian approach, Germany is backtracking is likely to announce a stimulus (estimated at euro 50bn.) backed by deficit spending. This expert observes:

“But the modest deficit-spending will do little to prevent a contraction of 2-3% in Germany’s GDP and will add to government debt. Here there was a warning on Wednesday. An auction of 10-year government bonds met with poor demand. The Bundesbank retained a third of the bonds it had planned to sell. Longer-term interest rates may be driven up.

The warning might better be heeded by the US and UK than by Germany itself. Germany’s budget is close to balance. The UK and US have projected deficits of about 8% of GDP which might easily get worse. The UK government plans to sell £146bn in debt this year. Are investors ready to take it?”

Euro-Zone & UK’s show time is fast approaching.

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