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EURO: UNCERTAINTY, CHALLENGES AND ECB’S MONETARY POLICY PUZZLE

Anastasiya Mileshkina

Anastasiya Mileshkina, Currency Analyst at FBS

Anastasiya Mileshkina

Anastasiya Mileshkina

Following Macron’s landslide victory in French presidential election, the euro spiked to its highest levels in more than six months. The risks to survival of the single currency have finally receded and now investors may enjoy the back-winds from the robust economic data flowing from the Eurozone. Notwithstanding these positive changes, we see further obstacles to the euro on the upside due to numerous headwind factors.

ECB: PLAYING THE WOMAN

In the past years, the European Central Bank has implemented a series of highly expansionary monetary policies to stimulate economic growth of the EZ countries and eliminate a threat of impending deflation. The region’s economic fundamentals have recently recorded strong gains with the composite PMI rising to its six-year high and German Ifo business climate index reaching the record maximum.

Despite the strong indication of the Eurozone economic recovery, the ECB policymakers are still wary of entering the tightening cycle mainly because of the stubbornly low inflation figures. After hitting the central bank’s 2% target in February 2017, annual HCPI inflation stood at 1.5% in March and accounted for 1.9% in April. The indicator has to show a more convincing upward trend for the ECB to take out some of its easing biases. At the present moment, HCPI inflation moves in a disorderly manner justifying the ECB’s continued stimulus measures.

Investors will be waiting for any signs that the ECB moving towards the exit from its extraordinary easing measures at the upcoming meetings. With the ECB being steady on hold and not signaling a winding down of QE, the further appreciation of the euro will be limited.

DWELLING IN POLITICAL UNCERTAINTY

With French presidential election already out of the way, there are still too main political events that might hurt the euro such as parliamentary elections in France and Germany.

While the centrist Emmanuel Macron defeated the anti-EU candidate Marine Le Pen in the presidential election, he still faces a battle in the parliament. French legislative election will be held on June 11 and 18. The voters will choose 577 members of the National Assembly. Macron’s party En Marche is set to take the lead in the election race, but is not expected to win a majority. As a result, the newly elected president will likely preside over an unstable parliament.

The risk is that Macron,just like his political predecessor François Hollande, will fail to tackle France’s economic malaise and stimulate the country’s economic growth and job creation without the solid parliamentary support. If Macron manages to get the much-needed economic reforms through he will be in a better position to work with Angela Merkel and give a new impetus to EZ economic growth and integration processes.

German Chancellor Angela Merkel has been a bedrock of political stability not only in Germany, but in the entire Eurozone. She will lose the chancellorship if Christian Democrats fail to win the majority of votes in the general election scheduled on September 24. Although the odds for such unfortunate outcome are not high, they are not completely off the table.

ITALIAN BANKING AND POLITICAL TURMOIL

Italy is another perennial pressure-point for Europe. In the past months, Italian economy demonstrated a weak performance. If we look at the April reading of Italian retail sales, we will see that the nation’s private consumption remains very sluggish mainly because of the political uncertainty and country’s indebtedness. Fitch Rating downgraded Italy’s sovereign debt from BBB+ to BBB in April citing numerous the country’s unsolved economic problems and mounting political risks ahead of March 2018 elections. Recent political polls show a growing lead of the anti-EU 5 Star Movement which strives for a referendum on Italy’s membership in the Eurozone. If this political establishment manages to gain a significant popular support, the next general election will most likely result in a hung parliament unable to press ahead with meaningful economic reforms.

The most pressing concerns, however, goes beyond Italians political problems and even beyond its fragile economic growth. The biggest area of alarm is Italian banking sector. According to the government estimates, Italian banks reported 360 billion euros in non-performing bad loans in 2016. Italy is a member of the Eurozone, so its banking crisis is not just its own problem. Uncertainty in the Italian banking sector may divert risk-averse investors from Italian assets, and thus the euro, impacting its value. In addition, should Italy’s largest financial institutions fail, the country will definitely sink into a domestic economic crisis that, in turn, will significantly hurt the value of the euro. The domino effect will make the negative consequences spread to other euro economies.

GREECE: BEING SADDLED WITH DEBT

Another epicenter of the euro region’s turmoil is Greece which is currently in talks with EU officials over its debt relief. While the deal is still not reached, the further round of negotiations is planned in the upcoming weeks. Whether Greek authorities manage to strike a debt-relief agreement with the Troika is still a question mark. There is also great uncertainty regarding the ability of the unpopular Alexis Tsipras’s government to bring the country’s economy to a more sustainable level in terms of debt serviceability. The debt-relief deal should be reached before the September election in Germany. Otherwise, Ms.Merkel will unlikely trade her solid electoral support for the Greece’s bailout. And if this bailout payment is forgone, the probability of country’s default will rise opening up a discussion around a Grexit.

All these potentially ground-shaking events and economic problems that we’ve identified in our article represent challenges for the euro area and the single currency. Whether the Eurozone manages to withstand these plentiful financial and political headwinds is the question that still needs to be answered. Given the degree of sustainability the euro area demonstrated in the past years, we remain optimistic and expect it manages to scrape through the spate of crises that are yet to come.

Global Banking & Finance Review

 

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