This is the third post in a series of four on recent economic, financial, and political developments in the Euro-zone rooted in the sovereign debt crisis. This third post will continue the examination of the economic challenges resulting from the crisis and how regional policymakers intend on addressing them.
Keeping in mind the chart from the first post in this series, the chart below gives prescient insight into how the ECB’s future policy actions will drive the Euro. We know this to be the case because market participants have already exhausted their enthusiasm towards peripheral European debt, and if yields creep back up as the economics remain a lingering problem, there is only one option for the ECB: expand its balance sheet.
The above chart shows the ECB’s total balance sheet assets (€B) (white) plotted against the EURUSD (yellow – inverted Y-axis). The relationship expressed suggests that the greater the size of the ECB’s balance sheet, the weaker the Euro is versus the U.S. Dollar. We actually can even take away the point that as the ECB’s balance sheet contracted significantly (approximately €500B) between late-December and late-April, the EURUSD only rallied slightly. However, as the ECB’s balance sheet expanded dramatically in late-2011 through mid-2012, the EURUSD fell in line.
Accordingly, with yields suppressed in the near-term, we suggest that any further action the ECB takes will necessarily result in the reexpansion of its balance sheet, which will weaken the Euro in the short-term, despite the implication of longer-term benefits (market participants will need to see it to believe it before they can buy into a stronger Euro). In recent weeks, as significant PMI survey reports fell below consensus forecasts and evidence of increased erosion in Italian, Greek, and Spanish labor markets was released, chatter has arisen the ECB is exploring the idea of implementing a program similar to the Federal Reserve’s TALF, or Troubled Asset Relief Program, in 2008.
The TALF absorbed $200B of bad loans from American banks beginning in late-2008, thereby allowing them to unfreeze credit and resume lending to individuals and smaller enterprises. The ECB hopes to replicate the results with a potential SME lending program, or a facility for small- and medium-sized enterprises to restore credit flow to the Euro-zone economy. The program could take the shape of outright loans, which would likely have an admittedly smaller impact on the Euro and even could be positive. But what’s more likely is that the ECB utilizes the tried and true model of the Fed, opens its balance sheet and absorbs bad debt, and lets the Euro’s exchange rate suffer.
This may not be bad. According to data manipulated by Barclay’s Capital, a -10% decline in the EURUSD exchange rate would help boost Euro-zone exporters’ competitive edge, leading to a +0.75% to +0.80% boost in GDP. Long-term, when the Euro-zone economy recovers, so too will the Euro. But in the near-term, any depreciation that takes place will be at the hand of a very willing ECB – President Draghi said last week that the central bank stands “ready to act” – an ECB that will sacrifice its balance sheet for the sake of restoring credit flow to the Euro-zone. Continued downside pressure on the Euro into the 3Q’13 is likely as a result.
The final article in this series will examine the political aspect of the crisis and the upcoming calendar of Euro-zone-specific events that all market participants, both speculators and bonafide hedgers alike, will need to be aware of over the coming months.